Chapter 01

Basics of Derivatives
Basics of • A derivative is a financial
instrument or contract whose
Derivatives value depends on the value of
another asset, referred to as the
underlying asset. These underlying
assets can range across various
categories, including metals,
energy resources, agricultural
commodities, and financial assets.
Derivative Markets: History and
Evolution
CME introduced the
CBOT listed the US's International
CBOT introduced
Sellers signed A futures market in first ‘exchange Monetary Market,
Treasury bill futures
contracts promising rice was developed traded” derivative which allowed
and T-Bond futures
future delivery in in Japan at Dojima contract (Futures trading in currency
contract.
Europe. near Osaka. contract). futures.

13th Century 1848 1919 1973 1982

12th Centry Late 17th 1865 1972 1975–1977

century

Chicago Board
Multiple examples of CME introduced the
Chicago Board of Chicago Mercantile Options Exchange
contracts with Eurodollar futures
Trade (CBOT) Exchange (CME) was became the first
English Cistercian contract, and the
facilitated trading of reorganized to allow marketplace for
Monasteries, who Kansas City Board of
forward contracts. futures trading. trading listed
frequently sold their Trade launched the
options.
wool up to 20 years first stock index
in advance to futures.
foreign merchants.
Factors influencing the growth of derivative market globally

Technological
High volatility in Global integration of advancements
financial markets. financial markets. reducing transaction
costs.

Increased Frequent innovations

understanding of and new applications
advanced risk of derivative
management tools. products.
 Indian Derivatives Market

1996 1999
SEBI established a committee led by The Securities Contract Regulation
Dr. L. C. Gupta to create a Act was amended to classify
regulatory framework for "derivatives" as securities, and a
derivatives trading in India. regulatory framework for their
trading was introduced.
SEBI formed a group under Prof. J.R. Exchange-traded derivatives were
Verma to recommend risk launched when SEBI allowed BSE and
containment measures for the Indian NSE to introduce the equity
derivatives market. derivatives segment.

1998 2000
Products in the Derivatives Market

Forwards: A customized, over-the-

counter contract between two parties Futures: Like forwards but traded on a
to buy or sell an asset at a pre-agreed regulated exchange with standardized
price on a future date. Both parties terms like lot size and maturity date.
must complete the transaction Futures are essentially exchange-
regardless of the asset's price at traded forward contracts.
delivery time.

Swaps: An agreement between two

Options: A contract giving the buyer
parties to exchange cash flows in the
the right, but not the obligation, to
future based on a predetermined
buy or sell an asset at a specific price
formula, often used to manage risks
before or on a set date. The buyer
related to interest rates, currency
pays a premium, and the seller must
exchange rates, or commodity prices.
fulfill the contract if the buyer
Swaps are essentially a series of
exercises the option.
forward contracts.
 Market Participants

01 02 03
Hedgers: Market Speculators/Traders: Arbitrageurs: Traders who
participants like Investors who predict profit by exploiting price
corporations and banks future price movements of differences of the same
that use derivatives to assets and take positions asset in different markets,
reduce the risk of price in derivatives for profit. buying low in one and
fluctuations in assets such They prefer derivatives for selling high in another.
as interest rates, stock trading because of Arbitrage opportunities
prices, and commodities. leverage, lower costs, and are short-lived as traders
faster execution. close the price gaps
quickly.
 Types of Derivatives Market

Exchange-Traded Derivatives: Over-the-counter (OTC) Derivatives:

• Traded on organized exchanges. • Traded directly between counterparties
• Contracts are standardized, and prices via phone or electronic media.
are determined through an auction • Contracts are customized to fit specific
system. needs.
• A clearing corporation guarantees the • Less regulated, with private
settlement of transactions, ensuring transactions and decentralized risk
performance. management.
• No formal rules for risk management or
limits on positions, leverage, or
margining.
• Participants include banks, financial
institutions, hedge funds, corporations,
and high-net-worth individuals.
 Significance of Derivatives

01 02 03
Price Discovery: It helps Risk Transfer: It allows Market Organization: It
in determining asset risk to be transferred shifts speculative
prices based on real from those with low risk activities from
valuations and market tolerance (e.g., unregulated markets to
expectations. hedgers) to those organized ones,
willing to take on more providing better risk
risk (e.g., traders). management and
enhancing financial
system stability.
 Various risks faced by the participants in derivatives

01 02 03 04
Counterparty Risk: Price Risk: Losses Legal/Regulatory Operational Risk:
The risk that the due to Risk: Issues with Problems like
other party unfavorable price contract fraud, poor
defaults. movements.Liquid enforceability. documentation, or
ity Risk: Difficulty execution errors.
in exiting a
position.
Thank You