FUTURE OF DERIVATIVES IN INDIA

RATAN DEEP SINGH – 200628522

SYMBIOSIS CENTRE FOR MANAGEMENT STUDIES

YEAR : 2006

ACKNOWLEDGEMENT

I would like to thank my guide Mr. Pankaj Arora (Portfolio Investment Analyst) for his kind

guidance and support through the project. He has always been there whenever I need any

expert advice and have been more than willing to go out of the way to help.

Finally, I would also like to take this opportunity to thank all my friends who took out time to

go through our documents and provide me positive criticism. The project would not have been

a value addition without the help of the above stated people.

INDEX

Sr. no. Particulars Page nos.

1 Introduction to the topic :

- Meaning of Derivative

- Is Derivative an Asset

- Introduction to Derivative Market

- History of Derivatives

- Introduction of Derivative in India

01

02

03

03

04

2 Brief Overview of Derivatives Transactions :

- Types of Derivative Market

- Types of Traders in Derivative Market

- Types of Derivatives Transactions

- How a Forward Contract Works

- Relationship between Forward & Expected Future Price

- Overview of Futures Derivatives

- Difference between Forward & Future Contract

- Overview of Options Derivatives

- Role of an Options Market

- Various Types of Options Transactions

- Description of Swap Derivative Market

- Types of Swap Transactions

- Uses & Advantage of Swaps Transactions

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07

09

10

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13

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3 Research Methodology :

- Statement of Problem

- Scope of the Project

- Objective of the Study

- Type of Research

- Source of Data collection

- Limitations of the Study

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42

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4

Analysis :

- Importance of Derivatives

- How Derivative is Useful for Indian Economy

- Derivative Market & Financial Risk

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45

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5 Findings Suggestions & Conclusions :

- How risk can be minimize associated with Derivatives

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6 Bibliography : 48

INTRODUCTION TO THE TOPIC :

1.1 Meaning of Derivative -

A Derivative is an agreement or contract that is not based on a real or true exchange. A

derivative is a kind of security whose price or value is determined by the value of the

underlying variables. It is more like a contract of future date in which two or more parties are

involved to alleviate future risk. For example, a person goes to the grocery store, exchanges a

currency (money) for a commodity (say, an apple). The exchange is complete, both parties

have something tangible. If the purchaser had called the store and asked for the apple to be

held for one hour while the purchaser drives to the store, and the seller agrees, then a

derivative has been created. The agreement (derivative) is derived from a proposed exchange

(trade money for apple in one hour, not now).

Usually, derivatives enjoy high leverage. Its value is affected by the volatility in the rates of

the underlying asset. To see the volatility of derivatives, we take the same above example:

Previously seller agreed to sell same apple for Rs.10 but now he can also charge to stop the

sale & store the same thing for next an hour.

In financial terms, a derivative is a financial instrument - or more simply, an agreement

between two people or two parties - that has a value determined by the price of something else

(called the underlying). Some of the widely known underlying assets are:

Indexes (consumer price index (CPI), stock market index, weather conditions or

inflation)

Bonds

Currencies

Interest rates

Exchange rates

Commodities

Stocks (equities)

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In a strict sense, derivatives are based upon all those major financial instruments, which are

explicitly traded like equity, debt instruments, forex instruments and commodity based

contracts. Thus, when we talk about derivatives, we usually mean only financial derivatives,

namely, forward, futures, options, swaps etc. The peculiar features of these instruments are

that:

They can be designed in such a way so as to the varied requirements of the users either by

simply using any one of the above instruments or by using a combination of two or more such

instruments.

They can be designed and traded on the basis of expectations regarding the future price

movements of underlying assets.

They are all off-balance sheet instruments and they are used as device for reducing the risks of

fluctuations in asset values. As the word implies, a derivative instrument is derived from

“something” backing it. This something may be a loan, an asset, an interest rate, a currency

flow, a stock trade, a commodity transaction, a trade flow etc. Derivatives enable a company

to hedge ‘this something’ without changing the flow associated with the business operation.

1.2 Is Derivative an Asset -

Referring to derivatives as assets would be a misconception, since a derivative is incapable of

having value of its own. However, some more commonplace derivatives, such as swaps,

futures, and options, which have a theoretical face value that can be calculated using formulas,

are frequently traded on open markets before their expiration date as if they were assets. It is a

financial contract with a value linked to the expected future price movements of the asset it is

linked to such as a share or a currency. However, since a derivative can be placed on any sort

of security, the scope of all derivatives possible is near endless. Thus, the real definition of a

derivative is an agreement between two parties that is contingent on a future outcome of the

underlying & should not be treated as an Asset.

2

1.3 Introduction to Derivative Market -

Referring The Derivatives Market is meant as the market where exchange of derivatives takes

place. Derivatives are one type of securities whose price is derived from the underlying assets.

And value of these derivatives is determined by the fluctuations in the underlying assets.

These underlying assets are most commonly stocks, bonds, currencies, interest rates,

commodities and market indices. As Derivatives are merely contracts between two or more

parties, anything like weather data or amount of rain can be used as underlying assets. The

Derivatives can be classified as Future Contracts, Forward Contracts, Options, Swaps and

Credit Derivatives. The market can be divided into two, that for exchange-traded derivatives

and that for over-the-counter derivatives. The legal nature of these products is very different as

well as the way they are traded, though many market participants are active in both.

1.4 History of Derivatives -

With the opening of the economy to multinationals and the adoption of the liberalized

economic policies, the economy is driven more towards the free market economy. The

complex nature of financial structuring itself involves the utilization of multi currency

transactions. It exposes the clients, particularly corporate clients to various risks such as

exchange rate risk, interest rate risk, economic risk and political risk.

With the integration of the financial markets and free mobility of capital, risks also multiplied.

For instance, when countries adopt floating exchange rates, they have to face risks due to

fluctuations in the exchange rates. Deregulation of interest rate cause interest risks. Again,

securitization has brought with it the risk of default or counter party risk. Apart from it, every

asset whether commodity or metal or share or currency is subject to depreciation in its value.

It may be due to certain inherent factors and external factors like the market condition,

Government’s policy, economic and political condition prevailing in the country and so on.

3

India had started with a controlled economic system and from there it moved on to become a

destination that witnesses constant fluctuation in prices on a daily basis now. Persistent efforts

of Reserve Bank of India (RBI) in building currency forward market and liberalization process

provided the risk management agencies their much needed momentum. Derivatives are the

indispensable components of liberalization process to handle risk. With National Stock

Exchange (NSE) measuring the market demands, the process of launching derivative markets

in India got started. In the year 1999, derivatives trading took place in India.

1.5 Introduction of Derivative in India -

In India, all attempts are being made to introduce derivative instruments in the capital market.

The National Stock Exchange has been planning to introduce index-based futures. A stiff net

worth criteria of Rs.7 to 10 corers cover is proposed for members who wish to enroll for such

trading. But, it has not yet received the necessary permission from the securities and Exchange

Board of India.

In the forex market, there are brighter chances of introducing derivatives on a large scale.

Infact, the necessary groundwork for the introduction of derivatives in forex market was

prepared by a high-level expert committee appointed by the RBI. It was headed by Mr. O.P.

Sodhani. Committee’s report was already submitted to the Government in 1995. As it is, a few

derivative products such as interest rate swaps, coupon swaps, currency swaps and fixed rate

agreements are available on a limited scale. It is easier to introduce derivatives in forex market

because most of these products are OTC products (Over-the-counter) and they are highly

flexible. These are always between two parties and one among them is always a financial

intermediary.

However, there should be proper legislations for the effective implementation of derivative

contracts. The utility of derivatives through Hedging can be derived, only when, there is

transparency with honest dealings. The players in the derivative market should have a sound

financial base for dealing in derivative transactions. What is more important for the success of

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derivatives is the prescription of proper capital adequacy norms, training of financial

intermediaries and the provision of well-established indices. Brokers must also be trained in

the intricacies of the derivative-transactions.

Now, derivatives have been introduced in the Indian Market in the form of index options and

index futures. Index options and index futures are basically derivate tools based on stock

index. They are really the risk management tools. Since derivates are permitted legally, one

can use them to insulate his equity portfolio against the vagaries of the market.

Every investor in the financial area is affected by index fluctuations. Hence, risk management

using index derivatives is of far more importance than risk management using individual

security options. Moreover, Portfolio risk is dominated by the market risk, regardless of the

composition of the portfolio. Hence, investors would be more interested in using index-based

derivative products rather than security based derivative products.

There are no derivatives based on interest rates in India today. However, Indian users of

hedging services are allowed to buy derivatives involving other currencies on foreign markets.

India has a strong dollar- rupee forward market with contracts being traded for one to six

month expiration. Daily trading volume on this forward market is around $500 million a day.

Hence, derivatives available in India in foreign exchange area are also highly beneficial to the

users.

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1. BRIEF OVERIVEW OF DERIVATIVES TRANSACTIONS :

2.1 The Types of Derivative Market -

Indian derivatives markets can be divided into two types including 1) the transaction which

depends on the exchange, and 2) the transaction which takes place 'over the counter' in one-to-

one scenario. They can thus be referred to as:

Exchange Traded Derivatives

Over the Counter (OTC) Derivatives

Over the Counter (OTC) Equity Derivatives

Operators in the Derivatives Market

So, mainly classification of Derivative Market is as Exchange Traded Derivatives Market and

Over the Counter Derivative Market.

Exchange Traded Derivatives are those derivatives which are traded through specialized

derivative exchanges whereas Over the Counter Derivatives are those which are privately

traded between two parties and involves no exchange or intermediary. Swaps, Options and

Forward Contracts are traded in Over the Counter Derivatives Market or OTC market.The

main participants of OTC market are the Investment Banks, Commercial Banks, Govt.

Sponsored Enterprises and Hedge Funds. The investment banks markets the derivatives

through traders to the clients like hedge funds and the rest.

In the Exchange Traded Derivatives Market or Future Market, exchange acts as the main party

and by trading of derivatives actually risk is traded between two parties. One party who

purchases future contract is said to go “long” and the person who sells the future contract is

said to go “short”. The holder of the “long” position owns the future contract and earns profit

from it if the price of the underlying security goes up in the future. On the contrary, holder of

the “short” position is in a profitable position if the price of the underlying security goes

down, as he has already sold the future contract. So, when a new future contract is introduced,

the total position in the contract is zero as no one is holding that for short or long.

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2.2 The Types of Traders in Derivative Market -

1. Hedgers – are those traders who are interested in transferring a risk element of their

portfolio. Those who protect themselves from the risk associated with the price of an asset

by using derivatives. A person keeps a close watch upon the prices discovered in trading

and when the comfortable price is reflected according to his wants, he sells futures

contracts. In this way he gets an assured fixed price of his produce. In general, hedgers use

futures for protection against adverse future price movements in the underlying cash

commodity. Hedgers are often businesses, or individuals, who at one point or another deal

in the underlying cash commodity.

Example - A Hedger pay more to the farmer or dealer of a produce if its prices go up. For

protection against higher prices of the produce, he hedges the risk exposure by buying

enough future contracts of the produce to cover the amount of produce he expects to buy.

Since cash and futures prices do tend to move in tandem, the futures position will profit if

the price of the produce raise enough to offset cash loss on the produce.

2. Speculators - They are the second major group of futures players. These participants

include independent floor traders and investors. They handle trades for their personal

clients or brokerage firms.

Buying a futures contract in anticipation of price increases is known as ‘going long’.

Selling a futures contract in anticipation of a price decrease is known as ‘going short’.

Speculative participation in futures trading has increased with the availability of

alternative methods of participation. Speculators traders who deliberately go for risk

components from hedgers in look out for profit. Speculators are somewhat like a middle

man. They are never interested in actual owing the commodity. They will just buy from

one end and sell it to the other in anticipation of future price movements. They actually

bet on the future movement in the price of an asset.

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3. Arbitrators – are those traders who work in various markets at the same time in order to

gain profit and do away with mis-pricing.

According to dictionary definition, a person who has been officially chosen to make a

decision between two people or groups who do not agree is known as Arbitrator. In

commodity market Arbitrators are the person who takes the advantage of a discrepancy

between prices in two different markets. If he finds future prices of a commodity edging

out with the cash price, he will take offsetting positions in both the markets to lock in a

profit. Moreover the commodity futures.

Arbitrators investor is not charged interest on the difference between margin and the full

contract value.

Traders Comparison - Speculators are superiors & have certain advantages over other

investments they are as follows -

If the trader’s judgment is good, he can make more money in the futures market.

Faster because prices tend, on average, to change more quickly than real estate or stock

prices.

Futures are highly leveraged investments. The trader puts up a small fraction of the value

of the underlying contract as margin, yet he can ride on the full value of the contract as it

moves up and down. The money he puts up is not a down payment on the underlying

contract, but a performance bond. The actual value of the contract is only exchanged on

those rare occasions when delivery takes place.

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2.3 Types of Derivative Transactions –

Derivatives can be based on different types of assets such as: Commodities

Equities (stocks)

Bonds

Interest rates

Exchange rates

Indexes (such as a stock market index, consumer price index (CPI)

Inflation or weather conditions

The range of derivatives is really wide. But most commonly known derivatives are -

1. Forwards

2. Futures

3. Options

4. Swaps

Forwards - In finance, a forward contract or simply a forward is a non-standardized,

customized contract between two parties to buy or sell an asset at a specified future time at a

price agreed today & settlement takes place on a a specific date in the future at today’s pre-

agreed price. This is just opposite to a spot contract, which is an agreement to buy or sell an

asset today. It costs nothing to enter a forward contract. The party agreeing to buy the

underlying asset in the future assumes a long position. The price agreed upon is called the

delivery price, which is equal to the forward price at the time the contract is entered into.

Forwards are priced in a manner similar to futures. Like in the case of a futures contract, the

first step in pricing a forward is to add the spot price to the cost of carry (interest forgone,

convenience yield, storage costs and interest/dividend received on the underlying). Unlike a

futures contract though, the price may also include a premium for counterparty credit risk, and

the fact that there is not daily marking to market process to minimize default risk. If there is no

allowance for these credit risks, then the forward price will equal the futures price.

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2.4 How a Forward Contract works –

Suppose that Karan wants to buy a house a year from now. At the same time, suppose that

Ratan currently owns a $100,000 house that he wishes to sell a year from now. Both parties

could enter into a forward contract with each other. Suppose that they both agree on the sale

price in one year's time of $104,000 (more below on why the sale price should be this

amount). Ratan and Karan have entered into a forward contract. Karan, because he is buying

the underlying, is said to have entered a long forward contract. Conversely, Ratan will have

the short forward contract.

At the end of one year, suppose that the current market valuation of Ratan's house is $110,000.

Then, because Ratan is obliged to sell to Karan for only $104,000, Karan will make a profit of

$6,000. To see why this is so, one needs only to recognize that Karan can buy from Ratan for

$104,000 and immediately sell to the market for $110,000. Karan has made the difference in

profit. In contrast, Ratan has made a potential loss of $6,000, and an actual profit of $4,000.

The similar situation works among currency forwards, where one party opens a forward

contract to buy or sell a currency (ex. a contract to buy Canadian dollars) to expire/settle at a

future date, as they do not wish to be exposed to exchange rate/currency risk over a period of

time. As the exchange rate between U.S. dollars and Canadian dollars fluctuates between the

trade date and the earlier of the date at which the contract is closed or the expiration date, one

party gains and the counterparty loses as one currency strengthens against the other.

Sometimes, the buy forward is opened because the investor will actually need Canadian

dollars at a future date such as to pay a debt owed that is denominated in Canadian dollars.

Other times, the party opening a forward does so, not because they need Canadian dollars nor

because they are hedging currency risk, but because they are speculating on the currency,

expecting the exchange rate to move favorably to generate a gain on closing the contract.

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Future Price - In finance, a future expected Price is a standardized price on which two parties

to buy or sell a specified asset of standardized quantity and quality at a specified future date

agreed today (the futures price). The contracts are traded on a futures exchange. The price is

determined by the instantaneous equilibrium between the forces of supply and demand among

competing buy and sell orders on the exchange at the time of the purchase or sale of the

contract.

In many cases, the underlying asset to a futures contract may not be traditional "commodities"

at all – that is, for financial futures, the underlying asset or item can be currencies, securities or

financial instruments and intangible assets or referenced items such as stock indexes and

interest rates.

The future date is called the delivery date or final settlement date. The official price of the

futures contract at the end of a day's trading session on the exchange is called the settlement

price for that day of business on the exchange.

2.5 Relationship between forward contract and the expected future price -

The market's opinion about what the spot price of an asset will be in the future is the expected

future spot price. Hence, it’s very difficult to predict a future value or price of respective asset

with current & spot price. There are a number of different hypotheses which try to explain the

relationship between the current forward price, (K)F0 and the expected future spot price, E(ST).

As per observation, the natural hedgers of a commodity are those who wish to sell the

commodity at a future point in time. Thus, hedgers will collectively hold a net short position

in the forward market. The other side of these contracts is held by speculators, who must

therefore hold a net long position. Hedgers are interested in reducing risk, and thus will accept

losing money on their forward contracts. Speculators on the other hand, are interested in

making a profit, and will hence only enter the contracts if they expect to make money. Thus, if

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speculators are holding a net long position, it must be the case that the expected future spot

price is greater than the forward price.

In other words, the expected payoff to the speculator at maturity is -

E(ST − K) = E(ST) − K, where K is the delivery price at maturity

Thus, if the speculators expect to profit,

E(ST) – F0 > 0

E(ST) > F0

E(ST) > F0, as K = F0 when they enter the contract

This market situation, where E(ST) > F0, is referred to as normal backwardation. Since,

forward/futures prices converge with the spot price at maturity. Normal backwardation implies

that futures prices for a certain maturity are increasing over time. The opposite situation,

where E(ST) < F0, is referred to as contango. Likewise, contango implies that futures prices for

a certain maturity are falling over time.

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2.6 Overview of Futures Derivative –

Future contracts is an agreement made and traded on the exchange between two parties to buy

or sell a commodity at a particular time in the future for a pre-defined price. Futures contracts

are special types of forward contracts in the sense that the former are standardized exchange-

traded contracts. Since both the parties are unaware of each other, the exchange provides a

mechanism to give the party assurance of honored contract. The risk to the holder is unlimited,

and because the payoff pattern is symmetrical, the risk to the seller is unlimited as well. The

exchange specifies standardized features of the contract. Money lost and gained by each party

on a futures contract are equal and opposite. In other words, futures trading is a zero-sum

game.

Futures contracts are forward contracts, meaning they represent a pledge to make a certain

transaction at a future date. The exchange of assets occurs on the date specified in the contract.

Futures are distinguished from generic forward contracts in that they contain standardized

terms, trade on a formal exchange, are regulated by overseeing agencies, and are guaranteed

by clearinghouses. Also, in order to insure that payment will occur, futures have a margin

requirement that must be settled daily. Finally, by making an offsetting trade, taking delivery

of goods, or arranging for an exchange of goods, futures contracts can be closed.

Future contracts are often used by commercial enterprises as ‘hedging tools’ to reduce the risk

of expected future purchases or sales of the underlying asset. If used to speculate, risk

increases. So risk depends on the underlying instrument and the use of the future.

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There are many kinds of future derivatives available, main are -

Currency Future - A currency future, also FX future or foreign exchange future, is a future

contract to exchange one currency with another at a specified date in the future at a exchange

rate price that is fixed on the purchase date. Typically, one of the currencies is the US dollar.

The price of a future is then in terms of US dollars per unit of other currency. This can be

different from the standard way of quoting in the spot foreign exchange markets. The trade

unit of each contract is then a certain amount of other currency. Most contracts have physical

delivery, so for those held at the end of the last trading day, actual payments are made in each

currency. However, most contracts are closed out before that. Investors can close out the

contract at any time prior to the contract's delivery date.

Interest Rate Future - Buying an interest rate futures contract allows the buyer of the

contract to lock in a future investment rate; not a borrowing rate as many believe. Interest rate

futures are based off an underlying security which is a debt obligation and moves in value as

interest rates change.

When interest rates move higher, the buyer of the futures contract will pay the seller in an

amount equal to that of the benefit received by investing at a higher rate versus that of the rate

specified in the futures contract. Conversely, when interest rates move lower, the seller of the

futures contract will compensate the buyer for the lower interest rate at the time of expiration.

To accurately determine the gain or loss of an interest rate futures contract, an interest rate

futures price index was created. When buying, the index can be calculated by subtracting the

futures interest rate from 100, or (100 - Futures Interest Rate). As rates fluctuate, so does this

price index. You can see that as rates increase, the index moves lower and vice versa.

For example, borrowers face the risk of interest rates rising. Futures use the inverse

relationship between interest rates and bond prices to hedge against the risk of rising interest

rates. A borrower will enter to sell a future today. Then if interest rates rise in the future, the

value of the future will fall (as it is linked to the underlying asset, bond prices), and hence a

profit can be made when closing out of the future (i.e. buying the future).

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Future Exchange - A futures exchange is a central financial exchange where people can trade

standardized future contracts, that is, a contract to buy specific quantities of a commodity,

stock, shares or financial instrument at a specified price with delivery set at a specified time in

the future.

Forward contracts were standard at the time. The contracts traded on futures exchanges are

always standardized. To make sure liquidity is high, there is only a limited number of

standardized contracts. However, most forward contracts weren't honored by both the buyer

and the seller.

For instance, if the buyer of a corn made a forward contract agreement to buy corn, and at the

time of delivery the price of corn differed dramatically from the original contract price, either

the buyer or the seller would back out. Additionally, the forward contracts market was very

illiquid and an exchange was needed that would bring together a market to find potential

buyers and sellers of a commodity instead of making people bear the burden of finding a

buyer or seller.

Exchange-traded contracts are standardized by the exchanges where they trade. The contract

details what asset is to be bought or sold, and how, when, where and in what quantity it is to

be delivered. The terms also specify the currency in which the contract will trade, minimum

tick value, and the last trading day and expiry or delivery month.

Futures contracts are not issued like other securities, but are "created" whenever Open interest

increases; that is, when one party first buys a contract from another party. Contracts are also

"destroyed" in the opposite manner whenever open interest decreases because traders resell to

reduce their long positions or rebuy to reduce their short positions.

Compare this with other securities, in which there is a primary market when an issuer issues

the security, and a secondary market where the security is later traded independently of the

issuer. Legally, the security represents an obligation of the issuer rather than the buyer and

seller; even if the issuer buys back some securities, they still exist. Only if they are legally

cancelled can they disappear.

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2.7 Difference between Forward & Future Contracts -

Fundamentally, forward and futures contracts have the same function: both types of contracts

allow people to buy or sell a specific type of asset at a specific time at a given price.

However, it is in the specific details that these contracts differ.

First of all, futures contracts are exchange-traded and, therefore, are standardized contracts.

Forward contracts, on the other hand, are private agreements between two parties and are not

as rigid in their stated terms and conditions. Because forward contracts are private agreements,

there is always a chance that a party may default on its side of the agreement. Futures

contracts have clearing houses that guarantee the transactions, which drastically lowers the

probability of default to almost never.

Secondly, the specific details concerning settlement and delivery are quite distinct.

For forward contracts, settlement of the contract occurs at the end of the contract. Futures

contracts are marked-to-market daily, which means that daily changes are settled day by day

until the end of the contract. Furthermore, settlement for futures contracts can occur over a

range of dates. Forward contracts, on the other hand, only possess one settlement date.

Lastly, because futures contracts are quite frequently employed by speculators, who bet

on the direction in which an asset's price will move, they are usually closed out prior to

maturity and delivery usually never happens. On the other hand, forward contracts are mostly

used by hedgers that want to eliminate the volatility of an asset's price, and delivery of the

asset or cash settlement will usually take place.

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2.8 Overview of Options Derivatives -

Future trades are an option which gives its holder the right, but not the obligation, to buy (call

option) or to sell (put option) some underlying asset on or before the options expiration date at

an agreed on price (the strike price).

In return for granting the option, the originator of the option collects a payment (the premium)

from the buyer. Granting the option is also referred to as "writing" the option. It is useful to

make the distinction between the term "seller" and "writer" when describing options. An

option can be sold by its original buyer to another party. The writer of an option who is the

originator of the option who must make good on delivering (or receiving) the underlying asset

or its cash equivalent, if the option is exercised.

These exchanges publish the options prices continuously and create live options markets for

options trading. Thus, the exchange offers the trading parties a platform to discover prices and

execute transactions. These exchanges assume the role of intermediaries for buyers and sellers.

Using Options Derivatives for Risk Management –

The basic idea of options on futures is price insurance. Economic and political uncertainties as

well as the volatility of financial markets have increased the amount of risk to investments.

The quantum in the use of derivatives to manage risks has leapfrogged in line with increased

exposure to risk prone investments.

The buyer of an options contract may choose to let the option expire without ever exercising

its rights. The futures contract, in contrast, requires one to purchase or sell the underlying if

held to maturity.

The seller or writer of an option is paid for assuming the risk of the obligation. The price paid

for this option is called a premium. This price is established in open transparent trading on

exchanges which financial instruments such as options.

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Investors can use option contracts to take a position in a market initially spending an initial

investment, which would be the price of the option. The premium paid by the buyer of an

option is the total financial risk that he/she is exposed to.

The advantage of options is that it offers complete protection against financial loss during the

life of the option regardless of how market prices move against one’s position. With a futures

both the buyers’ and the seller’s risk is, at least in theory, unlimited. With an option one is able

to withstand volatile market conditions.

2.9 The Role of an Option Market -

An option on a futures contact is an agreement which given the holder (buyer) the right but not

the obligation to buy (call option) or sell (put option) at a specified price (strike price) on or

before a given date (expiration day), a specified quantity of the underlying contract, which is

the futures contract. After this given date, the option expires. The writer (seller) of an option is

obliged to sell (call option) or buy (put option) the underlying product to (or from) the buyer

of the option at the specified price on the buyer’s request.

In sum, the main difference between an option and a future is the term “right”. With a future,

both the buyer (holder) and the seller (writer) are obligated to perform whereas with an option,

it is only the writer or seller of the option who is obligated to perform.

These exchanges ensure that the contract terms are backed by the credit of the exchange. They

also safeguard the anonymity of the counterparties and enforce market regulations to ensure

that the trades remain fair and transparent. During fast trading conditions, these exchanges

ensure the maintenance of orderly markets.

Holder (Buyer) Writer (Seller)

Call Option

Put Option

Right to buy Obligation to sell

Right to sell Obligation to buy

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2.10 Various Types of Options Derivative Transactions -

Options market consist a wide range of options for financial instruments, mainly are describes

below -

2.10.1 Call Option - A call option is a financial contract between two parties, the buyer and

the seller of this type of option. It is the option to buy shares of stock at a specified time in the

future. Often it is simply labeled a "call". The buyer of the option has the right, but not the

obligation to buy an agreed quantity of a particular commodity or financial instrument from

the seller of the option at a certain time (the expiration date) for a certain price. The seller is

obligated to sell the commodity or financial instrument should the buyer so decide. The buyer

pays a fee (called a premium) for this right.

The buyer of a call option wants the price of the underlying instrument to rise in the future; the

seller either expects that it will not, or is willing to give up some of the profit from a price rise

in return for the premium and retaining the opportunity to make a gain up to the strike price

Call options are most profitable for the buyer when the underlying instrument moves up,

making the price of the underlying instrument closer to, or above, the strike price. The call

buyer believes it's likely the price of the underlying asset will rise by the exercise date. The

risk is limited to the premium. The profit for the buyer can be very large, and is limited by

how high underlying's spot rises. When the price of the underlying instrument surpasses the

strike price, the option is said to be "in the money".

The call writer does not believe the price of the underlying security is likely to rise. The writer

sells the call to collect the premium. The total loss, for the call writer, can be very large, and is

only limited by how high the underlying's spot price rises.

2.10.2 Put Option - The put buyer either believes that the underlying asset's price will fall by

the exercise date or hopes to protect a long position in it. The advantage of buying a put over

short selling the asset is that the option owner's risk of loss is limited to the premium paid for

it, whereas the asset short seller's risk of loss is unlimited (its price can rise greatly, in fact, in

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theory it can rise infinitely, and such a rise is the short seller's loss.) The put buyer's prospect

(risk) of gain is limited to the option's strike price less the underlying's spot price and the

premium/fee paid for it.

The most widely-traded put options are on equities but they are traded on many other

instruments such as interest rates or commodities.

The put writer believes that the underlying security's price will rise, not fall. The writer sells

the put to collect the premium. The put writer's total potential loss is limited to the put's strike

price less the spot and premium already received. Puts can be used also to limit the writer's

portfolio risk and may be part of an option spread.

A naked put, also called an uncovered put, is a put option whose writer (the seller) does not

have a position in the underlying stock or other instrument. This strategy is best used by

investors who want to accumulate a position in the underlying stock, but only if the price is

low enough. If the buyer fails to exercise the options, then the writer keeps the option

premium as a 'gift' for playing the game.

If the underlying stock's market price is below the option's strike price when expiration

arrives, the option owner (buyer) can exercise the put option, forcing the writer to buy the

underlying stock at the strike price. That allows the buyer to profit from the difference

between the stock's market price and the option's strike price. But if the stock's market price is

above the option's strike price at the end of expiration day, the option expires worthless, and

the owner's loss is limited to the premium (fee) paid for it.

Basic Transactions for Call & Put Option Transaction -

Long call - A trader who believes that a stock's price will increase might buy the right to

purchase the stock (a call option) rather than just buy the stock. He would have no obligation

to buy the stock, only the right to do so until the expiration date. If the stock price at expiration

is above the exercise price by more than the premium (price) paid, he will profit. If the stock

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price at expiration is lower than the exercise price, he will let the call contract expire

worthless, and only lose the amount of the premium

Payoff from buying a call.

Long put - A trader who believes that a stock's price will decrease can buy the right to sell the

stock at a fixed price (a put option). He will be under no obligation to sell the stock, but has

the right to do so until the expiration date. If the stock price at expiration is below the exercise

price by more than the premium paid, he will profit. If the stock price at expiration is above

the exercise price, he will let the put contract expire worthless and only lose the premium paid.

Payoff from buying a put.

Short call -

A trader, who believes that a stock price will decrease, can sell the stock short or instead sell,

or "write," a call. The trader selling a call has an obligation to sell the stock to the call buyer at

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the buyer's option. If the stock price decreases, the short call position will make a profit in the

amount of the premium. If the stock price increases over the exercise price by more than the

amount of the premium, the short will lose money, with the potential loss unlimited.

Payoff from writing a call.

Short put - A trader who believes that a stock price will increase can buy the stock or instead

sell a put. The trader selling a put has an obligation to buy the stock from the put buyer at the

put buyer's option. If the stock price at expiration is above the exercise price, the short put

position will make a profit in the amount of the premium. If the stock price at expiration is

below the exercise price by more than the amount of the premium, the trader will lose money,

with the potential loss being up to the full value of the stock.

Payoff from writing a put.

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2.10.3 Box Spread Option - A dual option position involving a bull and bear spread with

identical expiry dates. This investment strategy provides for minimal risk. Additionally, it can

lead to an arbitrage position as an investor attempts to lock in a small return at expiry.

In options trading, a box spread is a combination of positions that has a certain payoff,

considered to be simply delta neutral interest rate position. For example, a bull spread

constructed from calls (e.g. long a 50 call, short a 60 call) combined with a bear spread

constructed from puts (e.g. long a 60 put, short a 50 put), has a constant payoff of the

difference in exercise prices (e.g. 10). Under the no-arbitrage assumption the net premium

paid out to acquire this position should be equal to the present value of the payoff.

2.10.3 (i) Bear Spread - In options trading, a bear spread is a bearish, vertical spread options

strategy that can be used when the options trader is moderately bearish on the underlying

security. Because of put-call parity, a bear spread can be constructed using either put options

or call options. If constructed using calls, it is a bear call spread. If constructed using puts, it is

a bear put spread.

Bear Call Spread - A bear call spread is a limited profit, limited risk options trading strategy

that can be used when the options trader is moderately bearish on the underlying security. It is

entered by buying call options of a certain strike price and selling the same number of call

options of lower strike price (in the money) on the same underlying security with the same

expiration month.

Bear Put Spread - A bear put spread is a limited profit, limited risk options trading strategy

that can be used when the options trader is moderately bearish on the underlying security. It is

entered by buying higher striking in-the-money put options and selling the same number of

lower striking out-of-the-money put options on the same underlying security and the same

expiration month. The options trader hopes that the price of the underlying drops, maximizing

his profit when the underlying drops below the strike price of the written option, netting him

the difference between the strike prices minus the cost of entering into the position.

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2.10.3 (ii) Bull Spread - In options trading, a bull spread is a bullish, vertical spread options

strategy that is designed to profit from a moderate rise in the price of the underlying security.

An option strategy in which maximum profit is attained if the underlying security rises in

price. Either calls or puts can be used. The lower strike price is purchased and the higher strike

price is sold. The options have the same expiration date.You make a lot of money if the stock

rises. You lose it all if it doesn't. It's one of those higher risk maneuvers that can cause a lot of

anxiety.

Bull Call Spread - A bull call spread is constructed by buying a call option with a low

exercise price, and selling another call option with a higher exercise price. Payoffs from a bull

call spread A bull spread can be constructed using two call options. Often the call with the

lower exercise price will be at-the-money while the call with the higher exercise price is out-

of-the-money. Both calls must have the same underlying security and expiration month.

Bull Put Spread - A bull put spread is constructed by selling higher striking in-the-money put

options and buying the same number of lower striking out-of-the-money put options on the

same underlying security with the same expiration date. The options trader employing this

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strategy hopes that the price of the underlying security goes up far enough such that the

written put options expire worthless.

2.10.4 Option Time Value - In finance, the value of an option consists of three components -

Intrinsic Value, Option Value & Time Value

Time value is simply the difference between option value and intrinsic value. Time value is

also known as extrinsic value, or instrumental value.

Intrinsic Value - The intrinsic value of an option is the value of exercising it now. If the

option has a positive monetary value, it is referred to as being in-the-money, otherwise it is

referred to as being out-of-the-money. If an option is out-of-the-money at expiration, its holder

will simply abandon the option and it will expire worthless. For this reason we assume that the

owner of the option will never choose to lose money by exercising, thus an option can never

have a negative value.

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Option value - (i.e. price) is found via a formula such as Black-Scholes or using a numerical

method such as the Binomial model. This price will reflect the "likelihood" of the option

finishing "in-the-money". For an out-the-money option, the further in the future the expiration

date - i.e. the longer the time to exercise - the higher the chance of this occurring, and thus the

higher the option price; for an in-the-money option the chance in the money decreases;

however the fact that the option cannot have negative value also works in the owner's favor.

Time Value - More specifically, an option's time value reflects the probability that the option

will gain in intrinsic value or become profitable to exercise before it expires. An important

factor is the option's volatility. Volatile prices of the underlying instrument can stimulate

option demand, enhancing the value. Numerically, this value depends on the time until the

expiration date and the volatility of the underlying instrument's price. The time value of an

option is not negative (because the option value is never lower than the intrinsic value), and

converges towards zero with time. At expiration, where the option value is simply its intrinsic

value, time value is zero. Prior to expiration, the change in time value with time is non-linear,

being a function of the option price

2.10.5 Strike Price - In options, the strike price, or exercise price, is a key variable in a

derivatives contract between two parties. Where the contract requires delivery of the

underlying instrument, the trade will be at the strike price, regardless of the spot price (market

price) of the underlying instrument at that time.

Definition - The fixed price at which the owner of an option can purchase (in the case of a

call), or sell (in the case of a put), the underlying security or commodity. It's the price at which

the stock will be bought or sold when the option is exercised. The strike price is often called

the exercise price.

For example, an IBM May 50 Call has a strike/exercise price of $50 a share. When the option

is exercised the owner of the option will buy (Call option) 100 shares of IBM stock for $50

per share.

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2.10.6 Other Options Style - In finance, the style or family of an option is a general term

denoting the class into which the option falls, usually defined by the dates on which the option

may be exercised. The vast majority of options are either European or American (style)

options. These options as well as others where the payoff is calculated similarly - are referred

to as "vanilla options". Options where the payoff is calculated differently are categorized as

"exotic options". Exotic options can pose challenging problems in valuation and hedging.

(A) Non-Vanilla Exercise Rights -

There is other, more unusual exercise styles in which the pay-off value remains the same as a

standard option (as in the classic American and European options above) but where early

exercise occurs differently:

A Bermudan option is an option where the buyer has the right to exercise at a set

number of times. This is intermediate between a European option - which allows exercise

at a single time, namely expiry & an American option, which allows exercise at any time.

For example a typical Bermudan swaption might confer the opportunity to enter into an

interest rate swap. The option holder might decide to enter into the swap at the first

exercise date or defer and have the opportunity to enter in six months time. Most exotic

interest rate options are of Bermudan style.

A Canary option is an option whose exercise style lies somewhere between European

options and Bermudan options. Typically, the holder can exercise the option at quarterly

dates, but not before a set time period (typically one year) has elapsed. The term was

coined by Keith Kline, who at the time was an agency fixed income trader at the Bank of

New York.

A capped style option is not an interest rate cap but a conventional option with a

pre-defined profit cap written into the contract. A capped-style option is automatically

exercised when the underlying security closes at a price making the option's mark to

market match the specified amount.

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A compound option is an option on another option, and as such presents the holder with

two separate exercise dates and decisions. If the first exercise date arrives and the 'inner'

option's market price is below the agreed strike the first option will be exercised, giving

the holder a further option at final maturity.

A shout option allows the holder effectively two exercise dates: during the life of the

option they can "shout" to the seller that they are locking-in the current price, and if this

gives them a better deal than the pay-off at maturity they'll use the underlying price on the

shout date rather than the price at maturity to calculate their final pay-off.

A swing option gives the purchaser the right to exercise one and only one call or put on

any one of a number of specified exercise dates. Penalties are imposed on the buyer if the

net volume purchased exceeds or falls below specified upper and lower limits. Allows the

buyer to "swing" the price of the underlying asset. Primarily used in energy trading.

(B) Exotic Options with Standard Exercise Styles -

These options can be exercised either European style or American style, they differ from

the plain vanilla option only in the calculation of their pay-off value.

A cross option is an option on some underlying in one currency with a strike

denominated in another currency. For example a standard call option on IBM, which is

denominated in dollars pays $MAX(S-K,0) (where S is the stock price at maturity and K

is the strike). A composite stock option might pay JPYMAX(S/Q-K,0), where Q is the

prevailing FX rate. The pricing of such options naturally needs to take into account FX

volatility and the correlation between the exchange rate of the two currencies involved

and the underlying stock price.

A quanto option is a cross option in which the exchange rate is fixed at the outset of the

trade, typically at 1. The payoff of an IBM quanto call option would then be JPYmax(S-

K,0).

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An exchange option is the right to exchange one asset for another (such as a sugar future

for a corporate bond).

A basket option is an option on the weighted average of several underlyings assets.

A rainbow option is a basket option where the weightings depend on the final

performances of the components. A common special case is an option on the worst-

performing of several stocks.

(C) Non-Vanilla Path Dependent Exotic Options –

The following "exotic options" are still options, but have payoffs calculated quite

differently from those above. Although these instruments are far more unusual they can

also vary in exercise between European and American.

A Lookback option is a path dependent option where the option owner has the right to

buy (sell) the underlying instrument at its lowest price over some preceding period.

An Asian option is an option where the payoff is not determined by the underlying price

at maturity but by the average underlying price over some pre-set period of time. For

example an Asian call option might pay Max (Daily Average Over Last Three Months

(S)-K,0). Asian options were originated in Asian markets to prevent option traders from

attempting to manipulate the price of the underlying security on the exercise date.

A Russian option is a look back option which runs for perpetuity. That is, there is no end

to the period into which the owner can look back.

A game option or Israeli option is an option where the writer has the opportunity to

cancel the option he has offered, but must pay the payoff at that point plus a penalty fee.

The payoff of a Cumulative Parisian option is dependent on the total amount of time the

underlying asset value has spent above or below a strike price.

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The payoff of a Standard Parisian option is dependent on the maximum amount of time

the underlying asset value has spent consecutively above or below a strike price.

A barrier option involves a mechanism where if a 'limit price' is crossed by the

underlying, the option either can be exercised or can no longer be exercised.

A double barrier option involves a mechanism where if either of two 'limit prices' is

crossed by the underlying, the option either can be exercised or can no longer be

exercised.

A Cumulative Parisian barrier option involves a mechanism where if the total amount

of time the underlying asset value has spent above or below a 'limit price', the option can

be exercised or can no longer be exercised.

A reoption occurs when a contract has expired without having been exercised. The owner

of the underlying security may then reoption the security.

A binary option (also known as a digital option) pays a fixed amount, or nothing at all,

depending on the price of the underlying instrument at maturity.

A chooser option gives the purchaser a fixed period of time to decide whether the

derivative will be a vanilla call or put.

A forward start option is an option whose strike price is determined in the future.

A cliquet option is a sequence of forward start options.

2.10.7 Employee Stock Option -

An employee stock option is a call option on the common stock of a company, issued as a

form of non-cash compensation. Restrictions on the option (such as vesting and limited

transferability) attempt to align the holder's interest with those of the business' shareholders. If

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the company's stock rises, holders of options generally experience a direct financial benefit.

This gives employees an incentive to behave in ways that will boost the company's stock

price.

Employee stock options are mostly offered to management as part of their executive

compensation package. They may also be offered to non-executive level staff, especially by

businesses that are not yet profitable, insofar as they may have few other means of

compensation. Alternatively, employee-type stock options can be offered to non-employees:

suppliers, consultants, lawyers and promoters for services rendered. Employee stock options

are similar to warrants, which are call options issued by a company with respect to its own

stock.

2.10.8 Warrants -

In finance, a warrant is a security that entitles the holder to buy stock of the issuing company

at a specified price, which can be higher or lower than the stock price at time of issue.

Warrants and Options are similar in that the two contractual financial instruments allow the

holder special rights to buy securities. Both are discretionary and have expiration dates. The

word Warrant simply means to "endow with the right", which is only slightly different to the

meaning of an Option.

Warrants are frequently attached to bonds or preferred stock as a sweetener, allowing the

issuer to pay lower interest rates or dividends. They can be used to enhance the yield of the

bond, and make them more attractive to potential buyers. Warrants can also be used in private

equity deals. Frequently, these warrants are detachable, and can be sold independently of the

bond or stock.

In the case of warrants issued with preferred stocks, stockholders may need to detach and sell

the warrant before they can receive dividend payments. Thus, it is sometimes beneficial to

detach and sell a warrant as soon as possible so the investor can earn dividends.

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Types of Warrants -

A wide range of warrants and warrant types are available. The reasons you might invest in one

type of warrant may be different from the reasons you might invest in another type of warrant.

Equity Warrants - Equity warrants can be call and put warrants.

Callable Warrants - give you the right to buy the underlying securities.

Putable Warrants - give you the right to sell the underlying securities

Covered Warrants - A covered warrants is a warrant that has some underlying backing,

for example the issuer will purchase the stock before hand or will use other instruments to

cover the option.

Basket Warrants - As with a regular equity index, warrants can be classified at, for

example, an industry level. Thus, it mirrors the performance of the industry.

Index Warrants - Index warrants use an index as the underlying asset. Your risk is

dispersed - using index call and index put warrants—just like with regular equity indexes.

It should be noted that they are priced using index points. That is, you deal with cash, not

directly with shares.

Wedding Warrants - are attached to the host debentures and can be exercised only if the

host debentures are surrendered.

Detachable Warrants - the warrant portion of the security can be detached from the

debenture and traded separately.

Naked Warrants - are issued without an accompanying bond, and like traditional

warrants, are traded on the stock exchange.

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2.10.9 Foreign Exchange Option -

Arrangement in which a party acquires (upon payment of a fee) the right but not the obligation

to buy or sell a specified amount of a currency on a fixed date and at a fixed rate. Such options

are used usually by importers as a hedge against exchange rate fluctuations.

In finance, a foreign exchange option is a derivative financial instrument where the owner has

the right but not the obligation to exchange money denominated in one currency into another

currency at a pre-agreed exchange rate on a specified date.

The FX options market is the deepest, largest and most liquid market for options of any kind

in the world. Most of the FX option volume is traded OTC and is lightly regulated, but a

fraction is traded on exchanges like the International Securities Exchange, Philadelphia Stock

Exchange, or the Chicago Mercantile Exchange for options on futures contracts. The global

market for exchange-traded currency options was notionally valued by the Bank for

International Settlements at $198,300 billion in 2009.

2.10.10 Interest Rate Options -

Interest rate Options are European-style, cash-settled options on the yield of U.S. Treasury

securities. Available to meet your needs are options on short, medium, and long-term rates.

These options give you an opportunity to invest based upon your views of the direction of

interest rates.

In general, when yield-based options are purchased, a call buyer and a put buyer have opposite

expectations about interest rate movements. A call buyer anticipates interest rates will go up,

increasing the value of the call position. A put buyer anticipates that rates will go down,

increasing the value of the put position. A yield-based call option buyer will profit if, by

expiration, the underlying interest rate rises above the strike price plus the premium paid for

the call. Alternatively, a yield-based put options buyer will profit if, by expiration, if the

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interest rate has declined below the strike price less the premium paid. Of course taxes and

commissions must be taken into account in all transactions.

An investment tool whose payoff depends on the future level of interest rates. Interest rate

options are both exchange traded and over-the-counter instruments.

An investor taking a long position in interest rate call options believes that interest rates will

rise, while an investor taking a position in interest rate put options believes that interest rates

will fall.

2.10.11 Bond Option - An option contract in which the underlying asset is a bond. Other than

the different characteristics of the underlying assets, there is no significant difference between

stock and bond options. Just as with other options, a bond option allows investors the ability to

hedge the risk of their bond portfolios or speculate on the direction of bond prices with limited

risk.

A buyer of a bond call option is expecting a decline in interest rates and an increase in bond

prices. The buyer of a put bond option is expecting an increase in interest rates and a decrease

in bond prices.

A European bond option is an option to buy or sell a bond at a certain date in future for

a predetermined price.

An American Bond option is an option to buy or sell a bond on or before a certain date

in future for a predetermined price.

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Embedded options with bonds -

The term "bond option" is also used for option-like features of some bonds. These are an

inherent part of the bond, rather than a separately traded product. These options are not

mutually exclusive, so a bond may have lots of options embedded.

A Callable Bond allows the issuer to buy back the bond at a predetermined price at

certain time in future. The holder of such a bond has, in effect, sold a call option to the

issuer. Callable bonds cannot be called for the first few years of their life. This period is

known as the lock out period.

A Putable Bond allows the holder to demand early redemption at a predetermined price at

certain time in future. The holder of such a bond has, in effect, purchased a put option on

the bond.

A Convertible Bond allows the holder to demand conversion of bonds into the stock of

the issuer at a predetermined price at certain time period in future.

An Exchangeable Bond allows the holder to demand conversion of bonds into the stock

of a different company, usually a public subsidiary of the issuer, at a predetermined price

at certain time period in future.

2.10.12 Real Options - An alternative or choice that becomes available with a business

investment opportunity. This kind of option is not a derivative instrument, but an actual option

(in the sense of "choice") that a business may gain by undertaking certain endeavors. For

example, by investing in a particular project, a company may have the real option

of expanding, downsizing, or abandoning other projects in the future. Other examples of real

options may be opportunities for R&D, M&A and licensing.

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They are referred to as "real" because they usually pertain to tangible assets, such as capital

equipment, rather than financial instruments. Taking into account real options can greatly

affect the valuation of potential investments. Oftentimes, however, valuation methods, such as

NPV, do not include the benefits that real options provide.

Real options capture the value of managerial flexibility to adapt decisions in response to

unexpected market developments. Companies create shareholder value by identifying,

managing and exercising real options associated with their investment portfolio. The real

options method applies financial options theory to quantify the value of management

flexibility in a world of uncertainty. If used as a conceptual tool, it allows management to

characterize and communicate the strategic value of an investment project.

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1.11 Description of Swap Derivatives Market –

In finance, a swap is a derivative in which counter parties exchange certain benefits of one

party's financial instrument for those of the other party's financial instrument. The benefits in

question depend on the type of financial instruments involved. For example, in the case of a

swap involving two bonds, the benefits in question can be the periodic interest (or coupon)

payments associated with the bonds.

In simple words swaps are private contracts between two entities to deal in cash flows in the

future following a pre-decided formula. They are somewhat like forward contracts' portfolios.

Swaps are also of two types such as interest rate swaps and currency swaps.

Interest rate swaps in this case, only interest related cash flows can be exchanged

between the entities in one currency.

Currency swaps in this case of swapping, principal and interest can be exchanged in one

currency for the same in other form of currency.

Specifically, the two counterparties agree to exchange one stream of cash flows against

another stream. These streams are called the legs of the swap. The swap agreement defines the

dates when the cash flows are to be paid and the way they are calculated. Usually at the time

when the contract is initiated at least one of these series of cash flows is determined by a

random or uncertain variable such as an interest rate, foreign exchange rate, equity price or

commodity price.

2.12 Types of Swap Transactions -

2.12.1 Interest rate swaps -

A is currently paying floating, but wants to pay fixed. B is currently paying fixed but wants to

pay floating. By entering into an interest rate swap, the net result is that each party can 'swap'

their existing obligation for their desired obligation. Normally the parties do not swap

payments directly, but rather, each sets up a separate swap with a financial intermediary such

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as a bank. In return for matching the two parties together, the bank takes a spread from the

swap payments.

Example: Party B makes periodic interest payments to party A based on a variable interest

rate of LIBOR +70 basis points. Party A in return makes periodic interest payments based on a

fixed rate of 8.65%. The payments are calculated over the notional amount. The first rate is

called variable, because it is reset at the beginning of each interest calculation period to the

then current reference rate, such as LIBOR. In reality, the actual rate received by A and B is

slightly lower due to a bank taking a spread.

2.12.2 Currency Swaps -

A currency swap involves exchanging principal and fixed rate interest payments on a loan in

one currency for principal and fixed rate interest payments on an equal loan in another

currency. Just like interest rate swaps, the currency swaps also are motivated by comparative

advantage.

2.12.3 Commodity Swaps -

A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged

for a fixed price over a specified period. The vast majority of commodity swaps involve crude

oil.

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/

2.12.4 Equity Swap -

An equity swap is a special type of total return swap, where the underlying asset is a stock, a

basket of stocks, or a stock index. Compared to actually owning the stock, in this case you do

not have to pay anything up front, but you do not have any voting or other rights that stock

holders do have.

2.12.5 Credit Default Swaps -

A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series

of payments to the seller and, in exchange, receives a payoff if a credit instrument - typically a

bond or loan - goes into default (fails to pay). Less commonly, the credit event that triggers the

payoff can be a company undergoing restructuring, bankruptcy or even just having its credit

rating downgraded. CDS contracts have been compared with insurance, because the buyer

pays a premium and, in return, receives a sum of money if one of the events specified in the

contract occur. Unlike an actual insurance contract the buyer is allowed to profit from the

contract and may also cover an asset to which the buyer has no direct exposure.

2.12.6 Basis Swap -

A basis swap is an interest rate swap which involves the exchange of two floating rate

financial instruments. A floating interest rate swap under which the floating rate payments is

referenced to different bases.

2.12.7 Assets Swap -

The term asset swap has a particular meaning. When one refers to an asset swap, one has in

mind the exchange of the flow of payments from a given security (the asset) for a different set

of cash flows.

An asset swap is an exchange of tangible assets for intangible assets or vice versa. Since it is a

swap of assets, the procedure takes place on the active side of the balance sheet and has no

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impact on the latter in regards to volume. As an example, a company may sell equity and

receive the value in cash thus increasing liquidity. A company often utilizes this method when

in need for money to invest (internal financing) or to pay-off debts.

2.12.8 Forex Swap -

In finance, a forex swap (or FX swap) is a simultaneous purchase and sale of identical

amounts of one currency for another with two different value dates (normally spot to forward).

Forex Swap Structure: A forex swap consists of two legs -

a spot foreign exchange transaction, and

a forward foreign exchange transaction.

These two legs are executed simultaneously for the same quantity, and therefore offset each

other. It is also common to trade forward-forward, where both transactions are for (different)

forward dates.

2.12.9 Variance Swap -

A variance swap is an over-the-counter financial derivative that allows one to speculate on or

hedge risks associated with the magnitude of movement, i.e. volatility, of some underlying

product, like an exchange rate, interest rate, or stock index.

One leg of the swap will pay an amount based upon the realized variance of the price changes

of the underlying product. Conventionally, these price changes will be daily log returns, based

upon the most commonly used closing price. The other leg of the swap will pay a fixed

amount, which is the strike, quoted at the deal's inception. Thus the net payoff to the

counterparties will be the difference between these two and will be settled in cash at the

expiration of the deal, though some cash payments will likely be made along the way by one

or the other counterparty to maintain agreed upon margin.

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2.13 Uses & Advantages of Swaps Transactions -

Many traders find variance swaps interesting or useful for their purity. An alternative way of

speculating on volatility is with an option, but if one only has interest in volatility risk, this

strategy will require constant delta hedging, so that direction risk of the underlying security is

approximately removed. What is more, a replicating portfolio of a variance swap would

require an entire strip of options, which would be very costly to execute. Finally, one might

often find the need to be regularly rolling this entire strip of options so that it remains centered

around the current price of the underlying security.

The advantage of variance swaps is that they provide pure exposure to the volatility of the

underlying price, as opposed to call and put options which may carry directional risk (delta).

The profit and loss from a variance swap depends directly on the difference between realized

and implied volatility.

Another aspect that some speculators may find interesting is that the quoted strike is

determined by the implied volatility smile in the options market, whereas the ultimate payout

will be based upon actual realized variance. Historically, implied variance has been above

realized variance, a phenomenon known as the Variance risk premium, creating an opportunity

for volatility arbitrage, in this case known as the rolling short variance trade. For the same

reason, these swaps can be used to hedge Options on Realized Variance.

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2. RESEARCH METHODOLOGY :

3.1 Statement of Problem -

To know how the Derivative market has performed so far and recent development and future

prospect of derivative market in India.

3.2 Scope of the Project -

The project covers the derivatives market and its instruments. For better understanding various

strategies with different situations and actions have been given. It includes the data collected

in the recent years and also the market in the derivatives in the recent years. This study

extends to the trading of derivatives done in the National Stock Markets. Along with that it

also tells us about the perception of a general investor towards the investment in derivative

market.

3.3 Objective of the study -

The basic idea behind undertaking Derivatives Market project to gain knowledge about future

derivative market & risk management.

(A) Primary Objective -

To analyze the performance of Derivatives Trading since 2000 with special reference to

Futures & Options.

To analyze investors perception towards investment in derivative market.

(B) Secondary Objectives -

To understand the concept of the Derivatives and Derivative Trading.

To know different types of Financial Derivatives.

To know the role of derivatives trading in India.

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3.4 Type of Research -

In this project Descriptive research methodologies were use. The research methodology

adopted for carrying out the study was at the first stage theoretical study is attempted and at

the second stage source of information are both primary & secondary.

3.5 Source of Data Collection -

It is the data which has already been collected by someone or an organization for some other

purpose or research study. The data for study has been collected from various sources.

Books

Journals

Internet Sources

The objective of the exploratory research is to gain insights and ideas. The objective of the

study descriptive research study is typically concerned with determining the frequency with

which something occurs.

3.6 Limitations of the Study -

The analysis was purely based on the secondary data. So, any error in the secondary data

might also affect the study undertaken.

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3. ANALYSIS :

4.1 Importance of Derivatives -

Thus, derivatives are becoming increasingly important in world markets as a tool for risk

management. Derivative instruments can be used to minimize risk. Derivatives are used to

separate the risks and transfer them to parties willing to bear these risks. The kind of hedging

that can be obtained by using derivatives is cheaper and more convenient than what could be

obtained by using cash instruments. It is so because, when we use derivatives for hedging,

actual delivery of the underlying asset is not at all essential for settlement purposes. The profit

or loss on derivative deal alone is adjusted in the derivative market.

Moreover, derivatives do not create any new risk. They simply manipulate risks and transfer

them to those who are willing to bear these risks. To cite a common example, let us assume

that Mr. X owns a car. If he does not take insurance, he runs a big risk. Suppose he buys

insurance, (a derivative instrument on the car) he reduces his risk. Thus, having an insurance

policy reduces the risk of owing a car. Similarly, hedging through derivatives reduces the risk

of owning a specified asset, which may be a share, currency etc.

Hedging risk through derivatives is not similar to speculation. The gain or loss on a derivative

deal is likely to be offset by an equivalent loss or gain in the values of underlying assets.

'Offsetting of risks' in an important property of hedging transactions. But, in speculation one

deliberately takes up a risk openly. When companies know well that they have to face risk in

possessing assets, it is better to transfer these risks to those who are ready to bear them. So,

they have to necessarily go for derivative instruments.

All derivative instruments are very simple to operate. Treasury managers and portfolio

managers can hedge all risks without going through the tedious process of hedging each day

and amount/share separately.

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Till recently, it may not have been possible for companies to hedge their long term risk, say

10-15 year risk. But with the rapid development of the derivative markets, now, it is possible

to cover such risks through derivative instruments like swap. Thus, the availability of

advanced derivatives market enables companies to concentrate on those management

decisions other than funding decisions. Further, all derivative products are low cost products.

Companies can hedge a substantial portion of their balance sheet exposure, with a low margin

requirement.

Derivatives also offer high liquidity. Just as derivatives can be contracted easily, it is also

possible for companies to get out of positions in case that market reacts otherwise. This also

does not involve much cost. Thus, derivatives are not only desirable but also necessary to

hedge the complex exposures and volatilities that the companies generally face in the financial

markets today.

4.2 How Derivatives is Useful for Indian Economy -

In the present state of the economy, there is an imperative need of the corporate clients to

protect their operating profits by shifting some of the uncontrollable financial risks to those

who are able to bear and manage them. Thus, risk management becomes a must for survival

since there is a high volatility in the present financial markets.

In this context, derivatives occupy an important place as risk reducing machinery. Derivatives

are useful to reduce many of the risks discussed above. In fact, the financial service companies

can play a very dynamic role in dealing with such risks. They can ensure that the above risks

are hedged by using derivatives like forwards, future, options, swaps etc. Derivatives, thus,

enable the clients to transfer their financial risks to the financial service companies. This really

protects the clients from unforeseen risks and helps them to get there due operating profits or

to keep the project well within the budget costs. To hedge the various risks that one faces in

the financial market today, derivatives are absolutely essential.

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4.3 Derivative Market and Financial Risk -

Derivatives play a vital role in risk management of both financial and non-financial

institutions. But, in the present world, it has become a rising concern that derivative market

operations may destabilize the efficiency of financial markets. In today’s world the companies

the financial and non-financial firms are using forward contracts, future contracts, options,

swaps and other various combinations of derivatives to manage risk and to increase returns. It

is true that growth of derivatives market reveal the increasing market demand for risk

managing instruments in the economy. But, the major concern is that, the main components of

over the Counter (OTC) derivatives are interest rates and currency swaps. So, the economy

will suffer surely if the derivative instruments are misused and if a major fault takes place in

derivatives market.

Financial transactions are fraught with several risk factors. Derivatives are instrumental in

alienating those risk factors from traditional instruments and shifting risks to those entities that

are ready to take them. Some of the basic risk components in derivatives business are -

Credit Risk: When one of the two parties fails to perform its role as per the agreement,

this is called the credit risk. It can also be referred to as default or counterparty risk. It

varies with different sources.

Market Risk: This is a kind of financial loss that takes place due to the adverse price

movements of the underlying variable or instrument.

Liquidity Risk: When a firm is unable to devise a transaction at current market rates, it

can be referred to as liquidity risk. There are two kinds of liquidity risks involved in the

scenario. First is concerned with the liquidity of separate items and second is related to

supporting the activities of the organization with funds comprising derivatives.

Legal Risk: Legal issues related with the agreement need to be scrutinized well, as one

can deal in derivatives across the different judicial boundaries.

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4. FINDING SUGGESTION & CONCLUSION :

Financial derivatives can be used in two ways: to hedge against unwanted risks or to speculate

by taking a position in anticipation of a market movement. Similarly, organizations today can

use financial derivatives to actively seek out specific risks and speculate on the direction of

interest-rate or exchange-rate movements, or they can use derivatives to hedge against

unwanted risks. Hence, it is not true that only risk-seeking institutions use derivatives.

5.1 How risk can be minimized associated with Derivatives -

Financial derivatives are important tools that can help organizations to meet their specific

risk-management objectives. As is the case with all tools, it is important that the user

understand the tool's intended function and that the necessary safety precautions be taken

before the tool is put to use.

When used properly, financial derivatives can help organizations to meet their risk-

management objectives so that funds are available for making worthwhile investments.

Again, a firm's decision to use derivatives should be driven by a risk-management

strategy that is based on broader corporate objectives.

Without a clearly defined risk-management strategy, use of financial derivatives can be

dangerous. It can threaten the accomplishment of a firm's long-range objectives and result

in unsafe and unsound practices that could lead to the organization's insolvency. But when

used wisely, financial derivatives can increase shareholder value by providing a means to

better control a firm's risk exposures and cash flows.

Clearly, derivatives are here to stay. We are well on our way to truly global financial

markets that will continue to develop new financial innovations to improve risk-

management practices. Financial derivatives are not the latest risk-management fad; they

are important tools for helping organizations to better manage their risk exposures.

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5. BIBLIOGRAPHY :

(A) Books References :

Financial Derivatives (Theory, Concepts and Problems) By: S.L. Gupta

Security Analysis And Portfolio Management (Second Edition) By: Ambika Prasad Dash

Capital Markets, 2E By: Gurusamy

(B) Internet Website Source :

www.managementparadise.com

www.wikipedia.com

www.economywatch.com

www.investopedia.com

Submission: Jan 2008

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