UNIT 1

Introduction
Topics: -
(1) Introduction: Exchange traded markets, Over the counter markets
(2) Products of derivatives: Forwards contract, futures contract and options
(3) Types of traders: Hedgers, Speculators & Arbitrageurs
# Introduction:
A derivative is a contract or a product whose value is derived from the value of some other assets known as the
underlying. Derivatives are based on a wide range of underlying assets. These assets include:
(a) Metals such as gold, silver etc.
(b) Energy resources such as oil, coal etc.
(c) Agri commodities such as wheat, sugar etc.
(d) Financial assets such as shares, bonds etc.

 Types of derivatives market:

(a) Exchanges Traded Markets: Exchange traded contracts are standardized, traded on organized exchanges
with prices determined by the interaction of buyers and seller through anonymous auction platform. A
clearing corporation guarantees contract performance (settlement of transactions).

(b) Over the Counter Markets: It is not a physical marketplace but a collection of broker-dealers scattered
across the country. The main idea of the market is more a way of doing business than a place. Buying and
selling of contracts are matched through negotiated bidding process over a network of telephone or
electronic media that link thousands of intermediaries. OTC market is less regulated market because
these transactions occur in private among qualified counterparties, who are supposed to be capable
enough to take care of themselves.

# Products of Derivatives:
(a) Forwards contract: It is a contractual agreement between two parties to buy/sell an underlying asset at a
certain future date for a particular price that is pre decided on the date of contract. Both the contracting
parties are committed and are obliged to honour the transaction irrespective of the price of the
underlying asset at the time of delivery. Since forwards are negotiated between two parties, the terms &
conditions of contracts are customized and these are known as Over the Counter (OTC) Contracts.

(b) Futures contract: A future contract is similar to a forward, except that the deal is made through an
organized and regulated exchange rather than being negotiated directly between two parties. Futures are
also standardized contracts (in terms of their lot size, maturity date, etc.) so that they can be traded on
the exchange. Indeed, we may say futures are exchange traded forward contracts.

(c) Options: An option is a contract that gives the right but not the obligation, to buy/sell the underlying on
or before a stated date and at a stated price. While the buyer of an option pays the premium and buys
the right, the writer/seller of an option receives the premium with the obligation to sell-/buy the
underlying asset, if the buyer exercises his right.

(d) Swaps: A swap is an agreement made between two parties to exchange cash flows in the future
according to a prearranged formula. Swaps are broadly speaking, a series of forwards contracts. Swaps
help market participants manage risks associated with the volatile interest rates, currency exchange rates
and commodity prices.
# Types of traders:
There are broadly 3 types of traders in the derivatives market – hedgers, traders/speculators and arbitrageurs.
(a) Hedgers: They face risk associated with the prices of underlying assets and use derivatives to reduce their
risk. Corporations, investing institutions and banks all use derivatives products to hedge or reduce their
exposure to market variables such as interest rates, share prices, bond prices, currency exchange rates and
commodity prices.

(b) Speculators/Traders: They try to predict the future movements in prices of underlying assets and based on
the view, take positions in derivative contracts. Derivatives are preferred over underlying asset for trading
purpose, as they offer leverage, are less expensive as the cost of transaction is generally lower than that of
the underlying, and are faster to execute in size (high volume market).

(c) Arbitrageurs: Arbitrage is a deal that produces profit by exploiting a price difference in a product in two
different markets. Arbitrage originates when a trader purchases an asset cheaply in one market and
simultaneously arranges to sell it at a higher price in another market. Such opportunities are unlikely to
persist for very long, since arbitrageurs would rush into these transactions, thus closing the price gap at
different locations.
UNIT 2
Mechanics of Futures Markets
Topics: -
(1) Specifications of a futures contract
(2) Convergence of futures price to spot price
(3) Contango & Backwardation
(4) The operation of margin accounts
(5) Types of Traders & Types of orders
(6) Forward vs. Futures contracts
# Specifications of a futures contract:
Futures contracts were created to overcome the limitations of forwards. A futures contract is an agreement made
through an organized exchange to buy/sell a fixed amount of a commodity or a financial asset on a future date at an
agreed price.
Features of futures contracts:
(a) Contract between two parties through exchange
(b) Centralized trading platform (i.e. exchange)
(c) Price discovery through free interaction of buyers and sellers
(d) Margins payable by both the parties
(e) Quality decided today (standardized)
(f) Quantity decided today (standardized)
Limitations of futures contract:
(a) Limited maturities
(b) Limited underlying set
(c) Lack of flexibility in contract design
(d) Increased administrative costs on account of MTM settlement, etc.
 Specifications of a futures contract:
(a) Underlying instrument: The underlying instrument refer to the index or stock (asset) on which the
futures contract is traded.

(b) Underlying price: It is the spot price or the price at which the underlying asset trades in the cash market.

(c) Contract multiplier/Contract size: As futures are traded in lots. The lot size or contract size for the index
and stock futures is determined by the exchange. It is different for each stock and index and can be
changed by the exchange from time to time depending upon the changes in the index level or stock
prices.

(d) Contract value: To know the contract value we must multiply the futures price with the contract
multiplier (Future price*lot size).

(e) Contract cycle: It is a period over which a contract is traded. Index and stock futures contracts traded on
the NSE follow a 3 months trading cycle. The NSE & BSE offers trading on monthly as well as weekly
futures contracts.

(f) Expiration day: The day on which a derivative contract ceases to exist. It is the last trading day of the
contract. On expiry, all the contracts are compulsorily settled. If a position is to be continued it must be
rolled over to another futures contract of the same underlying. For long position this means selling the
expiring contract and buying the next contract.

(g) Tick size: It is the minimum allowed move in the price quotations. Exchanges decide the tick size on
traded contracts as a part of contract specification. Tick size of nifty is 5 paisa.

(h) Daily settlement price: The exchange follows a daily settlement procedure for open positions in equity
index and stock futures contracts. All open positions are settled daily based on daily settlement price of
the futures contracts, which is calculated by the exchange on the basis of the last half-an-hour weighted
average price of that futures contract.

(i) Final settlement price: This is the price at which all open positions in the near month future contracts are
finally settled on the expiration day of the near month futures contract.

(j) Trading hours: The equity futures contracts can be traded during the normal market hours between 9:15
AM to 3:30 PM from Monday to Friday. The exchange publishes a list of annual trading holidays and
clearing holidays for the information of the market participants.