Chapter 1

Financial Derivative Basic Concepts

1.1. Financial Derivatives – Concept
1.2. Participants in Financial Derivatives
1.3. Products of Financial Derivatives
1.4. Uses of Financial Derivatives
1.5. Features of Financial Derivatives
1.6. History of Derivatives Market
1.7. Myth about Derivatives
1.8. Regulation of Derivatives in India

1.1. FINANCIAL DERIVATIVES – CONCEPT

The past decade has witnessed the multiple growths in the volume of international trade
and business due to the wave of globalization and liberalization all over the world. As a
result, the demand for the international money and financial instruments increased
significantly at the global level. In this respect, changes in the interest rates, exchange rates
and stock market prices at the different financial markets have increased the financial risks
to the corporate world. Adverse changes have even threatened the very survival of the
business world. It is, therefore, to manage such risks; the new financial instruments have
been developed in the financial markets, which are also popularly known as financial
derivatives.

The basic purpose of these instruments is to provide commitments to prices for future dates
for giving protection against adverse movements in future prices, in order to reduce the
extent of financial risks. Not only this, they also provide opportunities to earn profit for
those persons who are ready to go for higher risks. In other words, these instruments,
indeed, facilitate to transfer the risk from those who wish to avoid it to those who are
willing to accept the same.

Today, the financial derivatives have become increasingly popular and most commonly used
in the world of finance. This has grown with so phenomenal speed all over the world that
now it is called as the derivatives revolution. In an estimate, the present annual trading
volume of derivative markets has crossed US $ 30,000 billion, representing more than 100
times gross domestic product of India.

Financial derivatives like futures, forwards options and swaps are important tools to manage
assets, portfolios and financial risks. Thus, it is essential to know the terminology and
conceptual framework of all these financial derivatives in order to analyze and manage the
financial risks. The prices of these financial derivatives contracts depend upon the spot
prices of the underlying assets, costs of carrying assets into the future and relationship with
spot prices. For example, forward and futures contracts are similar in nature, but their
prices in future may differ. Therefore, before using any financial derivative instruments for
hedging, speculating, or arbitraging purpose, the trader or investor must carefully examine
all the important aspects relating to them.

Definition of Financial Derivatives

Before explaining the term financial derivative, let us see the dictionary meaning of
‘derivative’.
1. A word formed by derivation. It means, this word has been arisen by derivation.
2. Something derived; it means that some things have to be derived or arisen out of the
underlying variables. For example, financial derivative is an instrument indeed derived
from the financial market.
3. The limit of the ratio of the change is a function to the corresponding change in its
independent variable. This explains that the value of financial derivative will change as
per the change in the value of the underlying financial instrument.
4. A chemical substance related structurally to another substance, and theoretically
derivable from it. In other words, derivatives are structurally related to other
substances.
5. A substance that can be made from another substance in one or more steps. In case of
financial derivatives, they are derived from a combination of cash market instruments or
other derivative instruments.

Derivative are used for the following purposes

1. Hedging.
2. Speculations.
3. Arbitrations.

Derivative is a financial instrument whose value is derived from its underlying asset. E.g.
Future contract to buy Foreign Currency is a derivative contract. The value of this derivative
will be determined by its underlying asset e.g. the Foreign Currency. Underlying asset can be
Shares of Reliance, Commodity like gold, crude oil, Soybean, Indexes like BSE SENSEX etc.
Forward, Futures and Options are three common derivative instruments.
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Forward Contract: A forward contract is an arrangement entered today under which one
party agrees to buy and other agrees to sell a specified asset on a specific future date at an
agreed price.

Futures Contract: A futures contract is standardized contract between two parties where
one party commits to buy and other commits to sell, a specified quantity of a specified asset
at an agreed price on a given date in the future. Futures are exchange traded.

Options Contract: An Option is a contract between two parties under which the buyer of
the option buys the right, and not the obligation, to buy or sell a standardized quantity
(contract size) of a financial instrument (underlying asset) at or before a pre-determined
date (expiry date) at a price decided in advance (Exercise Price or Strike Price). Options are
exchange traded.
 When the option gives the buyer of the option the “right to buy” it is called a call option.
 When the option gives the buyer of the option the “right to sell” it is called a put option.
 Long: Long means “Buying” in the derivative market.
 Short: Short mean “Selling” in the derivative market.

Example 1
Assume that you want to gift 10 gm of gold to your sister, on her wedding anniversary after
three months. Current price is Rs. 30,000 per gram. You consider that the gold rate may rise
to Rs. 35,000 per 10 gm in next three months. Hence to protect yourself against the adverse
movement in price, you take position in derivative market. Suppose, 3 months gold forward
is trading at Rs. 32,000 in market, you buy a short forward. Suppose after 3 months, the spot
rate turned out to be Rs. 35,000 you will still be able to buy the gold for ₹ 32,000.

Example 2
You have 100 shares of X Ltd. bought at Rs. 10 each. You expect the stock price to remain
between 8 and 15 and you would like to protect yourself from fall in stock prices. You
should therefore buy a Short Forward (i.e. contract to sell) OR put (i.e. right to sell) at any
amount above Rs. 10 say 12. If the share prices go down than 12 you can still sell at 12 and
make profit.

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 1.2. PARTICIPANTS IN FINANCIAL DERIVATIVES

The participants in the derivative markets can be broadly classified in three depending upon
their motives. These are:
1. Hedgers
2. Speculators

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 3. Arbitrageurs

Hedgers
Hedgers are those who enter into a derivative contract with the objective of covering risk.
Farmer growing wheat faces uncertainty about the price of his produce at the time of the
harvest. Similarly, a flour mill needing wheat also faces uncertainty of price of input. Both
the farmer and the flour mill can enter into a forward contract, where the farmer agrees to
sell his produce when harvested at predetermined price to the flour mill. The farmer
apprehends price fall while the flour mill fears price rise. Both the parties face price risk. A
forward contract would eliminate price risk for both the parties. A forward contract is
entered into with the objective of hedging against the price risk being faced by the farmer as
well as the flour mill. Such participants in the derivatives markets are called hedgers. The
hedgers would like to conclude the contract with the delivery of the underlying asset. In the
example the contract would be settled by the farmer delivering the wheat to the flour mill
on the agreed date at an agreed price.

Speculators
Speculators are those who enter into a derivative contract to make profit by r assuming risk.
They have an independent view of future price behaviour of the underlying asset and take
appropriate position in derivatives with the intention of making profit later. For example,
the forward price in US dollar for a contract maturing in three months is ₹ 48.00. If one
believes that three months later the price of US dollar would be ₹ 50, one would buy
forward today and sell later. On the contrary, if one believes US dollar would depreciate to ₹
46.00 in 1 month one would sell now and buy later. Note that the intention is not to take
delivery of underlying, but instead gain from the differential in price. If only hedgers were to
operate in the derivative markets, the number of participants in the market would be
extremely limited.

A farmer would find it difficult to locate a flour mill with perfectly matched and complimentary
requirements in terms of quantity, quality, and timing of the delivery of the asset (wheat in
this case). Similarly, a flour mill would also find it difficult to locate a suitable farmer to
supply the exact requirements. If middlemen are permitted to operate, the hedgers need
not look for exact match, and instead they can deal with the middlemen who would buy the
produce from the farmer in advance with anticipation of higher price in the future at the
time of harvest. Such middlemen will be speculating on the future price and bid a current
price in a manner that is likely to result in gain for them.

By entering into a contract on the derivatives the speculators are assuming risk of price in
future. Speculators perform an extremely important function. They render liquidity to the
market. Without speculators in the market not only would it be difficult for hedgers to find
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matching parties but the hedge is likely to be far from being efficient. Presence of
speculators makes the markets competitive, reduces transaction costs, and expands the
market size. More importantly, they are the ones who assume risk and serve the needs of
hedgers who avoid risk. With speculators around, hedgers find counterparties conveniently.

Arbitrageurs
It would seem that hedgers and speculators would complete the market. Not really so
because we assume that different markets are efficient by themselves and they operate in
tandem. We describe derivative as the one that derives its price from the underlying asset.
Structurally the markets for derivatives and the underlying are separate. For example,
agricultural products would b€ bought and sold in the physical market (mandis), while
futures on them are traded on the commodity exchange.

However, there has to be complete harmony between the mandis and commodity
exchange. There cannot be any disparity in the prices in the mandis and the commodity
exchange.

The third category of participants, i.e. arbitrageurs, performs the function of making the
prices in different markets converge and be in tandem with each other. While hedgers and
speculators want to eliminate and assume risk respectively, the arbitrageurs take riskless
position and yet earn profit. They are constantly monitoring the prices of different assets in
different markets and identify opportunities to make profit that emanate from mispricing of
products. The most common example of arbitrage is the price difference that may be
prevailing in different stock markets. For example, if the share price of Hindustan Unilever is
₹ 175 in National Stock Exchange (NSE) and ₹ 177 in Bombay Stock Exchange (BSE), the
arbitrageur will buy at NSE and sell at BSE simultaneously and pocket the difference of ₹ 2
per share.

An arbitrageur takes risk neutral position and makes profits because markets are imperfect.
Naturally, such imperfections cannot exist for long. These imperfections are extremely
short-lived. The arbitrageur cashes upon these short-lived opportunities. Such actions
restore the balance in prices and remove distortions in the pricing of assets.

Fundamentally the speculators and arbitrageurs fall in the same category in as much as that
both are not looking at owning or disowning the underlying asset by delivery like hedgers.
Both speculators and arbitrageurs are also trying to render competitiveness to the market,
thereby helping the price discovery process. Difference between the two lies in the amount
of risk they assume. While speculators have their opinions about the future price of the
underlying asset by making investment, the arbitrageur is concentrating on the mispricing in
different markets by taking riskless position with no investment of his own. By his actions an
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arbitrageur is restoring the balance and consistency among different markets, while
speculators only hope for the desirable movement in prices. Arbitrageurs are the ones who
prohibit speculators to overbid or underbid the prices in the derivatives as compared to the
physical markets.

1.3. PRODUCTS OF FINANCIAL DERIVATIVES

Derivatives Products Traded in Derivatives Segment of BSE

The BSE created history on June 9, 2000 when it launched trading in Sensex based futures
contract for the first time. It was followed by trading in index options on June 1, 2001; in
stock options and single stock futures (31 stocks) on July 9, 2001 and November 9, 2002,
respectively. Currently, the number of stocks under single futures and options is 1096. BSE
achieved another milestone on September 13, 2004 when it launched Weekly Options, a
unique product unparalleled worldwide in the derivatives markets. It permitted trading in
the stocks of four leading companies namely; State Bank of India, Reliance Industries and
TISCO (renamed now Tata Steel). Chhota (mini) SENSEX7 was launched on January 1, 2008.
With a small or 'mini' market lot of 5, it allows for comparatively lower capital outlay, lower
trading costs, more precise hedging and flexible trading. Currency futures were introduced
on October 1, 2008 to enable participants to hedge their currency risks through trading in
the U.S. dollar-rupee future platforms.

Derivatives Products Traded in Derivatives Segment of NSE

NSE started trading in index futures, based on popular S&P CNX Index, on June 12, 2000 as
its first derivatives product. Trading on index options was introduced on June 4, 2001.
Futures on individual securities started on November 9, 2001. The futures contracts are
available on 2338 securities stipulated by the Securities & Exchange Board of India (SEBI).
Trading in options on individual securities commenced from July 2, 2001. The options
contracts are American style and cash settled and are available on 233 securities. Trading in
interest rate futures was introduced on 24 June 2003 but it was closed subsequently due to
pricing problem. The NSE achieved another landmark in product introduction by launching
Mini Index Futures & Options with a minimum contract size of ₹ 1 lacks. NSE crated history
by launching currency futures contract on US Dollar-Rupee on August 29, 2008 in Indian
Derivatives market.

List of Derivative Products

Equity Derivatives
1. Equity Options
2. Equity Index Options
3. Equity Index Futures
4. Equity Forward
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5. Equity Swap

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 6. Equity Variance Swap
7. Equity Volatility Swap
8. Equity Variance Option
9. Equity Volatility Option
10. Equity Warrants
11. Equity Convertibles
12. Equity Convertible Swaps
13. Equity Convertible Preferred
Interest Rate Derivatives
1. Bond Futures
2. Interest Rate Futures
3. Futures on Swaps
4. Options on Bond Futures
5. Options on Interest Rate Futures
6. Interest Rate Swap
7. Cross-Currency Swap
8. Bond Forwards
9. FRA – Floating Rate Agreements
Structured Products (Notes/Bonds/Bills)
1. FX Derivatives
2. FX Futures
3. FX Forwards
4. FX Listed Options
5. FX OTC Options
6. Currency-linked Notes
7. Currency Swaptions
Credit Derivatives
1. Credit Default Swap- Single Names
2. Credit Default Swap – Basket
3. Credit Default Swap – Index

1.4. USES OF FINANCIAL DERIVATIVES

Derivatives are supposed to provide the following services:

1. Risk aversion tools: One of the most important services provided by the derivatives is to
control, avoid, shift and manage efficiently different types of risks through various
strategies like hedging, arbitraging, spreading, etc. Derivatives assist the holders to shift
or modify suitably the risk characteristics of their portfolios. These are specifically useful
in highly volatile financial market conditions like erratic trading, highly flexible interest
rates, volatile exchange rates and monetary chaos.
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2. Prediction of future prices: Derivatives serve as barometers of the future trends in
prices which result in the discovery of new prices both on the spot and futures markets.
Further, they help in disseminating different information regarding the futures markets
trading of various commodities and securities to the society which enable to discover or
form suitable or correct or true equilibrium prices in the markets. As a result, they assist
in appropriate and superior allocation of resources in the society.
3. Enhance liquidity: As we see that in derivatives trading no immediate full amount of the
transaction is required since most of them are based on margin trading. As a result, large
number of traders, speculators arbitrageurs operates in such markets. So, derivatives
trading enhance liquidity and reduce trans-action costs in the markets for underlying
assets.
4. Assist investors: The derivatives assist the investors, traders and managers of large
pools of funds to devise such strategies so that they may make proper asset allocation
increase their yields and achieve other investment goals.
5. Integration of price structure: It has been observed from the derivatives trading in the
market that the derivatives have smoothen out price fluctuations, squeeze the price
spread, integrate price structure at different points of time and remove gluts and
shortages in the markets.
6. Catalyse growth of financial markets: The derivatives trading encourage the
competitive trading in the markets, different risk taking preference of the market
operators like speculators, hedgers, traders, arbitrageurs, etc. resulting in increase in
trading volume in the country. They also attract young investors, professionals and other
experts who will act as catalysts to the growth of financial markets.
7. Brings perfection in market: Lastly, it is observed that derivatives trading develop the
market towards ‘complete markets’. Complete market concept refers to that situation
where no particular investors can be better off than others, or patterns of returns of all
additional securities are spanned by the already existing securities in it, or there is no
further scope of additional security.

1.5. FEATURES OF FINANCIAL DERIVATIVES

1. It is a contract: Derivative is defined as the future contract between two parties. It

means there must be a contract-binding on the underlying parties and the same to be
fulfilled in future. The future period may be short or long depending upon the nature of
contract, for example, short term interest rate futures and long term interest rate
futures contract. Derives value from underlying asset: Normally, the derivative
instruments have the value which is derived from the values of other underlying assets,
such as agricultural commodities, metals, financial assets, intangible assets, etc. Value of
derivatives depends upon the value of underlying instrument and which changes as per

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the changes in the underlying assets, and sometimes, it may be nil or zero. Hence, they are
closely related.
2. Specified obligation: In general, the counter parties have specified obligation under the
derivative contract. Obviously, the nature of the obligation would be different as per the
type of the instrument of a derivative. For example, the obligation of the counter
parties, under the different derivatives, such as forward contract, future contract, option
contract and swap contract would be different.
3. Direct or exchange traded: The derivatives contracts can be undertaken directly
between the two parties or through the particular exchange like financial futures
contracts. The exchange-traded derivatives are quite liquid and have low transaction
costs in comparison to tailor-made contracts. Example of ex-change traded derivatives
are Dow Jons, S&P 500, Nikki 225, NIFTY option, S&P Junior that are traded on New York
Stock Exchange, Tokyo Stock Exchange, National Stock Exchange, Bombay Stock
Exchange and so on.
4. Related to notional amount: In general, the financial derivatives are carried off-balance
sheet. The size of the derivative contract depends upon its notional amount. The
notional amount is the amount used to calculate the payoff. For instance, in the option
contract, the potential loss and potential payoff, both may be different from the value of
underlying shares, because the payoff of derivative products differs from the payoff that
their notional amount might suggest.
5. Delivery of underlying asset not involved: Usually, in derivatives trading, the taking or
making of delivery of underlying assets is not involved, rather underlying transactions
are mostly settled by taking offsetting positions in the derivatives themselves. There is,
therefore, no effective limit on the quantity of claims, which can be traded in respect of
underlying assets.
6. May be used as deferred delivery: Derivatives are also known as deferred delivery or
deferred payment instrument. It means that it is easier to take short or long position in
derivatives in comparison to other assets or securities. Further, it is possible to combine
them to match specific, i.e., they are more easily amenable to financial engineering.
7. Secondary market instruments: Derivatives are mostly secondary market instruments
and have little usefulness in mobilizing fresh capital by the corporate world, however,
warrants and convertibles are exception in this respect.
8. Exposure to risk: Although in the market, the standardized, general and exchange-
traded derivatives are being increasingly evolved, however, still there are so many
privately negotiated customized, over-the-counter (OTC) traded derivatives are in
existence. They expose the trading parties to operational risk, counter-party risk and
legal risk. Further, there may also be uncertainty about the regulatory status of such
derivatives.
9. Off balance sheet item: Finally, the derivative instruments, sometimes, because of their
off-balance sheet nature, can be used to clear up the balance sheet. For example, a fund
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 manager who is restricted from taking particular currency can buy a structured note
whose coupon is tied to the performance of a particular currency pair.

1.6. HISTORY OF DERIVATIVES MARKET

It is difficult to trace the main origin of futures trading since it is not clearly established as to
where and when the first forward market came into existence. Historically, it is evident that
the development of futures markets followed the development of forward markets. It is
believed that the forward trading has been in existence since 12th century in England and
France. Forward trading in rice was started in 17th century in Japan, known as Cho-at-Mai a
kind (rice trade-on-book) concentrated around Dojima in Osaka, later on the trade in rice
grew with a high degree of standardization. In 1730, this market got official recognition from
the Tokugawa Shogurate. As such, the Dojima rice market became the first futures market in
the sense that it was registered on organized exchange with the standardized trading
norms.

The butter and eggs dealers of Chicago Produce Exchange joined hands in 1898 to form the
Chicago Mercantile Exchange for futures trading. The exchange provided a futures market
for many commodities including pork bellies (1961), live cattle (1964), live hogs (1966), and
feeder cattle (1971). The International Monetary Market was formed as a division of the
Chicago Mercantile Exchange in 1972 for futures trading in foreign currencies. In 1982, it
introduced a futures contract on the S&P 500 Stock Index. Many other exchanges
throughout the world now trade futures contracts. Among them are the Chicago Rice and
Cotton Exchange, the New York Futures Exchange, the London International Financial
Futures Exchange, the Toronto Futures Exchange and the Singapore international Monetary
Exchange. They grew so rapidly that the number of shares underlying the option contracts
sold each day exceeded the daily volume of shares traded on the New York Stock Exchange.

In 1874, the Chicago Produce Exchange was established which provided the market for butter,
eggs, poultry, and other perishable agricultural products. In the year 1877, the London
Metal Exchange came into existence, and today, it is leading market in metal trading both in
spot as well as forward. In the year 1898, the butter and egg dealers withdrew from the
Chicago Produce Exchange to form separately the Chicago Butter and Egg Board, and thus,
in 1919 this exchange was renamed as the Chicago Mercantile Exchange (CME) and was
reorganized for futures trading. Since then, so many other exchanges came into existence
throughout the world which trade in futures contracts.

Although financial derivatives have been in operation since long, they have become a major
force in financial markets only in the early 1970s. The basic reason behind this development
was the failure of Brettonwood System and the fixed exchange rate regime was broken
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down. As a result, new exchange rate regime, i.e., floating rate (flexible) system based upon
market forces came into existence. But due to pressure of demand and supply on different
currencies, the exchange rates were constantly changing, and often, substantially. As a
result, the business firms faced a new risk, known as currency or foreign exchange risk.
Accordingly, a new financial instrument was developed to overcome this risk in the new
financial environment.

Another important reason for the instability in the financial market was fluctuation in the
short-term interests. This was mainly due to that most of the government at that time tried
to manage foreign exchange fluctuations through short-term interest rates and by
maintaining money supply targets, but which were contrary to each other. Further, the
increased instability of short-term interest rates created adverse impact on long-term
interest rates, and hence, instability in bond prices because they are largely determined by
long-term interest rates. The result is that it created another risk, named interest rate risk,
for both the issuers and the investors of debt instruments.

Derivatives markets in India have been in existence in one form or the other for a long time.
In the area of commodities, the Bombay Cotton Trade Association started futures trading
way back in 1875. In 1952, the Government of India banned cash settlement and options
trading. Derivatives trading shifted to informal forwards markets. In recent years,
government policy has shifted in favour of an increased role of market-based pricing and
less suspicious derivatives trading.

The first step towards introduction of financial derivatives trading in India was the
promulgation of the Securities Laws (Amendment) Ordinance, 1995. It provided for
withdrawal of prohibition on options in securities. The last decade, beginning the year 2000,
saw lifting of ban on futures trading in many commodities. Around the same period,
national electronic commodity exchanges were also set up. Derivatives trading commenced
in India in June 2000 after SEBI granted the final approval to this effect in May 2001 on the
recommendation of L. C Gupta committee. Securities and Exchange Board of India (SEBI)
permitted the derivative segments of two stock exchanges, NSE3 and BSE4 , and their
clearing house/corporation to commence trading and settlement in approved derivatives
contracts. Initially, SEBI approved trading in index futures contracts based on various stock
market indices such as, S&P CNX, Nifty and Sensex.

Subsequently, index-based trading was permitted in options as well as individual securities.

The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on
individual securities commenced in July 2001. Futures contracts on individual stocks were
launched in November 2001. The derivatives trading on NSE commenced with S&P CNX
Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4,
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2001 and trading in options on individual securities commenced on July 2, 2001. Single stock
futures were launched on November 9, 2001. The index futures and options contract on NSE
are based on S&P CNX. In June 2003, NSE introduced Interest Rate Futures which were
subsequently banned due to pricing issue.

1.7. MYTH ABOUT DERIVATIVES

1. Very Complex in Nature – Many people think that the financial derivatives are new and
very complex in nature. But the fact is that, the derivatives are not at all new, they have
existed in the market for many years. In fact, the concept of options, one type of
financial derivatives, was found in the Greek philosopher Aristotle’s essays. However,
most of the financial derivatives are now days made simple to minimize the risks.
2. Only big Corporates make use of Derivatives – The second myth is related to the user of
derivatives. It is generally thought that only the big corporates and banks use
derivatives. But the ground reality is, many small firms and regional banks use
derivatives. The small regional banks can minimize the risks by using the derivatives.
That is, the economic benefits of financial derivatives are independent of the size of the
users; both small and big scale organizations may achieve the benefits.
3. Derivatives are Speculative – Most of the people think that the financial derivatives are
speculative. But the truth is that, many firms have achieved financial growth using the
derivatives. The derivative products drive the innovation of new technologies.
4. Derivative means loss – The common people think that the financial derivatives only
take money from company but not give back anything. The reality is completely the
opposite. Financial derivatives reduce the risk, which allows the companies to accelerate
their product activities.
5. Pricing are managed by participants – Somebody think that the financial derivatives
closely linked the market participants together, which increases the systematic risks.
6. Risky for Banks to use derivatives – Another misconception about the financial
derivative is that it can reduce the value of bank capital.
7. High Credit Risk – Many people are concerned about the risks, namely, credit risks,
market risks and operating risks associated with financial derivatives. They are used to
think that these risks are new, though it is not true. These risks are same like those
associated with the traditional financial instruments.

1.8. REGULATION OF DERIVATIVES IN INDIA

The regulatory framework in India is based on the L.C. Gupta Committee Report and the J.R.
Varma Committee Report. It is mostly consistent with regulating principles and addresses
the common concerns of investor protection, market efficiency and integrity and financial
integrity.
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The L.C. Gupta Committee Report provides a perspective on division of regulatory
responsibility between the exchange and the SEBI. It recommends that SEBI’s role should be
restricted to approving rules, bye laws and regulations of a derivatives exchange as also to
approving the proposed derivatives contracts before commencement of their trading. It
emphasises the supervisory and advisory role of SEBI with a view to permitting desirable
flexibility, maximizing regulatory effectiveness and minimizing regulatory cost.

Regulatory requirements for authorization of derivatives brokers/dealers include relating to

capital adequacy, net worth, certification requirement and initial registration with SEBI.

It also suggests establishment of a separate clearing corporation, maximum exposure limits,

mark to market margins, margin collection from clients and segregation of clients’ funds,
regulation of sales practice and accounting and disclosure requirements for derivatives
trading.

The J.R. Varma committee suggests a methodology for risk containment measures for index-
based futures and options, stock options and single stock futures. The risk containment
measures include calculation of margins, position limits, exposure limits and reporting and
disclosure.

To remove the road-block of non-recognition of derivatives as securities under Securities

Contract Regulation Act, the Securities Law (Amendment) Bill, 1999 was introduced to bring
about the much needed changes. Accordingly, in December, 1999, the new framework has
been approved and ‘Derivatives’ have been accorded the status of ‘Securities’.

Past Examination Theory Question’s on Unit Basis

Question 1: What is the difference between the over-the counter market and the exchange
traded market? What are the bid and offer quotes of a market maker in the OTC market?
(AM-14 Marks Summer-15)
Question 2: Discuss carefully the various participants of the derivatives market. Also explain
their role in mobilizing the derivatives market.
(AM-14 Marks Summer-15)
Question 3: What do you understand by financial derivatives? Explain the term basic
derivatives and complex derivatives. Discuss different types of basic and complex derivatives
(AK-14 Marks Summer-14)
Question 4: State the historical background of financial derivatives in India and discuss the
position of financial derivatives in India.
(AK-14 Marks Summer-14)

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Question 5: What do you understand by financial derivatives? Explain the term basic
derivatives and complex derivatives. Discuss different types of basic and complex
derivatives.
(AJ-7 Marks Winter-13)
Question 6: State the historical background of financial derivatives in India and discuss the
position of financial derivatives in India.
(AE-14 Marks Summer-11)
Question 7: What do you understand by Derivatives securities? State general approach to
pricing derivatives securities.
(AE-14 Marks Summer-11)
Question 8: Define and difference between ‘financial derivatives’ and ‘commodity
derivatives’. Explain the major types of financial derivatives.
(AD-14 Marks Winter-10)
Question 9: Give a detailed account of different types of participants of derivatives market.
(AD-14 Marks Winter-10)
Question 10: Who are the different participants of financial derivatives market? Discuss in
detail the different trading participants of financial derivatives market.
(JSD-14 Marks Summer-09)

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