FINANCIAL DERIVATIVES

MBA IV SEM
BY: DR.AJAY SHARMA
HOD
RBMI, BAREILLY
Derivatives market
The Derivatives market is a financial
market where derivative instruments—such
as futures, options, and swaps—are traded.
These instruments derive their value from an
underlying asset, such as stocks, bonds,
commodities, currencies, or interest rates.
The main purpose of derivatives is to hedge
risk or to speculate on the future price
movements of these underlying assets.
Main types of derivatives in the market
Exchange-Traded Derivatives (ETDs): These
are standardized contracts that are traded on
regulated exchanges (like the Chicago
Mercantile Exchange or the London
International Financial Futures Exchange).
Examples include futures and options
contracts.
Over-the-Counter Derivatives (OTC): These
are customized contracts traded directly
between parties (not through an exchange).
They include swaps, forward contracts, and
certain options.
Evolution of Derivatives:

The history of derivatives dates back to ancient

times, but the modern derivatives market has
evolved over several centuries, primarily in
response to the need for risk management in
agricultural, financial, and commodity sectors.
Ancient Times:
Babylonian and Greek Markets: Early forms of
derivatives appeared in Babylon and ancient Greece.
For example, farmers in Babylon used agreements
resembling modern-day futures contracts to lock in
the prices of their crops. Similarly, in ancient
Greece, merchants would engage in early forms of
contracts to protect themselves from uncertain
weather conditions affecting trade.
Features of Derivatives
Underlying Asset
Definition: A derivative's value is based on
an underlying asset, which could be a
physical commodity (like gold or oil), a
financial asset (like stocks or bonds), a
currency, an interest rate, or an index.
Importance: The price of the derivative
moves in correlation with the price changes
of the underlying asset.
Leverage
Definition: Derivatives typically allow traders and
investors to control a large position with a relatively
small initial investment (known as margin).
Importance: Leverage amplifies both potential profits
and losses, making derivatives a tool for speculation
and hedging. However, this also increases the financial
risk.
3. Hedging and Risk Management
Definition: One of the primary purposes of derivatives
is to hedge against potential price movements in an
underlying asset. For example, companies can use
derivatives to manage risks related to fluctuating
prices, interest rates, or currencies.
Importance: Hedging allows businesses and investors
to protect themselves against unexpected market
changes and reduce their exposure to risk.
Speculation
Definition: Derivatives can be used for
speculative purposes, where investors take
positions based on their expectations about
future price movements of the underlying
asset.
Importance: Speculators do not typically
intend to own the underlying asset but rather
seek to profit from price movements. This
adds liquidity to the market but also
increases risk.
Types of Derivatives
Futures: Standardized contracts traded on
exchanges, obligating parties to buy or sell the
underlying asset at a specific future date and price.
Options: Contracts that provide the buyer with the
right (but not the obligation) to buy or sell an asset
at a predetermined price before a specified date.
Swaps: Agreements between two parties to
exchange cash flows, such as interest rate swaps or
currency swaps.
Forwards: Similar to futures but customizable,
traded over-the-counter (OTC) rather than on
exchanges.
Importance: The variety of derivative types offers
flexibility in how they can be used for risk
management, speculation, or arbitrage.
Settlement
Definition: Derivatives can be settled either
physically (where the actual asset is exchanged)
or in cash (where the difference between the
agreed price and the market price is paid in cash).
Importance: Cash-settled derivatives are
common in financial markets, whereas physically
settled contracts are often seen in commodity
trading.
7. Standardization vs. Customization
Exchange-Traded Derivatives (ETDs): These
are standardized contracts that are traded on
regulated exchanges. They typically have
predefined terms, such as contract size and
expiration date, making them easy to trade and
highly liquid.
Counterparty Risk
Definition: In OTC derivatives, there is a risk that
one of the parties involved may default on its
obligations. This is known as counterparty risk.
Importance: Counterparty risk can be mitigated in
exchange-traded derivatives, where the exchange
acts as an intermediary, guaranteeing the trade and
minimizing the risk of default.
Liquidity
Definition: Liquidity refers to how easily a derivative
can be bought or sold in the market without
significantly affecting its price.
Importance: Exchange-traded derivatives tend to
have higher liquidity due to standardization and the
presence of a large number of participants, while OTC
derivatives are often less liquid due to customization.
Forward market transactions involve contracts that
agree on the purchase or sale of an asset at a specific future
date and at a predetermined price.
These contracts are typically used for hedging risk or
speculating on the future price of an asset. They are traded in
the over-the-counter (OTC) market, rather than on an
exchange, and can be customized to meet the specific needs of
the parties involved.
Key characteristics of forward market transactions:
 Customizability: Forward contracts can be tailored to the
specific needs of the buyer and seller, including the quantity,
delivery date, and underlying asset.
 Settlement: Settlement is usually done at the end of the
contract term, and payment is made when the contract is
fulfilled.
 No initial payment: Unlike options, there is no upfront
premium or payment in forward contracts.
 Counterparty risk: Since these contracts are not traded on
exchanges, there is a risk that one party might default on the
contract.
Forward Contracts

Forward Contracts are private agreements

between two parties to buy or sell an asset at
a specified price at a future date. These
contracts are typically used for hedging or
speculation. They can be customized to meet
the specific needs of the buyer and seller, and
are traded in the over-the-counter (OTC)
market rather than on an exchange.
Key Features of Forward Contracts:
 Customization: Forward contracts are highly flexible and can be tailored to
meet the specific needs of both parties, including the quantity, quality, and
delivery terms of the underlying asset.
 Settlement Date: The contract specifies a future date for the transaction to
take place, known as the settlement date. This is when the exchange of the
asset and payment occurs.
 No Initial Payment: Unlike futures contracts, forward contracts generally
don’t require any upfront payment or margin. The buyer and seller agree to
settle the contract at the specified future date.
 Obligation to Execute: Both parties are obligated to fulfill the terms of the
contract, which means the buyer must purchase, and the seller must sell, the
asset at the agreed price and time.
 Over-the-Counter (OTC): Forward contracts are negotiated directly
between the two parties, rather than on an exchange. This means there’s no
centralized clearinghouse, and the contract terms are unique to the
transaction.
 Counterparty Risk: Since forward contracts are not cleared through an
exchange, there is a risk that one party might default on the agreement. This
is called counterparty risk.
 Non-transferable: Forward contracts are not standardized, and they cannot
typically be traded or transferred to other parties. Once the contract is
entered into, it generally remains between the original buyer and seller.
Example of a Forward Contract:

Imagine a company that imports goods from

a foreign country. The company knows it will
need to pay for these goods in the foreign
currency in six months. To avoid the risk of
currency fluctuations, the company enters
into a forward contract to buy the foreign
currency in six months at a fixed exchange
rate.
This guarantees the company the exact
amount of foreign currency it needs at a
known price, regardless of how the exchange
rate fluctuates in the meantime.
Advantages of Forward Contracts:
Hedge Against Price Fluctuations:
Companies can use forward contracts to
protect themselves against fluctuations in
prices or exchange rates.
Customization: The terms of the contract
can be fully tailored to the needs of the
parties, making it more flexible than
standardized financial products like futures
contracts.
No Upfront Cost: There is no initial margin
or premium payment involved in entering a
forward contract, unlike options or futures.
Disadvantages of Forward Contracts:
Counterparty Risk: The biggest
disadvantage is the possibility that the other
party may default on the contract.
Lack of Liquidity: Forward contracts are
not traded on exchanges, so they are difficult
to liquidate or transfer to another party.
Potential for Large Losses: Because the
buyer and seller are locked into a fixed price,
they may experience significant financial loss
if market conditions move against them.
forward market in India

The forward market in India refers to the

market where forward contracts are traded
for various assets like currencies,
commodities, and securities.
These contracts allow participants to lock in
prices for future transactions, providing a
tool for hedging risk or speculating on price
movements.
Key Features of the Forward Market in India:
Currency Forward Market:
The most prominent segment of the forward
market in India is the currency forward
market. It allows businesses and individuals
to hedge against fluctuations in exchange
rates.
Commodity Forward Market:
Commodities like agriculture products,
metals, and energy resources are often
traded through forward contracts.
Hedging with forwards
Hedging with forward contracts is a
strategy used by individuals or companies to
reduce or eliminate the risk of price
fluctuations in the value of an asset,
typically in commodities, currencies, or
financial instruments. The goal of hedging
with forwards is to lock in a price today for a
transaction that will take place in the future.
By doing so, businesses or investors can
protect themselves from potential losses due
to unfavorable price movements.