CO1: Financial Derivatives: An Introduction, Meaning and Definition of Derivatives -
Evolution of Derivatives, Uses of Derivatives; Derivative Markets – Participants -
Classification – Types of Derivatives - Underlying Asset - Forwards Futures, Options and
Swaps. Trading Regulation of Derivatives in India.
INTRODUCTION TO DERIVATIVES
The objective of an investment decision is to get required rate of return with minimum risk. To
achieve this objective, various instruments, practices, and strategies have been devised and
developed in the recent past. With the opening of boundaries for international trade and
business, the world trade gained momentum in the last decade, the world has entered into a
new phase of global integration and liberalisation. The integration of capital markets world-
wide has given rise to increased financial risk with the frequent changes in the interest rates,
currency exchange rate and stock prices. To overcome the risk arising out of these fluctuating
variables and increased dependence of capital markets of one set of countries to the others, risk
management practices have also been reshaped by inventing such instruments as can mitigate
the risk element. These new popular instruments are known as financial derivatives which, not
only reduce financial risk but also open us new opportunity for high risk takers.
The emergence of the market for derivative products, most notably forwards, futures and
options, can be traced back to the willingness of risk-averse economic agents to guard
themselves against uncertainties arising out of fluctuations in asset prices. By their very nature,
the financial markets are marked by a very high degree of volatility. Through the use of
derivative products, it is possible to transfer price risks partially or fully by locking in asset
prices. As instruments of risk management, these generally do not influence the fluctuations in
the underlying asset prices. However, by locking in asset prices, derivative products minimize
the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-
averse investors.
DEFINITION OF DERIVATIVES
Literal meaning of derivative is that something which is derived. Now question arises as to
what is derived? From what it is derived? Simple one line answer is that value/price is derived
,from any underlying asset. The term ‘derivative’ indicates that it has no independent value, i.e.,
its value is entirely derived from the value of the underlying asset. The underlying asset can be
securities, commodities, bullion, currency, livestock or anything else.
The Securities Contracts (Regulation) Act 1956 defines ‘derivative’ as under:
Derivatives includes –
- Security derived from a debt instrument, share, loan whether secured or unsecured,
risk instrument or contract for differences or any other form of security.
- A contract which derives its value from the prices, or index of prices of underlying
securities.
“Derivatives are weapons of mass destruction.” - Warren Buffett
Firstly, derivatives originated as a tool for managing risk in commodities markets. In
commodity derivatives, the underlying asset is a commodity. It can be agricultural commodity
like wheat, soybeans, rapeseed, cotton etc. or precious metals like gold, silver etc. The term
financial derivative denotes a variety of financial instruments including stocks, bonds, treasury
bills, interest rate, foreign currencies, and other hybrid securities.
Financial derivatives include futures, forwards, options, swaps, etc. Futures contracts are the
most important form of derivatives, which are in existence long before the term ‘derivative’
was coined. Financial derivatives can also be derived from a combination of cash market
instruments or other financial derivative instruments. In fact, most of the financial derivatives
are not new instruments rather they are merely combinations of older generation derivatives
and/or standard cash market instruments.
EVOLUTION OF DERIVATIVES
The Story of Forwards
The basic cause of forward trading was to cover the price risk. In earlier years,
transporting goods from one market to other markets took many months. For example,
in the 1800s, food grains produced in England sent through ships to the United States
which normally took few months. Sometimes, during this time, the price trembled due
, to unfavourable events before the goods reached to the destination. In such cases, the
producers had to sell their goods at loss.
Therefore, the producers sought to avoid such price risk by selling their goods forward,
or on a “to arrive” basis. The basic idea behind this move at that time was simply to
cover future price risk.
On the opposite side, the speculator or other commercial firms seeking to offset their
price risk came forward to go for such trading. In this way, the forward trading in
commodities came into existence.
In the beginning, these forward trading agreements were formed to buy and sell food
grains in the future for actual delivery at the predetermined price.
Later on, these agreements became transferable, and during the American Civil War
period, Le., 1860 to 1865, it became common place to sell and resell such agreements
where actual delivery of produce was not necessary.
Gradually, the traders realized that the agreements were easier to buy and sell if the
same were standardized in terms of quantity, quality and place of delivery relating to
food grains.
In the nineteenth century this activity was centred in Chicago which was the main food
grains marketing centre in the United States.
In this way, the modern futures contracts first came into existence with the
establishment of the Chicago Board of Trade (CBOT) in the year 1848, and today, it is
the largest futures market of the world. In 1865, the CBOT framed the general rules for
such trading which later on became a trendsetter for so many other markets.
Evolution of Derivatives, Uses of Derivatives; Derivative Markets – Participants -
Classification – Types of Derivatives - Underlying Asset - Forwards Futures, Options and
Swaps. Trading Regulation of Derivatives in India.
INTRODUCTION TO DERIVATIVES
The objective of an investment decision is to get required rate of return with minimum risk. To
achieve this objective, various instruments, practices, and strategies have been devised and
developed in the recent past. With the opening of boundaries for international trade and
business, the world trade gained momentum in the last decade, the world has entered into a
new phase of global integration and liberalisation. The integration of capital markets world-
wide has given rise to increased financial risk with the frequent changes in the interest rates,
currency exchange rate and stock prices. To overcome the risk arising out of these fluctuating
variables and increased dependence of capital markets of one set of countries to the others, risk
management practices have also been reshaped by inventing such instruments as can mitigate
the risk element. These new popular instruments are known as financial derivatives which, not
only reduce financial risk but also open us new opportunity for high risk takers.
The emergence of the market for derivative products, most notably forwards, futures and
options, can be traced back to the willingness of risk-averse economic agents to guard
themselves against uncertainties arising out of fluctuations in asset prices. By their very nature,
the financial markets are marked by a very high degree of volatility. Through the use of
derivative products, it is possible to transfer price risks partially or fully by locking in asset
prices. As instruments of risk management, these generally do not influence the fluctuations in
the underlying asset prices. However, by locking in asset prices, derivative products minimize
the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-
averse investors.
DEFINITION OF DERIVATIVES
Literal meaning of derivative is that something which is derived. Now question arises as to
what is derived? From what it is derived? Simple one line answer is that value/price is derived
,from any underlying asset. The term ‘derivative’ indicates that it has no independent value, i.e.,
its value is entirely derived from the value of the underlying asset. The underlying asset can be
securities, commodities, bullion, currency, livestock or anything else.
The Securities Contracts (Regulation) Act 1956 defines ‘derivative’ as under:
Derivatives includes –
- Security derived from a debt instrument, share, loan whether secured or unsecured,
risk instrument or contract for differences or any other form of security.
- A contract which derives its value from the prices, or index of prices of underlying
securities.
“Derivatives are weapons of mass destruction.” - Warren Buffett
Firstly, derivatives originated as a tool for managing risk in commodities markets. In
commodity derivatives, the underlying asset is a commodity. It can be agricultural commodity
like wheat, soybeans, rapeseed, cotton etc. or precious metals like gold, silver etc. The term
financial derivative denotes a variety of financial instruments including stocks, bonds, treasury
bills, interest rate, foreign currencies, and other hybrid securities.
Financial derivatives include futures, forwards, options, swaps, etc. Futures contracts are the
most important form of derivatives, which are in existence long before the term ‘derivative’
was coined. Financial derivatives can also be derived from a combination of cash market
instruments or other financial derivative instruments. In fact, most of the financial derivatives
are not new instruments rather they are merely combinations of older generation derivatives
and/or standard cash market instruments.
EVOLUTION OF DERIVATIVES
The Story of Forwards
The basic cause of forward trading was to cover the price risk. In earlier years,
transporting goods from one market to other markets took many months. For example,
in the 1800s, food grains produced in England sent through ships to the United States
which normally took few months. Sometimes, during this time, the price trembled due
, to unfavourable events before the goods reached to the destination. In such cases, the
producers had to sell their goods at loss.
Therefore, the producers sought to avoid such price risk by selling their goods forward,
or on a “to arrive” basis. The basic idea behind this move at that time was simply to
cover future price risk.
On the opposite side, the speculator or other commercial firms seeking to offset their
price risk came forward to go for such trading. In this way, the forward trading in
commodities came into existence.
In the beginning, these forward trading agreements were formed to buy and sell food
grains in the future for actual delivery at the predetermined price.
Later on, these agreements became transferable, and during the American Civil War
period, Le., 1860 to 1865, it became common place to sell and resell such agreements
where actual delivery of produce was not necessary.
Gradually, the traders realized that the agreements were easier to buy and sell if the
same were standardized in terms of quantity, quality and place of delivery relating to
food grains.
In the nineteenth century this activity was centred in Chicago which was the main food
grains marketing centre in the United States.
In this way, the modern futures contracts first came into existence with the
establishment of the Chicago Board of Trade (CBOT) in the year 1848, and today, it is
the largest futures market of the world. In 1865, the CBOT framed the general rules for
such trading which later on became a trendsetter for so many other markets.
