DERIVATIVES by - Prof.
Hilary Gaurea
derivatives
“A financial instrument / contract whose value is derived
from the value of an underlying asset.
₹ 3299.00
Underlying Asset
stocks / bonds,
₹ 3320.00 ₹ 3280.00
commodities,
currencies, ₹ 3300.00
interest rates, or (3 months)
Bullish Bearish
market indices
Agreed to Buy Agreed to Sell
Features of
Features of aa Derivative
Derivative Contract
Contract
Derives its value from an underlying asset
Investors are required to pay a margin to the exchange or broker.
Allow you to control a large position with a small amount of capital
The use of leverage increases the risk significantly.
Physical settlement & Cash settlement
Exchange-traded derivatives are
standardized in terms
highly liquid
Forward Contract Future Contract
A customized agreement between
two parties to buy or sell an asset at a
ER
D I Standardized contracts traded on
stock exchanges where parties agree to
VA E
F
specified future date at a price agreed buy or sell the underlying asset at a
O
upon today predetermined price and date.
TIV
ES
Options Contract
S TYP Swaps
An option gives the buyer the right to Swaps are agreements between two
buy (Call Option) or right to sell (Put parties to exchange sequences of cash
Option) the underlying asset at a flows for a set period. Common types
specific price before or on a specific are interest rate swaps and currency
date. swaps.
Importance of Derivatives
Risk Management (Hedging)
Price Discovery
Speculation
Arbitrage Opportunities
Risk Management
Risk Management (Hedging)
(Hedging) Important Points
Hedging involves using derivative instruments to
protect from adverse price movements. Hedging does not eliminate losses
but protects from adverse movement.
Identify
Exposure Options give flexibility,
while futures/forwards are binding.
Choose Derivative Over-hedging can lead to
Instrument speculative positions.
Use mark-to-market and margin practices
to monitor derivative exposure.
Take an
Opposite Position
Hedging decisions should align with
your risk appetite and financial goals.
Who Uses Derivatives for Hedging?
Exporters/Importers Airlines
Hedge currency fluctuations Hedge fuel (crude oil) price
A textile exporter in India hedges IndiGo or Jet Airways hedging crude oil
USD/INR with currency futures through oil futures
Farmers/Agricultural Cos. Portfolio Managers
Hedge against falling crop prices Protect stock portfolio from market fall
A fund manager shorts Nifty futures to
A wheat farmer uses futures to lock in
hedge equity exposure
price before harvest
Banks Manufacturing Companies
Hedge interest rate risk Hedge commodity/raw material prices
SBI enters into interest rate swaps for Tata Motors hedges aluminum and steel using
fixed vs floating rate commodity futures
Price Discovery
Price Discovery
The price of an asset is determined by the interactions of buyers and sellers in a market, based on supply and
demand dynamics, expectations, and available information.
Price discovery refers to how these markets help reveal or signal the expected future prices of underlying
assets
Visual: How Futures Price Reflects Expectations
Futures > Spot → Market expects asset price to rise
Futures < Spot → Market expects asset price to fall
High call option premiums may indicate bullish sentiment
High put premiums reflect bearish expectations.
Indian Oil Companies
Crude Oil
Spot Rate : $82
Crude futures (3 m) are trading at $90
the market expects a price rise
Indian Importer An Investor
USD / INR Exchange Rate Infosys Stock
Spot Rate : ₹ 83.80 Spot Rate : ₹1,567.20
USD/INR futures (3 m) are trading at $84.50 futures (3 m) are trading at ₹1,595.80
Signals rupee depreciation the market expects a price rise
Speculation in
Speculation in Derivatives
Derivatives
The act of buying or selling futures, options, or other derivative instruments to profit from price movements,
without any intention to own or deliver the underlying asset.
Speculators do not intend to own the underlying asset.
They aim to profit from price fluctuations using futures, options, or other derivatives.
Speculation can be bullish (expecting price rise) or bearish (expecting price fall).
Speculation through derivatives is a double-edged sword. It offers high return potential, but also amplifies risk.
Successful speculators rely on:
Market analysis
Risk management strategies
Discipline and timing
Arbitrage Opportunities
Arbitrage Opportunities
Buying an asset in one market and simultaneously selling it in another market to profit from price differences
— without any risk. Derivative contracts like futures, options, and forwards are often used to exploit such
price mismatches.
Types of Arbitrage Using Derivatives
Cash-and-Carry Arbitrage (involving Futures)
Reverse Cash-and-Carry Arbitrage
Index Arbitrage
Currency Arbitrage Using Futures
Options Arbitrage (Box, Conversion, Reversal)
Evolution of
Evolution of Derivative
Derivative Market
Market in
in India
India
1990s – Informal Derivatives (Forward Market) 2000 – Launch of Derivatives Trading
Informal forward trading NSE & BSE launched Index Futures
Badla system Official beginning of the derivatives market
1991–1996 – Ban on Forward Trading
2001 – Index Options and Stock Options
1993: SEBI was established
June 2001: Index Options were introduced.
1996: Badla system was banned
July 2001: Stock options on individual securities began.
1998 – L.C. Gupta Committee Report
November 2002: Single Stock Futures introduced.
a regulatory framework for derivatives. FII participation,
Exchange-traded derivatives Margin requirements, risk management systems.
Currency Derivatives (2008)
1999 – Legal Framework Introduced
Interest Rate Futures (2009)
Amendments in SCRA
Weekly options (on Nifty and Bank Nifty)
Risk Management Concepts
Hedging
Using derivatives to offset the risk of price movements in an underlying asset.
Common instruments: Futures, Options, Swaps.
Speculation
Traders use derivatives to bet on the future direction of the market for profit.
Risk is assumed willingly to gain higher returns.
Arbitrage
The practice of exploiting price differences in different markets using derivatives.
It helps bring efficiency to the market and reduces mispricing.
Leverage
Derivatives require a smaller margin, offering high leverage.
Increases both potential returns and risks.
Margin and Mark-to-Market
Initial margin is a security deposit.
Mark-to-market is the daily adjustment of account balance based on market value.
Risk Limit Controls
Firms set limits (VaR, stop-loss) to manage exposure.
Limits ensure that potential losses remain within acceptable levels.
Market Operational
Risk Risk
Types of
Counterparty Legal/Regul
Risks in
Risk atory Risk
Derivatives
Liquidity Model
Risk Risk
