Financial Derivatives

Introduction to Derivatives

The term ‘Derivative’ stands for a contract whose price is derived from or is dependent upon an underlying asset. The underlying asset could be a financial asset such as currency, stock and market index, an interest bearing security or a physical commodity. Today, around the world, derivative contracts are traded on electricity, weather, temperature and even volatility.

According to the Securities Contract Regulation Act, (1956) the term “derivative” includes:

(i) A security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;

(ii) A contract which derives its value from the prices, or index of prices, of underlying securities.

Types of Derivatives: 

1. OTC (Over the Counter) OTC Derivatives are contracts that are traded/negotiated directly between the contracting parties. The OTC Derivative market is the largest market for derivatives and it is also the most unregulated. There is always an inherent risk of either of the parties not honouring the agreement.

2. ETD (Exchange Traded Derivatives) ETD are those that are traded via regulated/specialized trading exchanges. A derivative exchange acts as the intermediary for all transactions and requires an initial margin to be put up by both the parties of the trade to serve as a guarantee. In India NSE is one of the largest ETD exchange.

Types (Components or Instruments) of Derivative Contracts

Derivatives comprise four basic contracts namely Forwards, Futures, Options and Swaps. Over the past couple of decades several exotic contracts have also emerged but these are largely the variants of these basic contracts. Let us briefly define some of the contracts:

a.       Forward Contracts: A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges.

The salient features of forward contracts are as given below:

Ø  They are bilateral contracts and hence exposed to counter-party risk.

Ø  Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.

Ø  The contract price is generally not available in public domain.

Ø  On the expiration date, the contract has to be settled by delivery of the asset.

Ø  If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged.

b.      Future Contract: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. The standardized items in a futures contract are:

Ø  Quantity of the underlying

Ø  Quality of the underlying

Ø  The date and the month of delivery

Ø  The units of price quotation and minimum price change

Ø  Location of settlement

c.       Option Contracts: Option is basically an instrument that is traded at the derivative segment in stock market. Option is a contract between the buyer and seller to buy or sell a one or more lot of underlying asset at a fixed price on or before the expiry date of the contract. While buying an option a contract the buyer has the right to exercise the option within the stipulated time period but he or she is not bound to exercise that option. On the other hand if the buyer is willing to exercise the option the seller is bound to honor that contract. In option trading the price that is agreed up on for trading is called the strike price and the date on which the option contract is going to expire is called the expiration time or expiry. There can be different underlying assets for which options are traded including stocks, index, commodity, derivative instrument like the future contract and so on.

Types of option contract – There are mainly two types of option contacts that you can buy or sell at the stock market – ‘Call Option’ and the ‘Put Option’.

Call Option – When you are buying a call option it will give you the right to buy the underlying asset at the strike price within the stipulated time period. The option writer, who is creating the call option, will have the obligation to sell the asset if you are willing to buy as per the contract. For buying the call option you will have to pay the premium price of the contract to the option writer.

Put Option – A put option is the opposite of the call option. When you are buying a put option it will give you the right to sell off the asset in the strike price on or before the expiry of the option contract. While you will have the freedom to either honor the put option or ignore it, the seller of the put option will be legally bound to buy the put if you are willing to sell.

d.      Swaps: A swap is nothing but a barter or exchange but it plays a very important role in international finance. A swap is the exchange of one set of cash flows for another. A Swap is an agreement between two parties to exchange future cash flows according to a predefined formula. These streams of cash flow are called the "Legs" of the swap. Usually, when the swap contract is formed at least one of these series of cash flows are determined by a random or uncertain value like interest rate or equity price etc. Most swap contracts are traded OTC which are tailor made for the counter parties. Some are also traded in organized exchanges. The four generic types of swaps are:

1. Interest rate swaps

2. Currency swaps

3. Equity swaps &

4. Commodity swaps

Participants in Derivative Market

Derivatives have a very wide range of application in business as well as in finance & banking. There are four main types of participants in any Derivatives Market. They are: 

1. Dealers

2. Hedgers

3. Speculators and 

4. Arbitrageurs

A point to note here is that, the same individuals and organizations may play different roles under different market circumstances. Let us take a look at each one of them in detail

1.       Dealers:  Derivative contracts are bought and sold by dealers who work for banks and other security houses. Some contracts are traded on exchanges while others are OTC Transactions. In a large investment bank, the derivatives function is now a highly skilled affair. Marketing and sales staff speak to clients about what they want. Experts help to create solutions to those customer requirements using a combination of forwards, swaps and options. Any risk the bank assumes as a result of providing such tailor-made products is managed by the traders who run the banks derivatives books. In the meantime, risk managers keep an eye on the overall level of the risk the bank is running. Mathematicians, also known as “Quants” devise the tools required to price the new products created by the experts. 

Initially large banks tended to operate solely as intermediaries in the derivatives market, matching the buyers and the sellers. Over time, however, they have assumed more and more risk themselves. 

2.       Hedgers:  Corporations, investors, banks and governments all use derivative products to hedge or reduce their exposure to market variables like interest rates, share prices, bond prices, currency exchange rates, commodity prices etc. A simple and classic example would be a farmer who sells a futures contract to lock into a price for the crop he will deliver in a future date. The buyer might be a food processing company that wishes to fix the price for taking delivery of the crop in the future or a “Speculator” 

Another typical case is that of a company due to receive a payment in a foreign currency on a future date. It enters into a forward contract to sell the foreign currency to a bank and receive a predetermined quantity of domestic currency. Or, it purchases an option which gives it the right but not the obligation to sell the foreign currency at a set rate. 

3.       Speculators: Derivatives are nicely suited to speculate on the prices of commodities and other financial assets or on market variables like interest rates, market indices etc. Generally speaking, it is much less expensive to create a speculative position using derivatives than by trading the underlying commodity or asset. As a result, the potential returns are that much greater. 

A classic case is the trader who believes that the increasing demand or reduced supply is likely to boost the price of oil. Since it would be too expensive to buy and store actual oil, the trader buys exchange traded futures (ETFs) contracts agreeing to take delivery of oil on a future delivery date at a fixed price. If the oil prices rise in the market, the value of the futures contract will also rise and they can be sold back into the market at a profit. 

In fact, if the trader buys and then sells a futures contract before they reach the delivery date, the trader never has to take any delivery of actual oil. The profit from the whole trade is realized in cash without buying anything. 

4.       Arbitrageurs: An Arbitrage is a deal that produces risk-free profits by exploiting a mispricing in the market. A simple example is when a trader can buy an asset cheaply in location and simultaneously arrange to sell it at another location for a higher price. Since such opportunities are unlikely to exist for a long time, and since arbitrageurs would rush to buy the asset in the cheap location, the price gap will close very fast.

In the derivatives business, arbitrage opportunities typically arise because a product can be assembled in different ways out of different building blocks. If it is possible to sell a product for more than it costs to buy the constituent parts, then the risk free profit can be generated. In practice, the presence of transaction costs often means that only the large market players can profit from such opportunities.

In fact, many of these so called arbitrage deals constructed in the financial markets are not entirely risk free. They are designed to exploit differences in the market prices of products which are very similar but not completely identical. For this very reason, they are also called as “Relative Value” Trades.

Swaps and Its Types:

A swap is nothing but a barter or exchange but it plays a very important role in international finance. A swap is the exchange of one set of cash flows for another. A Swap is an agreement between two parties to exchange future cash flows according to a predefined formula. These streams of cash flow are called the "Legs" of the swap. Usually, when the swap contract is formed at least one of these series of cash flows are determined by a random or uncertain value like interest rate or equity price etc.

Most swap contracts are traded OTC which are tailor made for the counter parties. Some are also traded in organized exchanges. The five generic types of swaps are:

1. Interest rate swaps

2. Currency swaps

3. Equity swaps &

4. Commodity swaps

1. Interest Rate Swaps: In Interest rate swaps, each party agrees to pay either a fixed or a floating rate in a particular currency to the other party. The fixed or floating rate is multiplied with the Notional Principal Amount (NPA) say Rs. 1 lac. This notional amount is not exchanged between the parties involved in the Swap. This NPA is used only to calculate the interest flow between the two parties.

The most common interest rate swap is where one party 'A' pays a fixed rate to the other party 'B' while receiving a floating rate which is pegged to a reference rate like LIBOR. (LIBOR - London Inter Bank Offer Rate)

For e.g., a Swap arrangement between two people could be like, 'A' pays a fixed rate of 3% to 'B' on a principal of Rs. 1 lac every month and 'B' in turn would pay 'A' at the rate of LIBOR + 0.5%. The cash flow that 'B' can expect from 'A' is fixed whereas the value that 'A' would receive would vary based upon the LIBOR. If the LIBOR that month is 2% then 'A' would receive an interest of 2.5% that month. The fixed rate of 3% is termed as the 'Swap Rate'.

At the point of Initiation of the Swaps the swap is priced in such a way that the "Net Present Value" is '0'. If one party wants to pay 50 bps (Basis points or 0.5%) above the Swap rate, then the other party may have to pay the same 50 bps above LIBOR.

Net Present Value - NPV is defined as the total present value of a series of cash flows. The term NPV is used widely in the financial terms and it is used by people to decide on whether to invest in an instrument or not.

2. Currency Swaps: A currency swap is an agreement between two parties in which one party promises to make payments in one currency and the other promises to make payments in another currency. Currency swaps are similar yet notably different from interest rate swaps and are often combined with interest rate swaps.

Currency swaps help eliminate the differences between international capital markets. Interest rates swaps help eliminate barriers caused by regulatory structures. While currency swaps result in exchange of one currency with another, interest rate swaps help exchange a fixed rate of interest with a variable rate. The needs of the parties in a swap transaction are diametrically different. Swaps are not traded or listed on exchange but they do have an informal market and are traded among dealers.

A swap is a contract, which can be effectively combined with other type of derivative instruments. An option on a swap gives the party the right, but not the obligation to enter into a swap at a later date.

3. Equity Swaps: An Equity Swap is a special type of swap where the underlying asset is a stock or a group of stocks or even a stock market index. The key differentiator in equity swaps is the fact that the floating leg of the payment is dependent on the performance of the underlying stock. One party would receive fixed amounts regularly while the other would receive a payment depending on the performance of the Stock upon which the Equity swap is created.

  In commodity swaps, the cash flows to be exchanged are linked to commodity prices. Commodities are physical assets such as metals, energy stores and food including cattle. E.g. in a commodity swap, a party may agree to exchange cash flows linked to prices of oil for a fixed cash flow. Commodity swaps are used for hedging against Fluctuations in commodity prices or Fluctuations in spreads between final product and raw material prices (E.g. Cracking spread which indicates the spread between crude prices and refined product prices significantly affect the margins of oil refineries)

A Company that uses commodities as input may find its profits becoming very volatile if the commodity prices become volatile. This is particularly so when the output prices may not change as frequently as the commodity prices change. In such cases, the company would enter into a swap whereby it receives payment linked to commodity prices and pays a fixed rate in exchange. A producer of a commodity may want to reduce the variability of his revenues by being a receiver of a fixed rate in exchange for a rate linked to the commodity prices.

Importance and Limitations of Derivative:

Economic functions of Derivative

In spite of the fear and criticism with which the derivative markets are commonly looked at, these markets perform a number of economic functions.

1. Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices.

2. The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them.

3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses’ higher trade volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.

4. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kinds of mixed markets.

5. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense.

In a nut shell, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity. According to survey conducted in India regarding the sub brokers’ opinion on the impact of derivatives market on financial market, the result obtained is given as under.

Derivative securities have penetrated the Indian stock market and it emerged that investors are using these securities for different purposes, namely, risk management, profit enhancement, speculation and arbitrage. High net worth individuals and proprietary traders account for a large proportion of broker turnover. Interestingly, some retail participation was also witnessed despite the fact that these securities are considered largely beyond the reach of retail investors (because of complexity and relatively high initial investment). Based on the survey results, the authors identified some important policy issues such as the need to bring in more institutional participation to make the derivative market in India more efficient and to bring it in line with the best practices. Further, there is a need to popularize option instruments because they may prove to be a useful medium for enhancing retail participation in the derivative market.

 : The unregulated use of Derivatives can result in huge losses due to the use of Leverage or Borrowing. It is a well known fact that Derivatives allow investors to gain huge sums of money from small movements in the underlying asset's price. However, investors can lose huge amounts of money if the asset moves in the opposite direction. There have been a lot of instances where investors have lost significant amounts of money due to Derivatives.

  This is the risk that arises if either of the contracting parties fails to honour his end of the contract. This is very common in OTC Derivative products.

  Since the Derivative markets give an opportunity for an individual to earn huge profits; it’s often lucrative to small/inexperienced investors as well. Speculation in the Derivatives market requires great knowledge of the market and the future price movements on the asset over which the derivative is formed to ensure profit. This is the reason why small investors are generally advised to stay away from them.

Differentiate Between Futures and Forward

At a basic level, futures are also forwards but in a more organized and regulated form that are executed through exchange. The exchange acts a guarantee to any counter-party risk. To summarize, the main differences between forwards and futures are:

1. Futures are insured against counter-party risk whereas in forwards counter-party risk is the major risk.

2. Futures are traded on an exchange whereas Forwards are traded over the counter.

3. Futures are standardized financial instruments and the structure is not altered for the sake of investors. Forwards are tailor made and can be structured according to the parties involved. For example, futures are available for a selected expiry dates whereas forwards can be structured for any specific period of expiry.

4. Futures are more liquid compared to Forwards as the participants involved in futures market are more.

5. Futures are tradable whereas forwards are contracts between two parties and hence are not transferrable.

6. In futures the balance is settled everyday (also called mark to market settlement), whereas in forwards, the balance is settled at a time (in most of the cases, at the end of the expiry of the contract).

Over the Counter and Exchange Trading Counter

Many financial markets around the world, such as stock markets, do their trading through exchange. However, forex trading does not operate on an exchange basis, but trades as ‘Over-The-Counter’ markets (OTC). The stocks, bonds and other instruments traded on these exchanges are known as listed securities.  Over the counter, or OTC, traded securities encompass all other financial securities. Understanding the differences between listed and an OTC transaction is crucial whether you want to trade shares or sell your firm’s shares to investors.

Difference between Exchange Trading & OTC Trading:

1.       Centralization of Market: In a market that operates with exchange trading, transactions are completed through a centralized source. In other words, one party acts as the mediator connecting buyers and sellers. There is a specified number of traders that will trade on that single centralized system. On the other hand, over-the counter markets are generally decentralized. Here, there are many mediators who compete to link buyers to sellers. The advantage to this is that it ensures that costs for intermediary services are as low as possible.

2.       Standardization: An Exchange Trade is a standard contract wherein Stock exchange acts as a guarantor for all the trades. But, OTC contracts are customized as there is no specified guarantor and hence the risk increases a lot.

3.       Counterparty Risk: When you buy or sell something OTC in a private transaction, there is always the risk of not getting what you bargained for. The other party might not be able to deliver the stock, bond or other security within the agreed upon time frame. It might also deliver a different kind of stock or bond than promised. These risks are broadly referred to as counterparty risk. In an exchange, however, counterpart risk is not an issue. The trading occurs through brokers who are closely monitored by both the exchange and the Securities and Exchange Commission. Investors buy exchange traded securities with greater confidence and therefore pay more for such stocks. Because of this, businesses are better off selling shares through an exchange rather than in a private transaction.

4.       Visibility: As Exchange market is an open market wherein there is a clear visibility for prices, start date, expiration dates & counterparties involved in a deal etc. But, this is not the case with OTC market as all the terms & conditions associated with any deal is between the counterparties only.

5.       Parties Involved: In exchange traded markets, the exchange is the counterparty to all of the trades.  Additionally, there is price standardization and execution.  One negative these exchanges involves less price competition. OTC, or over the counter markets, have no centralized trading facility.  This promotes heavy competition between counterparties and lower transaction.  The lack of regulation can introduce fraudulent firms and transaction execution quality may decrease.

Conclusion: In exchange markets, there’s a regulator (exchange) through which transactions are completed, while in OTC market’s there is no regulator. Exchange markets have less chances of price manipulation, while the many competing traders in OTC markets can manipulate prices. Exchange markets ensure transaction security, while OTC markets are prone to fraud and dishonest traders.

 Introduction to Derivatives

The term ‘Derivative’ stands for a contract whose price is derived from or is dependent upon an underlying asset. The underlying asset could be a financial asset such as currency, stock and market index, an interest bearing security or a physical commodity. Today, around the world, derivative contracts are traded on electricity, weather, temperature and even volatility.

According to the Securities Contract Regulation Act, (1956) the term “derivative” includes:

(i) A security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;

(ii) A contract which derives its value from the prices, or index of prices, of underlying securities.

Types of Derivatives: 

1. OTC (Over the Counter) OTC Derivatives are contracts that are traded/negotiated directly between the contracting parties. The OTC Derivative market is the largest market for derivatives and it is also the most unregulated. There is always an inherent risk of either of the parties not honouring the agreement.

2. ETD (Exchange Traded Derivatives) ETD are those that are traded via regulated/specialized trading exchanges. A derivative exchange acts as the intermediary for all transactions and requires an initial margin to be put up by both the parties of the trade to serve as a guarantee. In India NSE is one of the largest ETD exchange.

Types (Components or Instruments) of Derivative Contracts

Derivatives comprise four basic contracts namely Forwards, Futures, Options and Swaps. Over the past couple of decades several exotic contracts have also emerged but these are largely the variants of these basic contracts. Let us briefly define some of the contracts:

a.       Forward Contracts: A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges.

The salient features of forward contracts are as given below:

Ø  They are bilateral contracts and hence exposed to counter-party risk.

Ø  Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.

Ø  The contract price is generally not available in public domain.

Ø  On the expiration date, the contract has to be settled by delivery of the asset.

Ø  If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged.

b.      Future Contract: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. The standardized items in a futures contract are:

Ø  Quantity of the underlying

Ø  Quality of the underlying

Ø  The date and the month of delivery

Ø  The units of price quotation and minimum price change

Ø  Location of settlement

c.       Option Contracts: Option is basically an instrument that is traded at the derivative segment in stock market. Option is a contract between the buyer and seller to buy or sell a one or more lot of underlying asset at a fixed price on or before the expiry date of the contract. While buying an option a contract the buyer has the right to exercise the option within the stipulated time period but he or she is not bound to exercise that option. On the other hand if the buyer is willing to exercise the option the seller is bound to honor that contract. In option trading the price that is agreed up on for trading is called the strike price and the date on which the option contract is going to expire is called the expiration time or expiry. There can be different underlying assets for which options are traded including stocks, index, commodity, derivative instrument like the future contract and so on.

Types of option contract – There are mainly two types of option contacts that you can buy or sell at the stock market – ‘Call Option’ and the ‘Put Option’.

Call Option – When you are buying a call option it will give you the right to buy the underlying asset at the strike price within the stipulated time period. The option writer, who is creating the call option, will have the obligation to sell the asset if you are willing to buy as per the contract. For buying the call option you will have to pay the premium price of the contract to the option writer.

Put Option – A put option is the opposite of the call option. When you are buying a put option it will give you the right to sell off the asset in the strike price on or before the expiry of the option contract. While you will have the freedom to either honor the put option or ignore it, the seller of the put option will be legally bound to buy the put if you are willing to sell.

d.      Swaps: A swap is nothing but a barter or exchange but it plays a very important role in international finance. A swap is the exchange of one set of cash flows for another. A Swap is an agreement between two parties to exchange future cash flows according to a predefined formula. These streams of cash flow are called the "Legs" of the swap. Usually, when the swap contract is formed at least one of these series of cash flows are determined by a random or uncertain value like interest rate or equity price etc. Most swap contracts are traded OTC which are tailor made for the counterparties. Some are also traded in organized exchanges. The four generic types of swaps are:

1. Interest rate swaps

2. Currency swaps

3. Equity swaps &

4. Commodity swaps

Participants in Derivative Market

Derivatives have a very wide range of application in business as well as in finance & banking. There are four main types of participants in any Derivatives Market. They are: 

1. Dealers

2. Hedgers

3. Speculators and 

4. Arbitrageurs

A point to note here is that, the same individuals and organizations may play different roles under different market circumstances. Let us take a look at each one of them in detail

1.       Dealers:  Derivative contracts are bought and sold by dealers who work for banks and other security houses. Some contracts are traded on exchanges while others are OTC Transactions. In a large investment bank, the derivatives function is now a highly skilled affair. Marketing and sales staff speak to clients about what they want. Experts help to create solutions to those customer requirements using a combination of forwards, swaps and options. Any risk the bank assumes as a result of providing such tailor-made products is managed by the traders who run the banks derivatives books. In the meantime, risk managers keep an eye on the overall level of the risk the bank is running. Mathematicians, also known as “Quants” devise the tools required to price the new products created by the experts. 

Initially large banks tended to operate solely as intermediaries in the derivatives market, matching the buyers and the sellers. Over time, however, they have assumed more and more risk themselves. 

2.       Hedgers:  Corporations, investors, banks and governments all use derivative products to hedge or reduce their exposure to market variables like interest rates, share prices, bond prices, currency exchange rates, commodity prices etc. A simple and classic example would be a farmer who sells a futures contract to lock into a price for the crop he will deliver in a future date. The buyer might be a food processing company that wishes to fix the price for taking delivery of the crop in the future or a “Speculator” 

Another typical case is that of a company due to receive a payment in a foreign currency on a future date. It enters into a forward contract to sell the foreign currency to a bank and receive a predetermined quantity of domestic currency. Or, it purchases an option which gives it the right but not the obligation to sell the foreign currency at a set rate. 

3.       Speculators: Derivatives are nicely suited to speculate on the prices of commodities and other financial assets or on market variables like interest rates, market indices etc. Generally speaking, it is much less expensive to create a speculative position using derivatives than by trading the underlying commodity or asset. As a result, the potential returns are that much greater. 

A classic case is the trader who believes that the increasing demand or reduced supply is likely to boost the price of oil. Since it would be too expensive to buy and store actual oil, the trader buys exchange traded futures (ETFs) contracts agreeing to take delivery of oil on a future delivery date at a fixed price. If the oil prices rise in the market, the value of the futures contract will also rise and they can be sold back into the market at a profit. 

In fact, if the trader buys and then sells a futures contract before they reach the delivery date, the trader never has to take any delivery of actual oil. The profit from the whole trade is realized in cash without buying anything. 

4.       Arbitrageurs: An Arbitrage is a deal that produces risk-free profits by exploiting a mispricing in the market. A simple example is when a trader can buy an asset cheaply in location and simultaneously arrange to sell it at another location for a higher price. Since such opportunities are unlikely to exist for a long time, and since arbitrageurs would rush to buy the asset in the cheap location, the price gap will close very fast.

In the derivatives business, arbitrage opportunities typically arise because a product can be assembled in different ways out of different building blocks. If it is possible to sell a product for more than it costs to buy the constituent parts, then the risk free profit can be generated. In practice, the presence of transaction costs often means that only the large market players can profit from such opportunities.

In fact, many of these so called arbitrage deals constructed in the financial markets are not entirely risk free. They are designed to exploit differences in the market prices of products which are very similar but not completely identical. For this very reason, they are also called as “Relative Value” Trades.

Swaps and Its Types:

A swap is nothing but a barter or exchange but it plays a very important role in international finance. A swap is the exchange of one set of cash flows for another. A Swap is an agreement between two parties to exchange future cash flows according to a predefined formula. These streams of cash flow are called the "Legs" of the swap. Usually, when the swap contract is formed at least one of these series of cash flows are determined by a random or uncertain value like interest rate or equity price etc.

Most swap contracts are traded OTC which are tailor made for the counterparties. Some are also traded in organized exchanges. The five generic types of swaps are:

1. Interest rate swaps

2. Currency swaps

3. Equity swaps &

4. Commodity swaps

1. Interest Rate Swaps: In Interest rate swaps, each party agrees to pay either a fixed or a floating rate in a particular currency to the other party. The fixed or floating rate is multiplied with the Notional Principal Amount (NPA) say Rs. 1 lac. This notional amount is not exchanged between the parties involved in the Swap. This NPA is used only to calculate the interest flow between the two parties.

The most common interest rate swap is where one party 'A' pays a fixed rate to the other party 'B' while receiving a floating rate which is pegged to a reference rate like LIBOR. (LIBOR - London Inter Bank Offer Rate)

For e.g., a Swap arrangement between two people could be like, 'A' pays a fixed rate of 3% to 'B' on a principal of Rs. 1 lac every month and 'B' in turn would pay 'A' at the rate of LIBOR + 0.5%. The cash flow that 'B' can expect from 'A' is fixed whereas the value that 'A' would receive would vary based upon the LIBOR. If the LIBOR that month is 2% then 'A' would receive an interest of 2.5% that month. The fixed rate of 3% is termed as the 'Swap Rate'.

At the point of Initiation of the Swaps the swap is priced in such a way that the "Net Present Value" is '0'. If one party wants to pay 50 bps (Basis points or 0.5%) above the Swap rate, then the other party may have to pay the same 50 bps above LIBOR.

Net Present Value - NPV is defined as the total present value of a series of cash flows. The term NPV is used widely in the financial terms and it is used by people to decide on whether to invest in an instrument or not.

2. Currency Swaps: A currency swap is an agreement between two parties in which one party promises to make payments in one currency and the other promises to make payments in another currency. Currency swaps are similar yet notably different from interest rate swaps and are often combined with interest rate swaps.

Currency swaps help eliminate the differences between international capital markets. Interest rates swaps help eliminate barriers caused by regulatory structures. While currency swaps result in exchange of one currency with another, interest rate swaps help exchange a fixed rate of interest with a variable rate. The needs of the parties in a swap transaction are diametrically different. Swaps are not traded or listed on exchange but they do have an informal market and are traded among dealers.

A swap is a contract, which can be effectively combined with other type of derivative instruments. An option on a swap gives the party the right, but not the obligation to enter into a swap at a later date.

3. Equity Swaps: An Equity Swap is a special type of swap where the underlying asset is a stock or a group of stocks or even a stock market index. The key differentiator in equity swaps is the fact that the floating leg of the payment is dependent on the performance of the underlying stock. One party would receive fixed amounts regularly while the other would receive a payment depending on the performance of the Stock upon which the Equity swap is created.

  In commodity swaps, the cash flows to be exchanged are linked to commodity prices. Commodities are physical assets such as metals, energy stores and food including cattle. E.g. in a commodity swap, a party may agree to exchange cash flows linked to prices of oil for a fixed cash flow. Commodity swaps are used for hedging against Fluctuations in commodity prices or Fluctuations in spreads between final product and raw material prices (E.g. Cracking spread which indicates the spread between crude prices and refined product prices significantly affect the margins of oil refineries)

A Company that uses commodities as input may find its profits becoming very volatile if the commodity prices become volatile. This is particularly so when the output prices may not change as frequently as the commodity prices change. In such cases, the company would enter into a swap whereby it receives payment linked to commodity prices and pays a fixed rate in exchange. A producer of a commodity may want to reduce the variability of his revenues by being a receiver of a fixed rate in exchange for a rate linked to the commodity prices.

Importance and Limitations of Derivative:

Economic functions of Derivative

In spite of the fear and criticism with which the derivative markets are commonly looked at, these markets perform a number of economic functions.

1. Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices.

2. The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them.

3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses’ higher trade volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.

4. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kinds of mixed markets.

5. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense.

In a nut shell, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity. According to survey conducted in India regarding the sub brokers’ opinion on the impact of derivatives market on financial market, the result obtained is given as under.

Derivative securities have penetrated the Indian stock market and it emerged that investors are using these securities for different purposes, namely, risk management, profit enhancement, speculation and arbitrage. High net worth individuals and proprietary traders account for a large proportion of broker turnover. Interestingly, some retail participation was also witnessed despite the fact that these securities are considered largely beyond the reach of retail investors (because of complexity and relatively high initial investment). Based on the survey results, the authors identified some important policy issues such as the need to bring in more institutional participation to make the derivative market in India more efficient and to bring it in line with the best practices. Further, there is a need to popularize option instruments because they may prove to be a useful medium for enhancing retail participation in the derivative market.

 : The unregulated use of Derivatives can result in huge losses due to the use of Leverage or Borrowing. It is a well known fact that Derivatives allow investors to gain huge sums of money from small movements in the underlying asset's price. However, investors can lose huge amounts of money if the asset moves in the opposite direction. There have been a lot of instances where investors have lost significant amounts of money due to Derivatives.

  This is the risk that arises if either of the contracting parties fails to honour his end of the contract. This is very common in OTC Derivative products.

  Since the Derivative markets give an opportunity for an individual to earn huge profits; it’s often lucrative to small/inexperienced investors as well. Speculation in the Derivatives market requires great knowledge of the market and the future price movements on the asset over which the derivative is formed to ensure profit. This is the reason why small investors are generally advised to stay away from them.

Differentiate Between Futures and Forward

At a basic level, futures are also forwards but in a more organized and regulated form that are executed through exchange. The exchange acts a guarantee to any counter-party risk. To summarize, the main differences between forwards and futures are:

1. Futures are insured against counter-party risk whereas in forwards counter-party risk is the major risk.

2. Futures are traded on an exchange whereas Forwards are traded over the counter.

3. Futures are standardized financial instruments and the structure is not altered for the sake of investors. Forwards are tailor made and can be structured according to the parties involved. For example, futures are available for a selected expiry dates whereas forwards can be structured for any specific period of expiry.

4. Futures are more liquid compared to Forwards as the participants involved in futures market are more.

5. Futures are tradable whereas forwards are contracts between two parties and hence are not transferrable.

6. In futures the balance is settled everyday (also called mark to market settlement), whereas in forwards, the balance is settled at a time (in most of the cases, at the end of the expiry of the contract).

Over the Counter and Exchange Trading Counter

Many financial markets around the world, such as stock markets, do their trading through exchange. However, forex trading does not operate on an exchange basis, but trades as ‘Over-The-Counter’ markets (OTC). The stocks, bonds and other instruments traded on these exchanges are known as listed securities.  Over the counter, or OTC, traded securities encompass all other financial securities. Understanding the differences between listed and an OTC transaction is crucial whether you want to trade shares or sell your firm’s shares to investors.

Difference between Exchange Trading & OTC Trading:

1.       Centralization of Market: In a market that operates with exchange trading, transactions are completed through a centralized source. In other words, one party acts as the mediator connecting buyers and sellers. There is a specified number of traders that will trade on that single centralized system. On the other hand, over-the counter markets are generally decentralized. Here, there are many mediators who compete to link buyers to sellers. The advantage to this is that it ensures that costs for intermediary services are as low as possible.

2.       Standardization: An Exchange Trade is a standard contract wherein Stock exchange acts as a guarantor for all the trades. But, OTC contracts are customized as there is no specified guarantor and hence the risk increases a lot.

3.       Counterparty Risk: When you buy or sell something OTC in a private transaction, there is always the risk of not getting what you bargained for. The other party might not be able to deliver the stock, bond or other security within the agreed upon time frame. It might also deliver a different kind of stock or bond than promised. These risks are broadly referred to as counter party risk. In an exchange, however, counterpart risk is not an issue. The trading occurs through brokers who are closely monitored by both the exchange and the Securities and Exchange Commission. Investors buy exchange traded securities with greater confidence and therefore pay more for such stocks. Because of this, businesses are better off selling shares through an exchange rather than in a private transaction.

4.       Visibility: As Exchange market is an open market wherein there is a clear visibility for prices, start date, expiration dates & counter parties involved in a deal etc. But, this is not the case with OTC market as all the terms & conditions associated with any deal is between the counter parties only.

5.       Parties Involved: In exchange traded markets, the exchange is the counter party to all of the trades.  Additionally, there is price standardization and execution.  One negative these exchanges involves less price competition. OTC, or over the counter markets, have no centralized trading facility.  This promotes heavy competition between counter parties and lower transaction.  The lack of regulation can introduce fraudulent firms and transaction execution quality may decrease.

Conclusion: In exchange markets, there’s a regulator (exchange) through which transactions are completed, while in OTC market’s there is no regulator. Exchange markets have less chances of price manipulation, while the many competing traders in OTC markets can manipulate prices. Exchange markets ensure transaction security, while OTC markets are prone to fraud and dishonest traders.