Derivatives & Risk Management

Unit-I
Chapter – 01
Financial Derivatives: Basic Market Concept
An Overview of Risk Management
“A ship is safe in harbor, but that’s not what ships are for”
Risk management is the process of analyzing exposure to risk and determining how to best handle such
exposure. Risk is an uncertain future event or condition which has not happened yet. A risk which has
already occurred is considered as an ‘issue’. It could have a positive or negative effect. Positive risks are
known as opportunities (gain maximum advantage). Risk is not loss; risk is uncertainty. For eg: If I know
that prices may go down; I will sell the asset/commodity well in advance. If I know the prices of raw
material go down, I won’t buy right know until prices falls down. Similarly, if I know that the prices may
go up, I will buy in advance.
Note: The problem is not loss, the problem is uncertainty. Therefore we need to have insurance for our
risk. Hence, we have financial products to overcome the risk uncertainty.
Risk Management is the identification, assessment & prioritization of risks (positive or negative) followed
by coordinated & economical application of resources to minimize, monitor & control the probability or
impact of unfortunate events or to maximize the realization of opportunities.
Risk Appetite: Amount or type of risk an organization is prepared to seek, accept or tolerate.
Risk Tolerance: Organization’s readiness to bear the risk after risk treatments in order to achieve
objectives (Maximize risk to maximize return is not true always).

Return is excessively volatile in financial markets because of frequent movement of foreign exchange
rates, interest rates and commodity prices. Price fluctuations make hard for corporate & individuals to
estimate the return to manage the risk effectively. Risk management is the managerial process that is used
to control price volatility.

Identification of Risk
Minimize Monitor Control
Probability or impact of unfortunate events

Assessment of Risk Resources

Maximize
Prioritization of Risk
Realization of opportunities

Dr. Meghashree Dadhich

Derivatives & Risk Management

Derivative securities are the instruments of risk management which provides valuable set of tools for
managing the risk in the financial markets. Derivative instruments (Forward, Futures & Options) minimize
the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse
investors.
Definitions of Derivatives
1. Derivative is a financial instrument or a contract between two parties and its value derived on an
underlying asset which is specified in the derivatives contract. For example: Derivatives contract on
Wheat / Bazara / Corn / Silver / Gold etc. (Commodity Derivatives) and Derivatives contract on
Equity / Preference / E-Gold / ADRs / GDRs etc (Financial Derivatives).
2. Derivatives are financial contracts whose value/price is dependent on the behavior of the price of one
or more basic underlying assets. These contracts are legally binding agreements, made on the trading
screen of stock exchanges to buy or sell an asset in future. The asset can be a share, index, interest
rate, bond, rupee dollar exchange rate, sugar, crude oil, soyabean, cotton, coffee etc.
Objectives of Risk Management
Risk management is a technique of controlling and avoiding threats to the investors. It involves
determining, analyzing and mitigating harmful risk as a continuous process to identify the exposures to
loss or injury. Risk Management refers to the systematic application of principles, approach (investment
through fundamental & technical analysis) and processes (regular & systematic investment) to the tasks of
identifying and assessing risks, and then planning and implementing risk responses (Diversified
investment).
1. Ensure the management of risk consistently to achieve the investment objectives such high return at
low risk, hedge against inflation, liquidity of investment at right time, tax exemption etc.
2. Provide a high-quality and realistic analysis to invest in the right securities at right time.
3. Initiate action to prevent or reduce the adverse effects of risk through portfolio analysis & revision
regularly.
4. Minimize the costs of risks by investing own saving at a place of investing to the borrowed money.
5. Meet statutory and legal obligations by entering into the financial market as per lawsuits.
6. Minimize the financial and other negative consequences of losses by entering in the financial market at
a right time (buy securities when market is bearish and sell securities when market is bullish).

Dr. Meghashree Dadhich

Derivatives & Risk Management
Derivatives
Suppose, I am scared that if I will die, who will take care of my family? I will buy life insurance plan.
Suppose, I am scared that if I will ill, who will take care of myself? I will buy health insurance plan.
Suppose, an exporter is scared that the dollar rate may goes down then how will he manage his risk? What
if I am a farmer & I am scared that the wheat prices might fall. So, these kinds of risk can be managed by
using ‘derivatives’.
Derivatives are securities or financial instruments whose value is derived from the value of another,
underlying asset. They can be bought, sold and traded in a similar way to shares or any other financial
instrument. The underlying assets or instruments on which derivatives can be based include commodities,
equities, residential mortgages, commercial real estate, loans, bonds, interest rates, exchange rates, stock
market indices, consumer price indices and weather conditions. Thus, a derivative instrument derives its
value from some underlying variable. A derivative instrument by itself does not constitute ownership. It is,
instead, a promise to convey ownership.
Derivatives are specialized contracts which are employed for a variety of purposes including reduction of
funding costs by borrowers, enhancing the yield on assets, modifying the payment structure of assets to
correspond to the investor’s market view, etc. However, the most important use of derivatives is in
transferring market risk, called hedging, which a protection against losses is resulting from unforeseen
price or volatility changes. The asset can be share, index, interest rate, bond ,rupee dollar exchange
rate ,sugar , crude oil, Soya been, coffee etc.
The main types of derivatives are forward contracts, futures, options and swaps. Credit derivatives are
based on loans, bonds or other forms of credit. The pricing and performance of derivatives is often based
on that of the underlying asset, although the reverse may also be true. Derivatives can drive the underlying
market and the volumes traded in certain futures and options contacts can exceed those in the
underlying cash markets. Derivatives can be traded on an exchange or in an over-the-counter (OTC)
market. Global derivatives traded market volume is in the hundreds of trillions of dollars annually.
"Derivative" includes –
 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;
 A contract which derives its value from the prices, or index or prices, of underlying securities.
“A derivative can be defined as a financial instrument whose value depends on (or derives from) the
values of other, more basic underlying variables.” - John C. Hull

Dr. Meghashree Dadhich

Derivatives & Risk Management
Derivatives are compared to insurance. Just as you pay an insurance company a premium in order to
obtain some protection against a specific event, there are derivative products that have a payoff contingent
upon the occurrence of some event for which you must pay a premium in advance.
Example: Suppose you have a home of Rs. 50, 00,000. You insure this house for premium of Rs 15000 (It
is a very risky house!) Now you think about policy (ignoring the house) as an investment.
 Suppose the house is fine after 1 year. You have lost the premium of Rs 15000.
 Suppose your house is fully damaged and broken in one year. You receive Rs 50,00,0000 on just
paying premium of Rs 15,000.If you have bought insurance of any sort you have bought an option.
Option is one type of a derivative.
Derivative Instruments
1. Forward Contract: A customized contract between two parties to buy or sell an asset at a specified
price on a future date. A forward contract can be used for hedging or speculation, although its non-
standardized nature makes it particularly apt for hedging. “A contract that commits one party to buy
and other to sell a given quantity of an asset for fixed price on specified future date.” Unlike
standard futures contracts, a forward contract can be customized to any commodity, amount
and delivery date. A forward contract settlement can occur on a cash or delivery basis. Forward
contracts do not trade on a centralized exchange and are therefore regarded as over-the-counter (OTC)
instruments.
2. Future Contracts: Future contracts are one of the most common types of derivatives. A futures
contract is an agreement between two parties for the sale of an asset at an agreed upon price. One
would generally use a futures contract to hedge against risk during a particular period of time.
3. Option: An option is similar to a futures contract in that it is an agreement between two parties
granting one the opportunity to buy or sell a security from or to the other party at a predetermined
future date. Yet, the key difference between options and futures is that with an option the buyer or
seller is not obligated to make the transaction if he or she decides not to, hence the name “option.”
4. Swap: A swap is most often a contract between two parties agreeing to trade loan terms. One might
use an interest rate swap in order to switch from a variable interest rate loan to a fixed interest
rate loan, or vice versa. If someone with a variable interest rate loan were trying to secure additional
financing, a lender might deny him or her loan because of the uncertain future bearing of the variable
interest rates upon the individual’s ability to repay debts, perhaps fearing that the individual
will default. For this reason, he or she might seek to switch their variable interest rate loan with
someone else, who has a loan with a fixed interest rate that is otherwise similar.

Dr. Meghashree Dadhich

Derivatives & Risk Management
Various Membership Categories in the Equity Derivatives Market
The various types of membership in the derivatives market are as follows:
 Trading Member (TM) – A TM is a member of the derivatives exchange and can trade on his
own behalf and on behalf of his clients.
 Clearing Member (CM) –These members are permitted to settle their own trades as well as the
trades of the other non-clearing members known as Trading Members who have agreed to
settle the trades through them.
 Self-clearing Member (SCM) – A SCM are those clearing members who can clear and settle
their own trades only.
Requirements to be a member of the Equity Derivatives Exchange/ Clearing Corporation
 Balance Sheet Net-worth Requirements: SEBI has prescribed a net-worth requirement of Rs.
3 crore for clearing members. The clearing members are required to furnish an auditor's
certificate for the net-worth every 6 months to the exchange. The net-worth requirement is Rs.
1 crore for a self-clearing member. SEBI has not specified any net-worth requirement for a
trading member.
 Liquid Net-worth Requirements: Every clearing member (both clearing members and self-
clearing members) has to maintain at least Rs. 50 lakh as Liquid Net worth with the exchange /
clearing corporation.
 Certification Requirements: The Members are required to pass the
certification programme approved by SEBI. Further, every trading member is required to
appoint at least two approved users who have passed the certification programme. Only the
approved users are permitted to operate the derivatives trading terminal.
Specified Measures by SEBI to protect the rights of investor in Derivatives Market
The measures specified by SEBI include:
 Investor's money has to be kept separate at all levels and is permitted to be used only against
the liability of the Investor and is not available to the trading member or clearing member or
even any other investor.
 The Trading Member is required to provide every investor with a risk disclosure document
which will disclose the risks associated with the derivatives trading so that investors can take a
conscious decision to trade in derivatives.
 Investor would get the contract note duly time stamped for receipt of the order and execution
of the order. The order will be executed with the identity of the client and without client ID

Dr. Meghashree Dadhich

Derivatives & Risk Management
order will not be accepted by the system. The investor could also demand the trade
confirmation slip with his ID in support of the contract note. This will protect him from the risk
of price favor, if any, extended by the Member.
 In the derivative markets all money paid by the Investor towards margins on all open positions
is kept in trust with the Clearing House/Clearing Corporation and in the event of default of the
Trading or Clearing Member the amounts paid by the client towards margins are segregated
and not utilized towards the default of the member. However, in the event of a default of a
member, losses suffered by the Investor, if any, on settled / closed out position are
compensated from the Investor Protection Fund, as per the rules, bye-laws and regulations of
the derivative segment of the exchanges.
 The Exchanges are required to set up arbitration and investor grievances redressal mechanism
operative from all the four areas / regions of the country.
Terminologies of Derivative Market
Financial Market
A financial market is a market in which people trade financial securities, commodities, and
other fungible items of value at low transaction costs and at prices that reflect supply and demand.
Securities include stocks and bonds, and commodities include precious metals or agricultural products.
The term "market" is sometimes used for what are more strictly exchanges, organizations that facilitate the
trade in financial securities, e.g., a stock exchange or commodity exchange. This may be a physical
location (like the NYSE, BSE, NSE) or an electronic system (like NASDAQ). Much trading of stocks
takes place on an exchange; still, corporate actions (merger, spin-off) are outside an exchange, while any
two companies or people, for whatever reason, may agree to sell stock from the one to the other without
using an exchange.
Market Capitalization
Different companies issue varied amounts of shares when they get listed. The value of one share also
differs from that of another company’s stock. Market capitalization smoothens out these differences. It is
the market stock price multiplied by the total number of shares held by the public. It, thus, reflects the
total market value of a stock taking into consideration both the size and the price of the stock. For
example, if a stock is priced at Rs. 50 per share, and there are 1,00,000 shares in the hands of public
investors, then its market capitalization stands at Rs. 50,00,000. It decides the weightage of a stock in the
index. This means, bigger the company’s market value, the more its price fluctuations affect the value of
the index.
Rolling Settlement
Dr. Meghashree Dadhich
Derivatives & Risk Management
Supposing your friend agrees to buy a book for you from a bookshop, you will have to pay him for it
eventually. Similarly, after you have bought or sold shares through your broker, the trade has to be settled.
Meaning, the buyer has to receive his shares and the seller has to receive his money. Settlement is the
process whereby payment is made by the buyers, and shares are delivered by the sellers. A rolling
settlement implies that all trades have to be settled by the end of the day. Hence, the entire transaction –
where the buyer pays for securities purchased and seller delivers the shares sold – have to be completed in
a day.
In India, we have adopted the T+2 settlements cycle. This means that a transaction conducted on Day 1
has to be settled on the Day 1 + 2 working days. This is when funds are paid and securities are transferred.
Thus, 'T+2' here, refers to Today + 2 working days. Saturdays and Sundays are not considered as working
days. So, if you enter into a transaction on Friday, the trade will be settled not on Sunday, but on Tuesday.
Even bank and exchange holidays are excluded.
Short Selling
An investor sells short when he anticipates that the price of a stock may fall from the existing price. So,
the investor borrows a share and sells it. Once the share price dips, he will buy the same share at a lower
price, and return it back, while pocketing a profit in the bargain. Simply put, you first sell at a high and
then buy at a low. Short-selling helps traders profit from declining stock and index prices. Since this is
usually conducted in anticipation of a stock movement, short-selling is considered a risky proposition.
Let us take an example. Suppose you expect shares of Infosys to fall tomorrow for whatever reason, you
enter an order to sell shares of Infosys at the current market price. Once the share price falls adequately
tomorrow, you buy at the lower rate. The difference in the sale and buying prices is your profit. However,
if the share prices increase after you sold at a reduced price, then you end up with a loss.
Circuit Filters & Trading Bands
Some stocks are more volatile than others. Too much volatility is not good for investors. To curb this
volatility, SEBI has come up with the concept of circuit filters. The market regulator has specified the
maximum limit the price of a stock can move on a given day. This is called a price trading band. If a stock
breaches this limit, trading is halted in that stock for a while. There are three levels of limits. Each limit
leads to trading halt for a progressively longer duration. If all three circuit filters are breached, then trading
is halted for the rest of the day. NSE define circuit filters in 5 categories including 2%, 5%, 10%, 20% and
no circuit filter. Also, prices may not be same on the two exchanges – NSE and BSE. So, circuit filters
can be different for shares on the two exchanges.

Dr. Meghashree Dadhich

Derivatives & Risk Management
Exercise price
The fixed price per share at which a call option conveys the right to purchase the underlying shares and at
which a put option conveys the right to sell the underlying shares. Also referred to as the option strike
price. Example: A call option with an exercise price of Rs.260 conveys the right to purchase 1,000 shares
at a price of Rs.260 per share.
Exercise
The use of the right by the option holder to purchase the underlying shares at the exercise price if the
option is a call, or to sell the underlying shares at the exercise price if the option is a put. Equity options
traded on LIFFE are 'American-style' options; they can be exercised by the option holder at any time prior
to expiry. When a call is exercised, the writer is obliged to make delivery of i.e. sell the underlying shares
at the exercise price of the option and the buyer is obliged to take delivery i.e. buy. When a put is
exercised, the writer is obliged to take delivery of i.e. purchase the underlying shares at the exercise price
of the option and the buyer is obliged to make delivery i.e. sell.
Premium
The sum of money that an option buyer pays for the right to acquire the option, and that an option seller
receives for incurring the obligation the option entails. Option premiums are expressed as a cost in Rs.per
share. The total cost of an option contract for 1,00 shares (referred to as a 'lot') would therefore be
1,00times the premium, e.g. one contract with a premium of Rs.14 would cost Rs.1400 (100x14).
Bull-Bear Markets
Markets are often described as ‘bull’ or ‘bear’ markets. These names have been derived from the manner
in which the animals attack their opponents. A bull thrusts its horns up into the air, and a bear swipes its
paws down. These actions are metaphors for the movement of a market: if stock prices trend upwards, it is
considered a bull market; if the trend is downwards, it is considered a bear market. The supply and
demand for securities largely determine whether the market is in the bull or bear phase. Forces like
investor psychology, government involvement in the economy and changes in economic activity also
drive the market up or down. These combine to make investors bid higher or lower prices for stocks.
Margin
Funds that an option writer must maintain on deposit with his broker to assure his ability to fulfill his
financial obligation to make or take delivery of the underlying shares. Since the buyers of equity options,
pay the entire option premium when the option is purchased, they have no further financial obligations and
are not subject to a margin requirement. However, if an option buyer exercises his right to acquire the
underlying shares, he would then become subject to the margin requirements applicable to the shares
acquired. Margin is called from the time the option is exercised until the transaction is settled.
Dr. Meghashree Dadhich
Derivatives & Risk Management
Margin Trading
Many traders trade on the stock market using borrowed funds or securities. This is called margin trading.
It is almost like buying securities on credit. Margin trading can lead to greater returns, but can also be very
risky. While it lets you actively seize market opportunities, it also subjects you to a number of unique risks
such as interest payments charged for the borrowed money. Kotaksecurities.com offers its customers the
facility of margin trading.
Cash Settlement
In the case of index options contracts where it is impossible or impractical to affect physical delivery,
open positions are closed out on the day of exercise or the last day of trading at a price determined by the
underlying index level.
Top-Down Approach
The top-down approach first takes into consideration the macro-economy. You understand the trends and
outlook for the overall economy. Using this, you choose a one or more industries that are expected to do
well in the near future. This is because every industry reacts to overall economic conditions like inflation,
interest rates, consumer demand and so on, in a different way. Select one amongst the industries after in-
depth analysis. Next, you understand the workings of the industry, the players and competitors and other
factors that affect the sector. Based on this, you select one of the companies in the industry.
Bottom-Up Approach
The bottom-up approach is just the opposite. You do not look at the economy or select an industry first,
but concentrate on company fundamentals. You first understand what your priorities are – high growth or
steady income through high dividends. Using appropriate ratios like the Price-to-Earnings ratio or the
Dividend-yield, you select a bunch of stocks. Next, analyze each of these companies; find answers for
questions like what factors drive profits? Is the company management efficient? Is the company heavily
indebted? What is the future outlook? And so on. Based on the results, select the company that best fits
your requirements. The bottom-up approach is most suited for weak market conditions. This is because;
the underlying belief is that these companies will perform well even if the economy is poor. They are thus
anomalies – companies that don’t follow the normal market trend.
Stock Volatility
Stock prices constantly fluctuate. This is because the demand for the stock changes. As more stocks
change hands, greater is the change in its share price. This is called stock volatility. Even the amount of
volatility in the market changes on a daily basis. To measure this volatility, the National Stock Exchange
introduced the VIX India index, also called the fear gauge. VIX is often used as an indicator of stock price

Dr. Meghashree Dadhich

Derivatives & Risk Management
trends. This is because, VIX rises when there is more fear and uncertainty in the market. This means,
investors perceive an increase in risk. This usually follows a fall in the market.
Insider Trading
In your dealings with the stock world, you will often come across the term 'insider trading'. In simple
words, the meaning of insider trading is 'the trading of shares based on knowledge not available to the rest
of the world’. It is illegal to trade after receiving 'tips' of confidential securities information.
This applies to corporate personnel as well as traders and brokers. This is why company management has
to report their trades to the exchange. For example, when corporate officers, directors, or employees trade
the company’s stocks after learning of significant, confidential corporate developments, it is considered an
illegal form of insider trading. This applies to employees of law, banking, brokerage and printing firms
who were given such information to provide services to the corporation whose securities they traded. Even
government employees, who trade after learning of such information, are considered to have broken the
law on insider trading. It is a punitive offence.
Lot size of Contract in the Equity Derivatives Market
Lot size refers to number of underlying securities in one contract. The lot size is determined
keeping in mind the minimum contract size requirement at the time of introduction of derivative
contracts on a particular underlying.
For example, if shares of XYZ Ltd are quoted at Rs.1000 each and the minimum contract size is
Rs.2 lacs, then the lot size for that particular scrip stands to be 200000/1000 = 200 shares i.e. one
contract in XYZ Ltd. covers 200 shares.
Mark to Market Settlement
The position in the future contracts for each member is marked-to-market to the daily settlement price of
the futures contracts at the end of each trade day.
The profits/ losses are computed as the difference between the trade price or the previous day's settlement
price, as the case may be, and the current day's settlement price. Investors who have suffered a loss are
required to pay the mark-to-market loss amount to NSCCL which is passed on to the members who have
made a profit. This is known as daily mark-to-market settlement.

Dr. Meghashree Dadhich

Derivatives & Risk Management
Unit-I
Chapter – 02
Introduction of Financial Derivatives
A derivative instrument is a financial contract whose payoff structure is determined by the value of an
underlying commodity, security, interest rate, share price index, exchange rate, oil price etc. Thus, a
derivative instrument derives its value from some underlying variable. A derivative instrument is, instead
a promise to convey ownership. Its value is determined by fluctuations in the underlying asset.
It is a financial instrument which derives its value/price from the underlying assets. Originally, underlying
corpus is first created which can consist of one security or a combination of different securities. The value
of the underlying asset is bound to change as the value of the underlying assets keep changing
continuously. Four most common examples of derivative instruments are Forwards, Futures, Options and
Swaps.
According to L.C. Gupta committee: “Derivative means Forward, Futures, Options & Swaps contract of
predetermined fixed duration linked for the purpose of contract fulfillment to the value of specified real or
financial assets or to an index security.”
The underlying bases of a derivative instrument may be any product including:
 Commodities such as grain, coffee beans, etc.;
 Precious metals like gold and silver;
 Foreign exchange rate;
 Bonds of different types including medium to long-term negotiable debt securities issued by
governments, companies etc.;
 Short-term securities such as T-bills;
 Over-the-counter (OTC) money market products such as loans or deposits.
However, the most important use of derivatives is in transferring market risk, called hedging; which is a
protection against losses resulting from unforeseen price or volatility changes. Thus, derivatives are a very
important tool of risk management.
Common Forms of 'Derivative'
1. Futures contracts are one of the most common types of derivatives. A futures contract (or
simply futures, colloquially) is an agreement between two parties for the sale of an asset at an agreed
upon price. In other words, Futures are exchange-traded contracts to sell or buy financial instruments
or physical commodities for a future delivery at an agreed price. There is an agreement to buy or sell a
specified quantity of financial instrument commodity in a designated future month at a price agreed

Dr. Meghashree Dadhich

Derivatives & Risk Management
upon by the buyer and seller. One would generally use a futures contract to hedge against risk during
a particular period of time. For example, suppose that on July 31, 2014 Diana owned ten thousand
shares of Wal-Mart (WMT) stock, which were then valued at $73.58 per share. Fearing that the value
of her shares would decline, Diana decided that she wanted to arrange a futures contract to protect the
value of her stock. Jerry, a speculator predicting a rise in the value of Wal-Mart stock, agrees to a
futures contract with Diana, dictating that in one year’s time Jerry will buy Diana’s ten thousand Wal-
Mart shares at their current value of $73.58.
The futures contract may in part be considered to be something like a bet between the two parties. If
the value of Diana’s stock declines, her investment is protected because Jerry has agreed to buy them
at their July 2014 value, and if the value of the stock increases, Jerry earns greater value on the stock,
as he is paying July 2014 prices for stock in July 2015. A year later, July 31 rolls around and Wal-
Mart is valued at $71.98 per share. Diana, then, has benefited from the futures contract, making $1.60
more per share than she would have if she had simply waited until July 2015 to sell her stock. While
this might not seem like much, this difference of $1.60 per share translates to a difference of $16,000
when considering the ten thousand shares that Diana sold. Jerry, on the other hand, has speculated
poorly and lost a sizeable sum.
2. Forward contracts are another important kind of derivative similar to futures contracts, the key
difference being that unlike futures, forward contracts (or “forwards”) are not traded on exchange, but
rather are only traded over-the-counter.
A forward contract is a customized contract between two parties, where settlement takes place on a
specific date in future at a price agreed today. The main features of forward contracts are
 They are bilateral contracts and hence exposed to counter - party risk.
 Each contract is custom designed, and hence is unique in terms of contract size, expiration date
and the asset type and quality.
 The contract price is generally not available in public domain.
 The contract has to be settled by delivery of the asset on expiration date.
 In case the party wishes to reverse the contract, it has to compulsorily go to the same counter party,
which being in a monopoly situation can command the price it wants.
Example: “A” Ltd requires $500000 on May 2006 for repayment of loan installment and interest .As
on December 2005 it appears to the company that the dollar may become dearer as compared to the
exchange rate, prevailing on that date say. Accordingly A Ltd may enter into forward contract with
banker for $500000.The Forward rate may be higher or lower than spot rate prevailing on the date of
the forward contract. Let us assume forward rate as on December 2005 was 1$=Rs 44 as against spot
Dr. Meghashree Dadhich
Derivatives & Risk Management
rate of Rs 43.50. As on future i.e. May 2006 the banker will pay A Ltd $500000 at Rs 44 irrespective
of the spot rate as on that date.
3. Swaps are another common type of derivative. A swap is most often a contract between two parties
agreeing to trade loan terms. One might use an interest rate swap in order to switch from a variable
interest rate loan to a fixed interest rate loan, or vice versa. If someone with a variable interest rate
loan were trying to secure additional financing, a lender might deny him or her loan because of the
uncertain future bearing of the variable interest rates upon the individual’s ability to repay debts,
perhaps fearing that the individual will default. For this reason, he or she might seek to switch their
variable interest rate loan with someone else, who has a loan with a fixed interest rate that is otherwise
similar. Although the loans will remain in the original holders’ names, the contract mandates that each
party will make payments toward the other’s loan at a mutually agreed upon rate. Yet, this can be
risky, because if one party defaults or goes bankrupt, the other will be forced back into their original
loan. Swaps can be made using interest rates, currencies or commodities. In other words: In a swap,
two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at
periodic intervals.
4. Options are another common form of derivative. An option is similar to a futures contract in that it is
an agreement between two parties granting one the opportunity to buy or sell a security from or to the
other party at a predetermined future date. Yet, the key difference between options and futures is that
with an option the buyer or seller is not obligated to make the transaction if he or she decides not to,
hence the name “option.” The exchange itself is, ultimately, optional. Like with futures, options may
be used to hedge the seller’s stock against a price drop and to provide the buyer with an opportunity
for financial gain through speculation. An option can be short or long, as well as a call or put.
Forward Contracts v/s Futures Contracts
S. No Basis Futures Forwards
1 Nature Traded on organized exchange Over the Counter
2 Contract Terms Standardized Customized
3 Liquidity More liquid Less liquid
4 Margin Payments Requires margin payments Not required
5 Settlement Follows daily settlement At the end of the period.
Can be reversed with any member Contract can be reversed only with the same
6 Squaring off
of the Exchange. counter-party with whom it was entered into.

Traders in Derivatives Market

There are three types of traders in the derivatives market:
1. Hedger
Dr. Meghashree Dadhich
Derivatives & Risk Management
2. Speculator
3. Arbitrageur
Hedger: Hedging is the prime reason which led to emergence of derivatives. A hedge is a position taken
in order to offset the risk associated with some other position. A hedger is someone who faces risk
associated with price movement of an asset and who uses derivatives as a means of reducing that risk. A
hedger is a trader who enters the futures market to reduce a pre-existing risk. For example: A trader buys a
large quantity of wheat that would take two weeks to reach him. Now, he fears that the wheat price may
fall in the coming two weeks and so wheat may have to be sold at lower prices. The trader can enter into a
future contract with a matching price to hedge. Thus, if the wheat price does fall, the trader would lose
money on the inventory of wheat but will profit from the future contract which would balance the loss.
Similarly, an investor who holds a large quantity of shares of a company can hedge by selling futures on
them, in case he fears a fall in the price of that share.
Speculators: While hedgers are interested in reducing or eliminating risk, speculators buy and sell
derivatives to make profit and not to reduce risk. Speculators are those who are willing to take increased
risks. Speculators wish to take a position in the market by betting on the future price movements of an
asset. Futures and options contracts can increase both the potential gains and losses in a speculative
venture. Speculators are important to derivatives markets as they facilitate hedging provide liquidity
ensure accurate pricing, and help to maintain price stability. It is the speculators who keep the market
going because they bear risks which no one else is willing to bear. In fact, the speculators consume
information, make forecasts about the prices and put their money in these forecast. For example: Suppose
that a share is currently quoted at Rs. 32 and a speculator opted call option with exercise price of Rs. 35
and due in a month, buying option is required Rs 50 for 100 shares ( a call option 50 paisa per share).
Now, if the price of the share is either less than or equal to Rs. 35, the call shall not be exercised and the
loss would be Rs. 50 of the contract fee. If, on the other hand, the price rules at Rs. 40, then the gain of Rs.
500 would be made (Rs. 40 – Rs. 35) and net gain would be Rs. 450 (Rs. 500 – Rs. 50).
The speculators in the derivatives markets may either be day traders or position traders. The day traders
speculate on the price movements during one trading day, one and close positions many times a day and
do not carry any position at the end of the day. On the other hand, the position traders also attempt to
gain from price fluctuations but they keep their positions for longer durations – may be for few days,
weeks or even months.
Arbitrageur: An arbitrageur is a person who simultaneously enters into transactions in two or more
markets to take advantage of discrepancy between prices in these markets. For example: if a share is
quoted at a lower rate on the Bombay Stock Exchange (BSE) and at a higher rate on National Stock
Dr. Meghashree Dadhich
Derivatives & Risk Management
Exchange (NSE) than an arbitrageur would profit by buying the share at BSE and simultaneously selling it
at NSE. Hence, arbitrage involves making profits from relative mis-pricing. Arbitrageurs also help to
make markets liquid, ensure accurate and uniform pricing, and enhance price stability.
All three types of trades and investors are required for a healthy functioning of the derivatives market.
Hedgers and investors provide economic substance to this market, and without them the markets would
become mere tools of gambling. Speculators provide liquidity and depth to the market. Arbitrageurs help
in bringing about price uniformity and price discovery. The presence of Hedgers, speculators and
arbitrageurs, not only enables the smooth functioning of the derivatives market but also helps in increasing
the liquidity of the market.
How are Derivative Contracts Linked to Stock Prices
Suppose you buy a Futures contract of Infosys shares at Rs 3,000 – the stock price of the IT Company
currently in the spot market. A month later, the contract is slated to expire. At this time, the stock is
trading at Rs 3,500. This means, you make a profit of Rs. 500 per share, as you are getting the stocks at a
cheaper rate.
Had the price remained unchanged, you would have received nothing. Similarly, if the stock price fell by
Rs. 800, you would have lost Rs. 800. As we can see, the above contract depends upon the price of the
underlying asset – Infosys shares. Similarly, derivatives trading can be conducted on the indices also.
Nifty Futures is a very commonly traded derivatives contract in the stock markets. The underlying security
in the case of a Nifty Futures contract would be the 50-share Nifty index.
Nature of Derivatives Market
1. Financial Derivatives: Financial derivatives offer organizations the opportunities to break financial
risk into smaller components and then to buy and sell those components to best meet specific risk
management objective. The value of a financial derivative derives from the price of an underlying
asset. Financial derivatives enable parties to trade specific financial risks (such as interest rate risk,
currency, equity and commodity price risk, and credit risk, etc.) to other entities who are more willing
or better suited, to take or manage these risks—typically, but not always, without trading in a primary
asset or commodity. The risk embodied in a derivatives contract can be traded either by trading the
contract itself, such as with options, or by creating a new contract which embodies risk characteristics
that match, in a countervailing manner, those of the existing contract owned.
2. Commodity Derivatives: Commodity derivatives are investment tools that allow investors to profit
from certain items without possessing them. This type of investing dates back to 1848 when
the Chicago Board of Trade was established. Initially, the idea behind commodity derivatives was to

Dr. Meghashree Dadhich

Derivatives & Risk Management
provide a means of risk protection for farmers. They could promise to sell crops in the future for a pre-
arranged price.
A modern commodity derivative trading is most popular with people outside of the commodities
industry. The majority of people who use this investment tool tend to be price speculators. These
people usually focus on supply and demand and try to predict whether prices will go up or down.
When the prices of a certain commodity move in their favor, they make money. If price moves in the
opposite direction, then they lose money.
The buyer of a derivative contract buys the right to exchange a commodity for a certain price at a
future date. Although this person is a contract buyer, he may be buying or selling the commodity. He
does not have to pay the full value of amount of the commodity that he is investing in. He only needs
to pay a small percentage, known as the margin price.
3. Weather Derivatives: Weather derivatives are financial instruments that can be used by organizations
or individuals as part of a risk management strategy to reduce risk associated with adverse or
unexpected weather conditions. In other words, it is an instrument used by companies
to hedge against the risk of weather-related losses. The investor who sells a weather derivative agrees
to bear this risk for a premium. If nothing happens, the investor makes a profit. However, if the
weather turns bad, then the company who buys the derivative claims the agreed amount.
Even in our advanced, technology-based society, we still live largely at the mercy of the weather. It
influences our daily lives and choices, and has an enormous impact on corporate revenues and
earnings. Until recently, there were very few financial tools offering companies' protection against
weather-related risks. However, the inception of the weather derivative - by making weather a tradable
commodity - has changed all this.
The risks businesses face due to weather are somewhat unique. Weather conditions tend to affect
volume and usage more than they directly affect price. An exceptionally warm winter, for example,
can leave utility and energy companies with excess supplies of oil or natural gas (because people need
less to heat their homes). Or, an exceptionally cold summer can leave hotel and airline seats empty.
Although the prices may change somewhat as a consequence of unusually high or low demand, price
adjustments don't necessarily compensate for lost revenues resulting from unseasonable temperatures.
Example: The main users of weather derivatives are energy companies as demand for their products
can vary drastically due to extreme weather conditions. The agricultural industry is the second main
user of such instruments although other purchasers include firms arranging major sporting (outdoor)
events and even tour operators. Hedge funds are reputedly also major investors in this alternative asset
class.
Dr. Meghashree Dadhich
Derivatives & Risk Management
A broad range of weather derivative products are available including options, futures, forwards and
swaps. Most are traded over-the-counter (OTC) although there are some traded electronically on
indexes like the Chicago Mercantile Exchange (CME). The CME offers weather derivative products
that “offers trading opportunities related to temperatures, snowfall, frost and hurricanes. The products
are based on a range of weather conditions in more than 47 cities in the United States, Europe, Canada,
Australia and Asia, with the hurricane products geared to nine US regions.”
How to Trade in Derivatives Market
Trading in the derivatives market is a lot similar to that in the cash segment of the stock market.
 First do your research. This is more important for the derivatives market. However, remember that the
strategies need to differ from that of the stock market. For example: you may wish you buy stocks that
are likely to rise in the future. In this case, you conduct a buy transaction. In the derivatives market,
this would need you to enter into a sell transaction. So the strategy would differ.
 Arrange for the requisite margin amount. Stock market rules require you to constantly maintain your
margin amount. This means, you cannot withdraw this amount from your trading account at any point
in time until the trade is settled. Also remember that the margin amount changes as the price of the
underlying stock rises or falls. So, always keep extra money in your account.
 Conduct the transaction through your trading account. You will have to first make sure that your
account allows you to trade in derivatives. If not, consult your brokerage or stock broker and get the
required services activated. Once you do this, you can place an order online or on phone with your
broker.
 Select your stocks and their contracts on the basis of the amount you have in hand, the margin
requirements, the price of the underlying shares, as well as the price of the contracts. Yes, you do have
to pay a small amount to buy the contract. Ensure all this fits your budget.
 You can wait until the contract is scheduled to expiry to settle the trade. In such a case, you can pay
the whole amount outstanding, or you can enter into an opposing trade. For example, you placed a
‘buy trade’ for Infosys futures at Rs 3,000 a week before expiry. To exit the trade before, you can
place a ‘sell trade’ future contract. If this amount is higher than Rs 3,000, you book profits. If not, you
will make losses.
What are the Pre-requisites to Invest
As said earlier, trading in the derivatives market is very similar to trading in the cash segment of the stock
markets. This has three key requisites:
1. Demat Account: This is the account which stores your securities in electronic format. It is unique to
every investor and trader.
Dr. Meghashree Dadhich
Derivatives & Risk Management
2. Trading Account: This is the account through which you conduct trades. The account number can be
considered your identity in the markets. This makes the trade unique to you. It is linked to the demat
account, and thus ensures that your shares go to your demat account.
3. Margin Maintenance: This pre-requisite is unique to derivatives trading. While many in the cash
segment too use margins to conduct trades, this is predominantly used in the derivatives segment.
Limitations of Derivatives
As mentioned above, derivative is a broad category of security, so using derivatives in making financial
decisions varies by the type of derivative in question. Generally speaking, the key to making a sound
investment is to fully understand the risks associated with the derivative, such as the
counterparty, underlying asset, price and expiration. The use of a derivative only makes sense if the
investor is fully aware of the risks and understands the impact of the investment within a
portfolio strategy.

Dr. Meghashree Dadhich

Derivatives & Risk Management
Unit-I
Chapter – 03
Regulatory Framework for Derivatives
Dr. L.C Gupta Committee constituted by SEBI had laid down the regulatory framework for derivative
trading in India. SEBI has also framed suggestive bye-law for Derivative Exchanges/Segments and their
Clearing Corporation/House which lays down the provisions for trading and settlement of derivative
contracts. The Rules, Bye-laws & Regulations of the Derivative Segment of the Exchanges and their
Clearing Corporation/House have to be framed in line with the suggestive Bye-laws. SEBI has also laid
the eligibility conditions for Derivative Exchange/Segment and its Clearing Corporation/House. The
eligibility conditions have been framed to ensure that Derivative Exchange/Segment & Clearing
Corporation/House provide a transparent trading environment, safety & integrity and provide facilities for
redressal of investor grievances.
Regulatory objectives
1. The Committee believes that regulation should be designed to achieve specific, well-defined goals. It
is inclined towards positive regulation designed to encourage healthy activity and behavior. It has been
guided by the following objectives :
a. Investor Protection: Attention needs to be given to the following four aspects:
i. Fairness and Transparency: The trading rules should ensure that trading is conducted in a fair
and transparent manner. Experience in other countries shows that in many cases, derivatives
brokers/dealers failed to disclose potential risk to the clients. In this context, sales practices
adopted by dealers for derivatives would require specific regulation. In some of the most widely
reported mishaps in the derivatives market elsewhere, the underlying reason was inadequate
internal control system at the user-firm itself so that overall exposure was not controlled and the
use of derivatives was for speculation rather than for risk hedging. These experiences provide
useful lessons for us for designing regulations.
ii. Safeguard for clients' moneys: Moneys and securities deposited by clients with the trading
members should not only be kept in a separate clients' account but should also not be attachable
for meeting the broker's own debts. It should be ensured that trading by dealers on own account
is totally segregated from that for clients.
iii. Competent and honest service: The eligibility criteria for trading members should be designed
to encourage competent and qualified personnel so that investors/clients are served well. This

Dr. Meghashree Dadhich

Derivatives & Risk Management
makes it necessary to prescribe qualification for derivatives brokers/dealers and the sales persons
appointed by them in terms of a knowledge base.
iv. Market integrity: The trading system should ensure that the market's integrity is safeguarded by
minimizing the possibility of defaults. This requires framing appropriate rules about capital
adequacy, margins, clearing corporation, etc.
b. Quality of markets: The concept of "Quality of Markets" goes well beyond market integrity and
aims at enhancing important market qualities, such as cost-efficiency, price-continuity, and price-
discovery. This is a much broader objective than market integrity.
c. Innovation: While curbing any undesirable tendencies, the regulatory framework should not stifle
innovation which is the source of all economic progress, more so because financial derivatives
represent a new rapidly developing area, aided by advancements in information technology.
i. Of course, the ultimate objective of regulation of financial markets has to be to promote more
efficient functioning of markets on the "real" side of the economy, i.e. economic efficiency.
ii. Leaving aside those who use derivatives for hedging of risk to which they are exposed, the other
participants in derivatives trading are attracted by the speculative opportunities which such
trading offers due to inherently high leverage. For this reason, the risk involved for derivative
traders and speculators is high. This is indicated by some of the widely publicised mishaps in
other countries. Hence, the regulatory frame for derivative trading, in all its aspects, has to be
much stricter than what exists for cash trading. The scope of regulation should cover derivative
exchanges, derivative traders, brokers and sales-persons, derivative contracts or products,
derivative trading rules and derivative clearing mechanism.
iii. In the Committee's view, the regulatory responsibility for derivatives trading will have to be
shared between the exchange conducting derivatives trading on the one hand and SEBI on the
other. The committee envisages that this sharing of regulatory responsibility is so designed as to
maximize regulatory effectiveness and to minimize regulatory costs.
Major Issues Concerning Regulatory Framework
The Committee's attention had been drawn to several important issues in connection with derivatives
trading. The Committee has considered such issues, some of which have a direct bearing on the design of
the regulatory framework. They are listed below:
a. Should a derivatives exchange be organized as independent and separate from an existing stock
exchange?
b. What exactly should be the division of regulatory responsibility, including both framing and enforcing
the regulations, between SEBI and the derivatives exchange?
Dr. Meghashree Dadhich
Derivatives & Risk Management
c. How should we ensure that the derivatives exchange will effectively fulfill its regulatory
responsibility?
d. What criteria should SEBI adopt for granting permission for derivatives trading to an exchange?
e. What conditions should the clearing mechanism for derivatives trading satisfy in view of high leverage
involved?
f. What new regulations or changes in existing regulations will have to be introduced by SEBI for
derivatives trading?
Should derivatives trading be conducted in a separate exchange?
1. A major issue raised before the Committee for its decision was whether regulations should mandate
the creation of a separate exchange for derivatives trading, or allow an existing stock exchange to
conduct such trading. The Committee has examined various aspects of the problem. It has also
reviewed the position prevailing in other countries. Exchange-traded financial derivatives originated in
USA and were subsequently introduced in many other countries. Organizational and regulatory
arrangements are not the same in all countries. Interestingly, in U.S.A., for reasons of history and
regulatory structure, futures trading in financial instruments including currency, bonds and equities,
was started in early 1970s, under the auspices of commodity futures markets rather than under
securities exchanges where the underlying bonds and equities were being traded. This may have
happened partly because currency futures, which had nothing to do with securities markets, were the
first to emerge among financial derivatives in U.S.A. and partly because derivatives were not
"securities" under U.S. laws. Cash trading in securities and options on securities were under the
Securities and Exchange Commission (SEC) while futures trading were under the Commodities
Futures Trading Commission (CFTC). In other countries, the arrangements have varied.
2. The Committee examined the relative merits of allowing derivatives trading to be conducted by an
existing stock exchange vis-à-vis a separate exchange for derivatives. The arguments for each are
summarized below.
Arguments for allowing existing stock exchanges to start futures trading:
a. The weightiest argument in this regard is the advantage of synergies arising from the pooling of costs
of expensive information technology networks and the sharing of expertise required for running a
modern exchange. Setting-up a separate derivatives exchange will involve high costs and require more
time.
b. The recent trend in other countries seems to be towards bringing futures and cash trading under
coordinated supervision. The lack of coordination was recognized as an important problem in U.S.A.

Dr. Meghashree Dadhich

 Derivatives & Risk Management
in the aftermath of the October 1987 market crash. Exchange-level supervisory coordination between
futures and cash markets is greatly facilitated if both are parts of the same exchange.

Arguments for setting-up separate futures exchange:

a. The trading rules and entry requirements for futures trading would have to be different from those for
cash trading.
b. The possibility of collusion among traders for market manipulation seems to be greater if cash and
futures trading are conducted in the same exchange.
c. A separate exchange will start with a clean slate and would not have to restrict the entry to the existing
members only but the entry will be thrown open to all potential eligible players.
Recommendations for Derivative Market
From the purely regulatory angle, a separate exchange for futures trading seems to be a neater
arrangement. However, considering the constraints in infrastructure facilities, the existing stock exchanges
having cash trading may also be permitted to trade derivatives provided they meet the minimum eligibility
conditions as indicated below:
i. The trading should take place through an online screen-based trading system, which also has a disaster
recovery site. The per-half-hour capacity of the computers and the network should be at least 4 to 5
times of the anticipated peak load in any half hour, or of the actual peak load seen in any half-hour
during the preceding six months. This shall be reviewed from time to time on the basis of experience.
ii. The clearing of the derivatives market should be done by an independent clearing corporation, which
satisfies the conditions listed in a later chapter of this report.
iii. The exchange must have an online surveillance capability which monitors positions, prices and
volumes in real-time so as to deter market manipulation. Price and position limits should be used for
improving market quality.
iv. Information about trades, quantities, and quotes should be disseminated by the exchange in realtime
over at least two information vending networks which are accessible to investors in the country.
v. The Exchange should have at least 50 members to start derivatives trading.
vi. If derivative trading is to take place at an existing cash market, it should be done in a separate segment
with a separate membership; i.e., all members of the existing cash market would not automatically
become members of the derivatives market.
vii. The derivatives market should have a separate governing council which shall not have representation
of trading/clearing members of the derivatives Exchange beyond whatever percentage SEBI may
prescribe after reviewing the working of the present governance system of exchanges.
Dr. Meghashree Dadhich
 Derivatives & Risk Management
viii. The Chairman of the Governing Council of the Derivative Division/Exchange shall be a member of
the Governing Council. If the Chairman is a Broker/Dealer, then, he shall not carry on any Broking or
Dealing Business on any Exchange during his tenure as Chairman.
ix. The exchange should have arbitration and investor grievances redressal mechanism operative from all
the four areas/regions of the country.
x. The exchange should have an adequate inspection capability.
xi. No trading/clearing member should be allowed simultaneously to be on the governing council of both
the derivatives market and the cash market. If already existing, the Exchange should have a
satisfactory record of monitoring its members, handling investor complaints and preventing
irregularities in trading
Development of Derivatives Markets in India
Indian Derivatives markets 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 in1875. In 1952, with the ban
on cash settlement and option trading by the Government of India, derivatives trading shifted to informal
forwards markets. In recent years, government policy has shifted in favor of an increased role of market-
based pricing and less suspicious derivatives trading. The first step towards the introduction of financial
derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995.
This provided for withdrawal of prohibition on options in securities. In the last decade, beginning the year
2000, ban on futures trading in many commodities was lifted out. During 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 May2001 on the
recommendation of L. C Gupta committee. Securities and Exchange Board of India (SEBI) permitted the
derivative segments of two stock exchanges, NSE and BSE, 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.
Role of Derivatives in India’s Financial Development
Derivatives are financial instruments whose payoffs derive from other, more primitive financial variables
such as a stock price, a commodity price, an index level, an interest rate, or an exchange rate. The world
market for derivatives is an immense one. The notion amount outstanding in the over-the-counter (OTC)
derivatives market worldwide exceeds $640 trillion, with a collective gross market value of over $27
trillion. The exchange-traded market has another $60 trillion in outstanding notional. The growth of
derivatives usage over the last two decades has been rapid in both advanced economies and emerging
Dr. Meghashree Dadhich
Derivatives & Risk Management
markets; in both OTC contracts and those that are exchange-traded; and across all underlying classes,
including interest-rate, currency, equity, and the most recent addition, credit. Derivatives are enormously
useful instruments in the management of risk. They can be used to hedge an existing market exposure
(forwards and futures), to obtain downside protection to an exposure even while retaining upside potential
(options), to transform the nature of an exposure (swaps), and to obtain insurance against events such as
default (credit derivatives). For corporations and financial institutions looking to manage exchange-rate
risk, input costs, financing costs, or credit exposures, these are invaluable features, and explain to a
considerable extent the rapid growth of the derivatives market as globalization and global inter linkages
have grown. Derivatives are also highly levered instruments, and this has its own implications. On the one
hand, the leverage makes derivatives attractive to speculators (those who wish to bet on price direction).
In itself, this is not a bad thing, since speculators add considerable liquidity to the market and, by taking
the opposite side, facilitate the positions hedgers want to take. However, leverage magnifies the effect of
price moves, so sharp unfavorable price moves can easily spell disaster to the derivatives portfolio and
thence to the larger business entity. Indeed, the annals of financial history are littered with stories of
corporations and financial institutions which collapsed when deterioration in market conditions led to
massive losses in the derivatives portfolio – occasionally, even in cases where the derivatives were being
used to hedge existing exposures. The potentially lethal cocktail of leverage and volatility makes it vital
that users understand fully the risks of the instruments, and regulators the systemic impact of volatility
spikes. India’s derivatives markets, both OTC and exchange-traded, have seen rapid growth over the last
decade, and with relatively few sputters. The successes are visible and real – several Indian exchanges
rank among the world’s top exchanges in terms of number of derivatives contracts traded; and there have
been no large scale derivatives disasters of the sort that have roiled the advanced economies.

Dr. Meghashree Dadhich