Mentor-I.K.

TIWARI

NISM-Series-VIII: Equity
Derivatives Certification
Examination

CHAPTER 1: BASICS OF DERIVATIVES

 Chapter Outline

 Basics of Derivatives
 Derivatives Market – History & Evolution
 Indian Derivatives Market
 Market Participants
 Types of Derivatives Market
 Significance of Derivatives
 Various risks faced by the participants in derivatives
 What are Derivatives

 Derivative is a contract or a product whose value is derived from

value of some other asset known as underlying. Derivatives are
based on wide range of underlying assets. Eg:
1. Metals such as Gold, Silver etc.
2. Energy resources such as Crude Oil, Coal, Electricity, Natural Gas
etc.
3. Agri commodities like wheat, Sugar, Coffee, Pulses etc.
4. Financial assets such as Shares, Bonds and Foreign Exchange.
 Derivatives Market – History & Evolution
 .
12th Century‐ In European trade fairs, sellers signed contracts promising future delivery of the items they sold.
 13th Century‐ There are many examples of contracts entered into by English Cistercian Monasteries, who frequently sold their
wool up to 20 years in advance, to foreign merchants.
 1634‐1637 ‐ Tulip Mania in Holland: Fortunes were lost in after a speculative boom in tulip futures burst.
 Late 17th Century ‐ In Japan at Dojima, near Osaka, a futures market in rice was developed to protect rice producers from
bad weather or warfare
 In 1848, The Chicago Board of Trade (CBOT) facilitated trading of forward contracts on various commodities.
 In 1865, the CBOT went a step further and listed the first ‘exchange traded” derivative contract in the US. These contracts were
called ‘futures contracts”
 In 1919, Chicago Butter and Egg Board, a spin‐off of CBOT, was reorganised to allow futures trading. Later its name was
changed to Chicago Mercantile Exchange (CME).
 In 1972, Chicago Mercantile Exchange introduced International Monetary Market (IMM), which allowed trading in currency
futures.
 In 1973, Chicago Board Options Exchange (CBOE) became the first marketplace for trading listed options.
 In 1975, CBOT introduced Treasury bill futures contract. It was the first successful pure interest rate futures
 In 1977, CBOT introduced T‐bond futures contract.
 In 1982, CME introduced Eurodollar futures contractIn 1982, Kansas City Board of Trade launched the first stock index futures.
 In 1983, Chicago Board Options Exchange (CBOE) introduced option on stock indexes with the S&P 100® (OEX) and S&P 500®
(SPXSM) Indexes.
 Factors influencing the growth of derivative market globally
Over the last five decades, derivatives market has seen a phenomenal growth. Many derivative contracts were launched
at exchanges across the world. Some of the factors driving the growth of financial derivatives are:
• Increased fluctuations in underlying asset prices in financial markets.
• Integration of financial markets globally.
• Use of latest technology in communications has helped in reduction of transaction costs.
• Enhanced understanding of market participants on sophisticated risk management tools to manage risk.
• Frequent innovations in derivatives market and newer applications of products.
 Indian Derivatives Market
 SEBI set up a 24– member committee under the Chairmanship of Dr. L. C. Gupta on November 18, 1996 to develop
appropriate regulatory framework for derivatives trading in India.
 The committee submitted its report on March 17, 1998 recommending that derivatives should be declared as ‘securities’
so that regulatory framework applicable to trading of ‘securities’ could also govern trading of derivatives.
 Subsequently, SEBI set up a group in June 1998 under the Chairmanship of Prof. J. R. Verma, to recommend measures for
risk containment in derivatives market in India.
 The committee submitted its report in October 1998. It worked out the operational details of margining system,
methodology for charging initial margins, membership details and net‐worth criterion, deposit requirements and real time
monitoring of positions requirements.
 In 1999, The Securities Contract Regulation Act (SCRA) was amended to include “derivatives” within the domain of
‘securities’ and regulatory framework was developed for governing derivatives trading. In March 2000, government
repealed a three‐decade‐ old notification, which prohibited forward trading in securities.
 The exchange traded derivatives started in India in June 2000 with SEBI permitting BSE and NSE to introduce equity
derivative segment. To begin with, SEBI approved trading in index futures contracts based on CNX Nifty and BSE Sensex,
which commenced trading 13 in June 2000
 trading in Index options commenced in June 2001 and trading in options on individual stocks commenced in July 2001.
 Futures contracts on individual stocks started in November 2001
 MCX‐SX (renamed as MSEI) started trading in all these products (Futures and options on index SX40 and individual stocks)
in February 2013.
 Products in Derivatives Market

 Forwards: It is a contractual agreement between two parties to buy/sell an

underlying asset at a certain future date for a particular price that is pre‐decided
on the date of contract.
 Futures: A futures contract is similar to a forward, except that the deal is made
through an organized and regulated exchange rather than being negotiated
directly between two parties.
 Options: An Option is a contract that gives the right, but not an obligation, to
buy/sell the underlying on or before a stated date and at a stated price. While
buyer of option pays the premium and buys the right, writer/seller of option
receives the premium with obligation to sell/ buy the underlying asset, if the
buyer exercises his right.
 Swaps: A swap is an agreement made between two parties to exchange cash
flows in the future according to a prearranged formula. Swaps are, broadly
speaking, series of forward contracts.
 Market Participants

 Hedgers: They face risk associated with the prices of underlying assets and use
derivatives to reduce their risk. Corporations, investing institutions and banks all
use derivative products to hedge or reduce their exposures to market
variables.
 Traders: They try to predict the future movements in prices of underlying assets
and take positions in derivative contracts. Derivatives are preferred over
underlying asset as they offer leverage, are less expensive and are faster to
execute in size.
 Arbitrageurs: Arbitrage is a deal that produces profit by exploiting a price
difference in a product in two different markets. Arbitrage originates when a
trader purchases an asset cheaply in one location and simultaneously
arranges to sell it at a higher price in another location.
 Types of Derivatives Market

 In the OTC derivatives markets, transactions among the dealing counterparties, have following features compared to
exchange traded derivatives:

--Contracts are tailor made to fit in the specific requirements of dealing counterparties.
• The management of counter-party (credit) risk is decentralized and located within individual institutions.
• There are no formal centralized limits on individual positions, leverage, or margining.
• There are no formal rules or mechanisms for risk management to ensure market stability and integrity, and for
safeguarding the collective interest of market participants.
• Transactions are private with little or no disclosure to the entire market.
 Significance of Derivatives

 Derivatives market helps in improving price discovery based on actual

valuations and expectations.
 Derivatives market helps in transfer of various risks from those who are
exposed to risk but have low risk appetite to participants with high risk
appetite.
 Derivatives market helps shift of speculative trades from unorganized market
to organized market.
 Various risks faced by the participants in derivatives

 counterparty risk (default by counterparty)

 price risk (loss on position because of price move)
 liquidity risk (inability to exit from a position)
 legal or regulatory risk (enforceability of contracts)
 operational risk (fraud, inadequate documentation, improper execution, etc.

 Model Risk Disclosure Document is issued by the members of Exchanges and

contains important information on trading in Equities and F&O Segments of
exchanges. All prospective participants should read this document before trading
on Capital Market/Cash Segment or F&O segment of the Exchanges.
 Mentor –
INDRAKAMAL

THANK YOU