The Most Important Questions

Antim Prahar

MBA/BBA

By
Dr. Anand Vyas
1 Types of Derivatives
Derivatives are financial instruments that derive their value from an underlying
asset. They are widely used in the financial markets for various purposes such as
hedging, speculation, and arbitrage. There are several types of derivatives, each
serving a specific purpose. Let's explore some of the commonly used types of
derivatives:

1. Futures Contracts: Futures contracts are agreements between two parties to buy
or sell an asset at a predetermined price and date in the future. These contracts are
standardized and traded on exchanges. For example, a farmer may enter into a
futures contract to sell his crop at a fixed price to protect against price fluctuations.

2. Options Contracts: Options give the holder the right, but not the obligation, to
buy (call option) or sell (put option) an asset at a predetermined price within a
specified period. They provide flexibility to investors and are used for hedging and
speculation. An investor might purchase a call option on a stock to benefit from
potential price increases.
3. Swaps: Swaps involve the exchange of cash flows between two parties
based on a predetermined formula. They are commonly used to manage
interest rate or currency risks. For instance, a company with a variable
interest rate loan might enter into an interest rate swap to convert it into a
fixed rate loan.

4. Forwards Contracts: Forwards are similar to futures contracts but are not
standardized and traded on exchanges. They are customized agreements
between two parties to buy or sell an asset at a future date and a specific
price. Forward contracts are commonly used in over-the-counter markets for
non-standardized assets.

These are just a few examples of derivatives commonly used in financial

markets. Each type of derivative has its unique features and applications,
catering to different risk management and investment needs.
2 Financial Swaps
Financial swaps are derivative contracts that allow two parties to exchange
cash flows or other financial instruments based on a specified set of
conditions. Swaps are widely used by financial institutions, corporations, and
investors to manage risks, reduce costs, or speculate on market movements.
In finance, a swap is a financial contract between two parties where they
agree to exchange one stream of cash flow for another. These cash flows are
referred to as "legs" of the swap. Swaps are commonly used for various
purposes, such as switching financing from one country to another,
converting a floating interest rate to a fixed interest rate (or vice versa), or
adjusting investment objectives.

For example, let's consider a situation where the World Bank issued ₹290
million in euro-bonds in August 1981. They decided to swap the interest and
principal payments on these bonds with IBM in exchange for Indian Rupees
(INR). This allowed the World Bank to effectively change the currency of their
bond payments to suit their needs.
The use of interest rate swaps, currency swaps, and swaptions (options on swaps)
has grown rapidly over the years. Currently, the total value of outstanding interest
rate and currency swaps is nearly ₹6 trillion. Swaps have become popular because
they can be used to hedge risks, such as interest rate risk, or to speculate on the
expected direction of underlying prices.

One of the key advantages of swaps is that they allow firms in different countries to
take advantage of comparative advantages in interest rates. For instance, if one
firm has access to a lower fixed interest rate while another firm has access to a
lower floating interest rate, they can enter into a swap agreement to benefit from
these lower rates. This can be mutually beneficial for both firms.

In summary, swaps are financial contracts that involve the exchange of cash flows
between two parties. They have gained significant popularity and are used for
various purposes, such as adjusting currency exposure, managing interest rate risks,
and taking speculative positions. The flexibility and potential benefits of swaps
make them a valuable tool in the financial market.
3 Types of Swaps
1. Interest Rate Swaps: Interest rate swaps involve exchanging fixed and
floating interest rate payments. One party pays a fixed interest rate while the
other pays a variable interest rate based on a reference rate, such as LIBOR
(London Interbank Offered Rate). These swaps are commonly used to
manage interest rate risks and achieve desired cash flow structures.

2. Currency Swaps: Currency swaps involve the exchange of principal and

interest payments in different currencies. They are used to manage foreign
exchange risks or obtain better borrowing rates in foreign markets. For
example, a company in India that needs US dollars might enter into a
currency swap with a US company, exchanging rupees for dollars at a
predetermined exchange rate.
3. Credit Default Swaps: Credit default swaps (CDS) provide insurance against
the default of a particular debt instrument. In a CDS, one party makes
regular premium payments to the other party, who agrees to compensate for
any losses resulting from a credit event, such as a default. These swaps are
commonly used to hedge credit risk exposure.

4. Commodity Swaps: Commodity swaps involve the exchange of cash flows

based on the price fluctuations of commodities such as oil, natural gas, or
agricultural products. They are used by producers, consumers, and investors
to manage commodity price risks. For instance, an airline might enter into a
commodity swap to hedge against rising fuel prices.

Swaps play a crucial role in managing various financial risks and optimizing
investment strategies. They provide flexibility and customization to suit the
specific needs of market participants. Understanding the different types of
swaps empowers individuals and organizations to make informed decisions
in the complex world of financial markets.
4 Hedging
• Hedging is a risk management strategy used by individuals or companies to
protect themselves against potential losses or adverse price movements in
financial markets. It involves taking offsetting positions or using financial
instruments to minimize the impact of price fluctuations.
• Let's consider a simple example to understand hedging. Imagine you are a farmer
who grows wheat. You expect to harvest a significant quantity of wheat in a few
months, and you want to ensure that you get a good price for it. However, you
are concerned that the price of wheat might drop by the time you're ready to sell.
• To hedge against this risk, you can enter into a futures contract. A futures
contract is a derivative instrument that allows you to buy or sell an underlying
asset, such as wheat, at a predetermined price and date in the future. In this
case, you would enter into a futures contract to sell your wheat at a specific price
when it's ready for harvest.
• By entering into this futures contract, you are effectively locking in a price for
your wheat in advance. If the price of wheat does drop by the time you're ready
to sell, you will still receive the higher price agreed upon in the futures contract,
thus offsetting the potential loss.
• On the other hand, let's consider the perspective of a cereal manufacturer who relies on
wheat as a key ingredient. The manufacturer is concerned that the price of wheat might
increase in the future, which would drive up their production costs. To hedge against this
risk, they can enter into a futures contract to buy wheat at a predetermined price.

• By entering into this futures contract, the cereal manufacturer is securing a fixed price
for their wheat supply. If the price of wheat rises in the market, they can still buy it at the
lower price agreed upon in the futures contract, thus reducing their production costs and
protecting themselves from potential losses.

• In both examples, the farmers and the cereal manufacturer are using futures contracts as
a hedging tool to mitigate the risks associated with price fluctuations. By entering into
these contracts, they are safeguarding their financial positions and ensuring a certain
level of certainty in their transactions.

• Hedging is a commonly used strategy not only in agriculture but also in various
industries, such as energy, finance, and commodities. It helps individuals and businesses
protect themselves from potential losses and manage their exposure to market volatility.
5 Indian Derivative Market
The Indian derivative market plays a significant role in the country's financial landscape. It
provides a platform for investors to trade various derivative instruments, enabling them to
manage risks, speculate on price movements, and enhance their investment strategies.
Here are some key aspects of the Indian derivative market:

1. Types of Derivatives: The Indian derivative market comprises different types of

derivatives, including equity derivatives, currency derivatives, and commodity derivatives.
- Equity Derivatives: Equity derivatives allow investors to trade derivative contracts based
on underlying stocks or stock indices. This includes futures contracts, options contracts,
and index derivatives.
- Currency Derivatives: Currency derivatives enable participants to trade contracts based
on currency pairs, such as the Indian Rupee (INR) against other major currencies. These
contracts help manage foreign exchange risks and facilitate currency speculation.
- Commodity Derivatives: Commodity derivatives involve the trading of contracts based
on various commodities, such as gold, silver, crude oil, agricultural products, and more.
These contracts provide a means to hedge against price fluctuations in commodities and
offer opportunities for speculation.
2. Exchanges: The major exchanges in the Indian derivative market
include the National Stock Exchange (NSE) and the Bombay Stock
Exchange (BSE). These exchanges provide a well-regulated platform for
trading derivatives and offer robust liquidity and transparency.
3. Regulatory Framework: The Securities and Exchange Board of India
(SEBI) is the regulatory body overseeing the Indian derivative market.
SEBI ensures that market participants adhere to rules and regulations,
safeguards investor interests, and maintains the integrity of the market.
• 4. Market Participants: The Indian derivative market attracts various participants,
including individual investors, institutional investors, traders, speculators, and hedgers.
These participants engage in derivative trading for different purposes, such as risk
management, profit generation, and portfolio diversification.
• 5. Hedging and Risk Management: Derivatives play a crucial role in hedging and risk
management strategies for market participants. Hedging involves using derivative
instruments to offset potential losses or reduce exposure to price fluctuations. For
example, investors can hedge their equity portfolios using equity index futures or
options. Similarly, exporters and importers can hedge currency risks using currency
futures or options.
• 6. Speculation and Arbitrage: Derivatives also provide opportunities for speculation and
arbitrage. Speculators aim to profit from anticipated price movements in the underlying
assets. Arbitrageurs take advantage of price disparities between different markets or
instruments to make risk-free profits. These activities contribute to market liquidity and
price discovery.
• 7. Margin Requirements: The derivative market in India operates on a margin system,
where market participants are required to deposit an initial margin and maintain a mark-
to-market margin. This system ensures financial security and reduces the risk of default.
• In conclusion, the Indian derivative market offers a wide range of derivative instruments,
including equity, currency, and commodity derivatives. It provides a platform for
investors to manage risks, speculate on price movements, and enhance their investment
strategies. With well-regulated exchanges and a robust regulatory framework, the Indian
derivative market continues to attract market participants and contribute to the overall
financial ecosystem of the country.
6 Indian Stock Market
• The Indian stock market, also known as the Indian equity market, is a vital component of
the country's financial system. It provides a platform for investors to trade shares or
stocks of publicly listed companies. Here are some key aspects of the Indian stock
market:

• 1. Exchanges: The two major stock exchanges in India are the National Stock Exchange
(NSE) and the Bombay Stock Exchange (BSE). These exchanges facilitate the buying and
selling of stocks and other securities. They ensure fair trading practices, maintain
transparency, and provide a regulated environment for market participants.

• 2. Indices: The Indian stock market is represented by various market indices that track
the performance of specific groups of stocks. The prominent indices include the Nifty 50
and the Sensex. The Nifty 50 comprises 50 large-cap stocks listed on the NSE, while the
Sensex represents 30 large-cap stocks listed on the BSE. These indices act as benchmarks
for assessing the overall market sentiment and performance.
• 3. Market Participants: The Indian stock market attracts a wide range of
participants, including retail investors, institutional investors (such as
mutual funds and insurance companies), foreign institutional investors
(FIIs), and high-net-worth individuals. These participants play a crucial role
in shaping market dynamics and liquidity.

• 4. Equity Market Instruments: The Indian stock market offers various equity
market instruments for trading. The primary instrument is common stocks
or shares, which represent ownership in a company. Additionally, there are
other equity-related instruments like preference shares, convertible
securities, and depository receipts.

• 5. Market Regulation: The Securities and Exchange Board of India (SEBI) is

the regulatory authority responsible for overseeing the Indian stock
market. SEBI ensures compliance with regulations, safeguards investor
interests, and maintains market integrity. It formulates rules and guidelines
to protect investors and promote fair trading practices.
• 6. Market Indices: The Indian stock market is influenced by various factors, including domestic and global
economic conditions, corporate earnings, government policies, and investor sentiment. Market indices
reflect the overall performance and direction of the stock market, and they serve as indicators of market
trends and investor confidence.

• 7. Trading Mechanism: The Indian stock market operates on a trading mechanism known as a continuous
trading system. This system allows investors to buy or sell stocks throughout the trading hours. Orders are
matched electronically, and trades are executed based on price-time priority.

• 8. Market Volatility: The Indian stock market can experience volatility due to various factors, such as
economic events, corporate announcements, geopolitical developments, and global market trends. Volatility
presents both opportunities and risks for investors, and it is essential to carefully analyze and manage
investment decisions.

• 9. Investor Protection: The Indian stock market has made significant efforts to enhance investor protection
and awareness. SEBI has implemented various measures, such as mandatory disclosure requirements,
investor education programs, and grievance redressal mechanisms. These initiatives aim to ensure
transparency and instill investor confidence.

• In conclusion, the Indian stock market provides a platform for investors to trade stocks of publicly listed
companies. With well-regulated exchanges, a diverse range of market participants, and stringent investor
protection measures, the Indian stock market plays a crucial role in mobilizing capital, facilitating investment,
and contributing to the overall growth of the Indian economy.
7 Distinction Between Futures and Forward Contract
BASIS FOR
FORWARD CONTRACT FUTURES CONTRACT
COMPARISON
Forward Contract is an agreement between parties A contract in which the parties agree to exchange
Meaning to buy and sell the underlying asset at a specified the asset for cash at a fixed price and at a future
date and agreed rate in future. specified date, is known as future contract.
What is it? It is a tailor made contract. It is a standardized contract.
Over the counter, i.e. there is no secondary
Traded on Organized stock exchange.
market.
Settlement On maturity date. On a daily basis.
Risk High Low
As they are private agreement, the chances of
Default No such probability.
default are relatively high.
Size of contract Depends on the contract terms. Fixed
Collateral Not required Initial margin required.
Maturity As per the terms of contract. Predetermined date
Regulation Self regulated By stock exchange
Liquidity Low High
8 Hedging with Forwards
Hedging with forwards is a risk management strategy used by individuals and businesses to
protect themselves against potential losses resulting from adverse price movements in the
future. Forward contracts are commonly used for hedging purposes due to their
customizable nature and ability to lock in future prices. Here's how hedging with forwards
works:
1. Identifying the Risk: The first step in hedging with forwards is to identify the specific risk
that needs to be hedged. This could be price risk associated with a particular asset or
commodity, such as currencies, commodities, or interest rates.
2. Determining the Exposure: Once the risk is identified, the next step is to quantify the
exposure to that risk. This involves assessing the potential impact of price fluctuations on
the underlying asset and the corresponding financial position.
3. Entering into a Forward Contract: After determining the exposure, the hedger can enter
into a forward contract with a counterparty. In a forward contract, both parties agree to
buy or sell an underlying asset at a specified price (the forward price) on a future date (the
delivery date). The forward price is determined at the time of contract initiation, and the
delivery date is typically agreed upon in advance.
4. Price Protection: By entering into a forward contract, the hedger effectively locks in the
future price of the underlying asset. This provides protection against unfavorable price
movements. If the price of the asset decreases in the market, the hedger can still buy or
sell at the pre-determined forward price, thereby minimizing potential losses.
• 5. Offsetting the Exposure: The hedger's exposure to price risk is offset by the forward
contract. Any loss incurred due to a decline in the asset's price is compensated by the
gain on the forward contract. This helps stabilize the hedger's overall financial position,
reducing the impact of adverse price movements.

• 6. Contract Settlement: At the maturity of the forward contract, the actual delivery of the
underlying asset takes place, and the parties involved fulfill their contractual obligations.
Alternatively, the contract can also be settled through a cash settlement, where the
difference between the forward price and the prevailing market price is exchanged.

• 7. Limitations and Considerations: While hedging with forwards can be an effective risk
management tool, it's important to consider certain limitations. Forwards are typically
traded over-the-counter (OTC), which means they are subject to counterparty risk.
Additionally, forward contracts lack the flexibility and liquidity of exchange-traded
instruments like futures contracts.

• Hedging with forwards allows individuals and businesses to mitigate price risk by locking
in future prices for specific assets or commodities. By entering into forward contracts,
hedgers can reduce their exposure to adverse price movements, providing a level of
certainty and stability to their financial positions.
9 Introduction to Indian Commodity Markets, History
The Indian commodity market is an essential part of the country's financial system, facilitating
the trading of various commodities. Here is an introduction to the Indian commodity markets,
including a brief history:
1. Definition: The commodity market involves the buying and selling of physical commodities,
such as agricultural products (wheat, rice, cotton), energy resources (crude oil, natural gas),
metals (gold, silver), and other raw materials. It provides a platform for producers, consumers,
and investors to trade these commodities based on their supply and demand dynamics.
2. History: The history of commodity trading in India can be traced back to ancient times. India
has a rich heritage of trading commodities, with several prominent marketplaces known as
"mandis" or "bazaars" existing for centuries. These marketplaces served as hubs for agricultural
produce trading and played a significant role in the country's economy.
3. Evolution: The modern Indian commodity markets have evolved over time. Prior to
liberalization in the 1990s, commodity trading was largely unregulated. However, with
economic reforms, the government initiated steps to develop a regulated and organized
commodity market. In 2003, three national-level commodity exchanges, namely Multi
Commodity Exchange (MCX), National Commodity and Derivatives Exchange (NCDEX), and
National Multi Commodity Exchange (NMCE), were established to provide a structured
platform for commodity trading.
• 4. Regulatory Framework: The Securities and Exchange Board of India (SEBI) is the regulatory
authority responsible for overseeing the Indian commodity markets. SEBI regulates the
commodity derivatives segment, ensuring fair trading practices, transparency, and investor
protection. It formulates rules, regulations, and guidelines to govern commodity exchanges,
brokers, and participants.
• 5. Spot and Derivatives Markets: The Indian commodity market consists of both spot and
derivatives segments. The spot market involves the physical trading of commodities for
immediate delivery, where buyers and sellers enter into direct transactions. The derivatives
market, on the other hand, involves trading derivative contracts based on commodities, such as
futures and options contracts. These derivative instruments allow market participants to hedge
risks, speculate on price movements, and enhance trading strategies.
• 6. Market Participants: The Indian commodity markets attract a diverse range of participants. This
includes producers, such as farmers and mining companies, who sell their commodities in the
spot market. Buyers, such as manufacturers and traders, source commodities for their businesses.
Investors and speculators participate in the derivatives market to take advantage of price
movements and profit from trading activities.
• 7. Importance and Impact: The Indian commodity markets play a crucial role in the country's
economy. They provide price discovery mechanisms, enabling fair valuation of commodities.
Commodity trading facilitates efficient allocation of resources, ensures smooth supply chains, and
helps manage price risks for producers and consumers. Additionally, commodity markets
contribute to overall economic growth, provide employment opportunities, and attract
investment in the agriculture and mining sectors.
• The Indian commodity markets have witnessed significant growth and development in recent
years. With regulatory reforms, technological advancements, and increased participation, these
markets continue to evolve, offering avenues for hedging, investment, and trading activities
related to a wide range of commodities.
10 Forward Rate Agreement
• A Forward Rate Agreement, or FRA, is an agreement between two parties
who want to protect themselves against future movements in interest rates.
By entering into an FRA, the parties lock in an interest rate for a stated
period of time starting on a future settlement date, based on a specified
notional principal amount. The buyer of the FRA enters into the contract to
protect itself from a future increase in interest rates. This occurs when a
company believes that interest rates may rise and wants to fix its borrowing
cost today. The seller of the FRA wants to protect itself from a future decline
in interest rates. This strategy is used by investors who want to hedge the
return obtained on a future deposit.
• FRAs are settled using cash on the settlement date. This is the start date of
the notional loan or deposit. The exposure to each counterparty is
determined by the interest rate differential between the market rate on
settlement date and the rate specified in the FRA contract. There are no
principal flows.
• The FRA is a very flexible instrument and can be tailored to meet the needs
of both the buyer and seller to protect themselves against the volatility of
interest rates which affect their future borrowings or investments.
• The principle advantages of FRAs are:

• Contracts can be structured to meet the specific needs of the user;

• Counterparty exposure is limited to the interest rate differential
between the market rate and the contract rate;
• Administration costs are minimized as there is only one cash flow on
the settlement date as opposed to daily futures settlement;
• They are off-balance sheet items; and
• They can easily be reversed or closed out using an offsetting FRA at a
new price.
11 Uses of commodity derivatives: Hedging,
Speculation and Arbitrage
• Commodity derivatives are financial tools that allow investors to profit from commodities without
actually owning them. When someone buys a derivatives contract, they gain the right to exchange a
commodity for a specific price at a later date. The buyer can be either buying or selling the
commodity. The buyer doesn't have to pay the full value of the commodity upfront. Instead, they only
need to pay a small percentage called the margin price. Once the agreement is made, the seller
transfers ownership of the commodity to the buyer on the agreed future date, along with physical
delivery. The buyer's profit or loss is based on the spot price of the commodity. Exchanges facilitate
the settlement and clearing of these contracts.

• Hedging is a strategy used to manage risk by individuals and businesses. It involves holding assets with
the expectation that their value will increase enough to cover the costs associated with holding them.
The costs of holding assets can include the tied-up capital or storage expenses. In economic
equilibrium, the marginal cost of holding an asset should be equal to the expected price appreciation
of that asset. By increasing inventory, a holder exposes themselves to increased capital risk due to
price fluctuations. To reduce this risk, the holder can hedge by selling their inventory for future
delivery at a fixed price through futures contracts. This transfers the risk to speculators who are willing
to buy these contracts.
• Speculation refers to trading based on expectations, assumptions, or hunches.
Every trade is driven by the investor's expectations. Sellers usually expect prices
to fall and sell to make a profit, while buyers expect prices to rise and enter the
market to generate returns. Speculation carries a significant risk of loss, but it also
offers the potential for significant profits. Speculation is not limited to financial
instruments; it is also common in other assets like real estate. Extreme
speculation can lead to asset bubbles. Even small traders can engage in
speculative trades because the profit margin can be high.

• Arbitrage involves buying and selling an asset simultaneously in different markets

to profit from price discrepancies. Arbitrage opportunities arise due to market
inefficiencies. Traders engage in arbitrage when there is a mismatch in prices
between different markets. For example, if a stock is listed on multiple exchanges,
its price may differ due to currency fluctuations, time zone differences, or other
factors. Arbitrage traders take advantage of these price discrepancies by buying
the asset where it is cheaper and selling it where it is more expensive. Arbitrage
opportunities are usually short-lived as markets are designed to be efficient, and
the discrepancies are quickly corrected. While arbitrage is more common in
identical instruments, some traders also take advantage of predictable
relationships between instruments. Proper execution of arbitrage trades can be
relatively low-risk, but sudden changes in exchange rates or high trading
commissions can make arbitrage opportunities unfeasible.