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Unit 8: Derivatives

effective method for users to hedge and manage their exposures to interest rates, commodity Notes
prices, or exchange rates.

The need for derivatives as hedging tool was felt first in the commodities market. Agricultural
futures and options helped farmers and processors hedge against commodity price risk. After
the fallout of Bretton Woods Agreement, the financial markets in the world started undergoing
radical changes. This period is marked by remarkable innovations in the financial markets such
as introduction of floating rates for the currencies, increased trading in variety of derivatives
instruments, on-line trading in the capital markets, etc. As the complexity of instruments increased
manifold, the accompanying risk factors grew in gigantic proportions. This situation led to
development derivatives as effective risk management tools for the market participants.
Looking at the equity market, derivatives allow corporations and institutional investors to
effectively manage their portfolios of assets and liabilities through instruments like stock index
futures and options. An equity fund, for example, can reduce its exposure to the stock market
quickly and at a relatively low cost without selling off part of its equity assets by using stock
index futures or index options.
By providing investors and issuers with a wider array of tools for managing risks and raising
capital, derivatives improve the allocation of credit and the sharing of risk in the global economy,
lowering the cost of capital formation and stimulating economic growth. Now that global
markets for trade and finance have become more integrated, derivatives have strengthened
these important linkages between global markets, increasing market liquidity and efficiency
and facilitating the flow of trade and finance.

Which are the main operators in the derivatives market?
Did u know?
Hedgers: Operators, who want to transfer a risk component of their portfolio.
Speculators: Operators, who intentionally take the risk from hedgers in pursuit of profit.
Arbitrageurs: Operators who operate in the different markets simultaneously, in pursuit
of profit and eliminate mispricing.

8.5 Derivative Products

Derivative is a product/contract that does not have any value on its own i.e. it derives its value
from some underlying.

8.5.1 Forward Contract

A forward contract is an agreement made today between a buyer and seller to exchange the
commodity or instrument for cash at a predetermined future date at a price agreed upon today.
The agreed upon price is called the ‘forward price’. With a forward market the transfer of
ownership occurs on the spot, but delivery of the commodity or instrument does not occur until
some future date. In a forward contract, two parties agree to do a trade at some future date, at a
stated price and quantity. No money changes hands at the time the deal is signed. For example,
a wheat farmer may wish to contract to sell their harvest at a future date to eliminate the risk of
a change in prices by that date. Such transaction would take place through a forward market.
Forward contracts are not traded on an exchange, they are said to trade over the counter (OTC).
The quantities of the underlying asset and terms of contract are fully negotiable. The secondary
market does not exist for the forward contracts and faces the problems of liquidity and
negotiability.

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