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Unit 11: Introduction to Derivatives

11.3.2 Set of Assumptions Notes

Set of Assumptions is described as follows:
No seasonal demand and supply in the underlying asset.

Storability of the underlying asset is not a problem.
The underlying asset can be sold short.
No transaction cost; no taxes.
No margin requirements, and so the analysis relates to a forward contract, rather than a
futures contract.
Self Assessment

Fill in the blanks:
8. ........................................... are operators, who want to transfer a risk component of their
portfolio.
9. ........................................... are operators, who intentionally take the risk from hedgers in
pursuit of profit.

10. ........................................... are operators who operate in the different markets simultaneously,
in pursuit of profit and eliminate mispricing.

11.4 Myths and Realities about Derivatives

Numerous studies of derivatives activity have led to a broad consensus, both in the private and
public sectors that derivatives provide numerous and substantial benefits to the users. Derivatives
are a low-cost, effective method for users to hedge and manage their exposures to interest rates,
commodity prices, or exchange rates.

!

Caution Derivatives increase speculation and do not serve any economic purpose.
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

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