Page 12 - DCOM510_FINANCIAL_DERIVATIVES

Unit 1: Introduction to Derivatives

Notes
!
Caution In the event of a credit incident, the buyer has a right to demand compensation
from the seller.

In its simplest form, the CDS is written with respect to one single reference entity, the so called
single-name CDS. Some data providers compile indices of a basket of single-name CDSs of
similar ratings (e.g., the S&P US Investment Grade CDS Index consists of 100 equally weighted
investment grade US corporate credits). These index trenches give investors the opportunity to
take on exposures to specific segments of the CDS index default loss distribution.

Self Assessment
State whether the following statements are true or false:
4. Index futures contract enable an investor to buy a stock index at a specified date for a
certain price.
5. The option strike price is the specified futures price at which the future is traded if the
option is exercised.
6. Interest rate futures contract doesn’t permit a buyer to lock in a future investment rate.

1.3 Participants and Functions (Types of Members to be included)

Banks, financial institutions, corporate, brokers and individuals are the participants of the
derivative market in India. It is observed that financial derivatives are those assets whose
values are determined by the value of some other assets, called as the underlying. Presently,
there are bewilderingly complex varieties of derivatives already in existence, and the markets
are innovating newer and newer ones continuously. Now let us discuss the various participants
and economic functions of derivative market in the following sub-sections:

1.3.1 Participants in a Derivative Market
The derivatives market is similar to any other financial market and has following three broad
categories of participants:
Hedgers: These are investors with a present or anticipated exposure to the underlying asset
which is subject to price risks. Hedgers use the derivatives markets primarily for price
risk management of assets and portfolios.

Example: An importer has to pay US $ to buy goods and rupee is expected to fall to
` 50/$ from ` 48/$, then the importer can minimize his losses by buying a currency future
at ` 49/$.
Speculators: These are individuals who take a view on the future direction of the markets.
They take a view whether prices would rise or fall in future and accordingly buy or sell
futures and options to try and make a profit from the future price movements of the
underlying asset.

Example: If you will the stock price of Reliance is expected to go up to ` 400 in 1
month, one can buy a 1 month future of Reliance at ` 350 and make profits.
Arbitragers: These are the third important participants in the derivatives market. They
take positions in financial markets to earn risk less profits. The arbitragers take short and
long positions in the same or different contracts at the same time to create a position
which can generate a risk less profit.

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