Page 13 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes
Example: A futures price is simply the current price plus the interest cost. If there is any
change in the interest, it presents an arbitrage opportunity.

1.3.2 Economic Function of the Derivative Market

The derivatives market performs a number of economic functions. In this section, we discuss
some of them.

Detection of Prices: Prices in an organized derivatives market reflect the perception of the
market participants about the future and lead the prices of underlying to the perceived
future level. The prices of derivatives converge with the prices of the underlying at the
expiration of the derivative contract. Thus derivatives help in discovery of future as well
as current prices.
Transfer of Risk: The derivatives market helps to transfer risks from those who have them
but do not like them to those who have an appetite for them.

Liquidity and Volume Trading: Third, derivatives due to their inherent nature are linked
to the underlying cash markets. With the introduction of derivatives, the underlying
market witnesses higher trading volumes. This is because of participation by more players
who would not otherwise participate for lack of an arrangement to transfer risk.

Encourages participating more people: An important incidental benefit that flows from
derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The
derivatives have a history of attracting many bright, creative, well-educated people with
an entrepreneurial attitude. They often energize others to create new businesses, new
products and new employment opportunities, the benefit of which are immense.

In a nut shell, derivatives markets help increase savings and investment in the long run. Transfer
of risk enables market participants to expand their volume of activity.

Self Assessment

Fill in the blanks:

7. In a ……………. derivatives, the underlying instrument is a commodity which may be
wheat, cotton, pepper, sugar, jute, turmeric, corn, soybeans, crude oil, natural gas, gold,
silver, copper and so on.

8. In a ……………derivative, the underlying instrument may be treasury bills, stocks, bonds,
foreign exchange, stock index, gilt-edged securities, cost of living index, etc.
9. A ……….. contract is a customized contract between two entities, where settlement takes
place on a specific date in the future at today’s pre-agreed price.

1.4 Types of Derivatives

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. For example, various types of financial derivatives based on their different
properties like, plain, simple or straightforward, composite, joint or hybrid, synthetic, leveraged,
mildly leveraged, customized or OTC traded, standardized or organized exchange traded, etc.,
are available in the market.

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