Page 18 - DCOM510_FINANCIAL_DERIVATIVES

Unit 1: Introduction to Derivatives

creates the possibility of systemic financial events, which fall outside the more formal clearing Notes
house structures. Moreover, those who provide OTC derivative products, hedge their risks
through the use of exchange traded derivatives. In view of the inherent risks associated with
OTC derivatives, and their dependence on exchange traded derivatives, Indian law considers
them illegal.

Task Mr. Ramesh is speculating on SBI (currently trading at ` 850) and is holding one
share of SBI. Three-month short futures on SBI are ` 840 while a put option at ` 842 is also
available at premium of ` 3. What should Ramesh do? (For simplicity, there is no margin
requirement under futures trading).

Self Assessment

State whether the following statements are true or false:
14. Privately negotiated derivative contracts are called exchange traded derivatives.
15. The OTC contracts are generally not regulated by a regulatory authority.

Case Study Changing Trends of Derivatives

uring the derivatives crisis of the early and mid-1990s, big firms like Gibson
Greetings and Procter & Gamble had to bear immense losses as a result of
Dderivatives speculation, while Orange County and Calif were forced to file for
bankruptcy as their treasurer’s failed in their derivatives bets. It was the time when many
felt that corporate treasurers and others were lured in derivatives betting by Wall Street
salesmen who had a little more understanding about these products than the customers.
But these days, derivatives rarely make news.
According to Wharton accounting professor, Wayne Guay, the way derivatives are being
used in the market has matured. He feels that twenty years ago derivatives were not at all
common in the market, but today many derivatives contracts are standardised, well
understood and economically priced. In order to understand the amount of risk faced by
companies through their derivatives bets, Guay and SP Kothari, an accounting professor
at MIT’s Sloan School of Management examined the non-financial firms that used
derivatives.
The result revealed that for most of the firms the quantity of derivatives that they used
was quite insignificant when compared to how big these companies were.
Questions:
1. Comment on the changing trends of derivatives in the last decade.
2. ‘The Indian derivatives market has witnessed a number of changes in the recent
past. After the introduction of futures and options on individual stocks, the market
is all set to get a face-lift with the introduction of currency options’. Comment.
Source: Madhu Vij. “International Financial Management”. Excel Books (2010).

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