Introduction
The Nature of Derivatives A derivative is an instrument whose value depends on the values of other more basic underlying variables. Or A derivative is an instrument whose value is a function the values of other more basic underlying variables.
The Securities Contracts (Regulation) Act 1956 defines derivatives as under : Derivative includes 1.Security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. 2.A contract which derives its value from the prices, or index of prices of underlying securities
Features of Financial Derivatives A derivative instrument relates to the future contract between two parties Value derived from the values of the other underlying assets. Counter parties have specific obligation under the derivative contract. Derivative contract can either be direct or thru exchange like options & futures. Usually settled by offsetting rather than delivery of the asset. Known as deferred delivery or deferred payment instrument, easier to take long & short positions. Mostly secondary market instruments except warrants & convertibles.
Derivatives Markets Exchange traded –Traditionally exchanges have used the open-outcry system, but increasingly they have switched to electronic trading –Contracts are standard there is virtually no credit risk –Example of default: HKFE in October, 1987 Over-the-counter (OTC) –A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers –Contracts can be non-standard and there is some small amount of credit risk –Defaults much bigger than exchanged based
Examples of Derivatives Forward Contracts Futures Contracts Swaps Options
Reasons for development of Derivatives - Increase in growth of International trade & Business due to Globalization & liberalization - Increase in volatility in the interest rates, stock prices at different financial markets - Increase in the risks associated with business & its recognition
Ways Derivatives are Used To hedge risks To speculate (take a view on the future direction of the market) To lock in an arbitrage profit To change the nature of a liability –Interest rate swap to reduce mortgage risk in banks To change the nature of an investment without incurring the costs of selling one portfolio and buying another
Uses of Derivatives To control, avoid, shift and manage efficiently different types of risks. Serves as barometer of the future trends in the prices which results in the discovery of the new prices both in the spot & future markets. Trading on margins,enhances the liquidity & reduces the transaction costs. Assists the investors to make proper asset allocation to increase their yields & achieve the other investment objectives. Derivatives have smoothened out the price fluctuations, squeeze the price spread. Derivative trading develop the market towards ‘complete market’