CHAPTER – III

THEORETICAL FRAMEWORK
 DERIVATIVES

The emergence of the market for derivative products, most notably forwards, futures and
options, can be traced back to the willingness of risk-averse economic agents to guard
themselves against uncertainties arising out of fluctuations in asset prices. By their very nature,
the financial markets are marked very high degree of volatility. Through the use of derivative
products, it is possible to partially or fully transfer price risks by locking-in asset prices. As
instruments of risk management, these generally do not influence the fluctuations in the
underlying asset prices. However, by locking-in asset prices, derivative products minimize the
impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse
investors.
Derivatives are risk management instruments, which derive their value from an
underlying asset. The underlying asset can be bullion, index, share, bonds, currency, interest
etc. Annual turnover of the derivatives is increasing each year from 1986 onwards,
Year Annual turnover
1986 146 millions
1992 453 millions
1998 1329 millions
2002 & 2003 it has reached to equivalent stage of cash market
Derivatives are used by banks, securities firms, companies and investors to hedge risks,
to gain access to cheaper money and to make profits Derivatives are likely to grow even at a
faster rate in future they are first of all cheaper to world have met the increasing volume of
products tailored to the needs of particular customers, trading in derivatives has increased even
in the over the counter markets.
In Britain unit trusts allowed to invest in futures & options .The capital adequacy norms
for banks in the European Economic Community demand less capital to hedge or speculate
through derivatives than to carry underlying assets. Derivatives are weighted lightly than other
assets that appear on bank balance sheets. The size of these off-balance sheet assets that include
derivatives is more than seven times as large as balance sheet items at some American banks
causing concern to regulators.
DEFINITION:
Derivative is a product whose value is derived from the value of one or more basic variables,
called bases (underlying asset, index, or reference rate), in a contractual manner. The
underlying asset can be equity, forex, commodity or any other asset. In the Indian context the
Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines “derivative” to include-
• A security derived from a debt instrument, share, and loan whether secured or unsecured,
risk instrument or contract for differences or any other form of security.
• A contract, which derives its value from the prices, or index of prices, of underlying
securities.
Derivatives are the securities under the SC(R)A and hence the trading of derivatives is
governed by the regulatory framework under the SC(R)A.

HISTORY OF DERIVATIVES MARKET:

• Early forward contracts in the US addressed merchants concerns about ensuring that
there were buyers and sellers for commodities.

• However “credit risk” remained a serious problem. To deal with this problem, a group
of Chicago; businessmen formed the Chicago Board of Trade (CBOT) in1848.

• The primary intention of the CBOT was to provide a centralized location known in
advance for buyers and sellers to negotiate forward contracts.
• In 1865, the CBOT went one step further and listed the first “exchange traded”
derivatives contract in the US; these contracts were called “futures contracts”.

• In 1919, Chicago Butter and Egg Board, a spin-off CBOT was reorganized to allow
futures trading. Its name was changed to Chicago Mercantile Exchange (CME).

• The CBOT and the CME remain the two largest organized futures exchanges, indeed
the two largest “financial” exchanges of any kind in the world today. The first stock
index futures contract was traded at Kansas City Board of Trade.

• Currently the most popular stock index futures contract in the world is based on S&P
500 indexes, traded on Chicago Mercantile Exchange.

• During the Mid eighties, financial futures became the most active derivative
instruments generating volumes many times more than the commodity futures.

• Index futures, futures on T-bills and Euro-Dollar futures are the three most popular
futures contracts traded today.

• Other popular international exchanges that trade derivates are LIFFE, DTB, SGX,
TIFFE, MATIF , Eurex etc.
THE DEVELOPMENT OF DERIVATIVES:

Holding portfolios of securities is associated with the risk of the possibility that the investor
may realize his returns, which would be much lesser than what he expected to get. There are
various factors, which affect the returns:

1. Price or dividend (interest)

2. Some are internal to the firm like

• Industrial policy
• Management capabilities
• Consumer’s preference
• Labour strike, etc.
These forces are to a large extent controllable and are termed as non systematic risks. An
investor can easily manage such non-systematic by having a well-diversified portfolio spread
across the companies, industries and groups so that a loss in one may easily be compensated
with a gain in other. There are yet other of influence which are external to the firm, cannot be
controlled and affect large number of securities. They are termed as systematic risk.
They are:
1. Economic
2. Political
3. Sociological changes are sources of systematic risk.

For instance, inflation, interest rate, etc. their effect is to cause prices of nearly all-individual
stocks to move together in the same manner. We therefore quite often find stock prices falling
from time to time in spite of company’s earnings rising and vice versa. Rational Behind the
development of derivatives market is to manage this systematic risk, liquidity in the sense of
being able to buy and sell relatively large amounts quickly without substantial price concession.
In debt market, a large position of the total risk of securities is systematic. Debt instruments
are also finite life securities with limited marketability due to their small size relative to many
common stocks. Those factors favor for the purpose of both portfolio hedging and speculation,
the introduction of a derivatives securities that is on some broader market rather than an
individual security.

PARTICIPANTS IN THE DERIVATIVES MARKET

The following three broad categories of participants who trade in the derivatives market:
• Hedgers
• Speculators and
• Arbitrageurs
Hedgers: Hedgers face risk associated with the price of an asset. They use futures or options
markets to reduce or eliminate this risk.
Speculators: Speculators wish to bet on future movements in the price of an asset. Futures and
Options contracts can give them an extra leverage; that is, they can increase both the potential
gains and potential losses in a speculative venture.

Arbitrageurs: Arbitrageurs are in business to take advantage of a discrepancy between prices

in two different markets.
For example, they see the futures price of an asset getting out of line with the cash price; they
will take offsetting positions in the two markets to lock in a profit.

FUNCTIONS OF THE DERIVATIVES MARKET:

The derivatives market performs a number of economic functions. They are:
• Prices in an organized derivatives market reflect the perception of market participants about
the future and lead the prices of underlying to the perceived future level.
• 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
because of participation by more players who would not otherwise participate for lack of
an arrangement to transfer risk.
• Speculative trades shift to a more controlled environment of derivatives market. In the
absence of an organized derivatives market, speculators trade in the underlying cash
markets.
• An important incidental benefit that flows from derivatives trading is that it acts as a
catalyst for new entrepreneurial activity.
• Derivatives markets help increase savings and investment in the long run. Transfer of risk
enables market participants to expand their volume of activity.

TYPES OF DERIVATIVES
The most commonly used derivatives contracts are forwards, futures and
options. Here various derivatives contracts that have come to be used are given briefly:
• Forwards
• Futures
• Options
• Swaps

Forwards: A forward contract is customized contract between two entities, where settlement
takes place on a specific date in the future at today’s pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. Futures contracts are special types of forward
contracts in the sense that the former are standardized exchange-traded contracts.

Options: Options are of two types – calls and puts

 Calls give the buyer the right but not the obligation to buy a given quantity of the
underlying asset, at a given price on or before a given future date. Puts give the buyer the right,
but not the obligation to sell a given quantity of the underlying asset at a given price on or
before a given date.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the future
according to a prearranged formula. They can be regarded as portfolios of forward contracts.
The two commonly used swaps are:
• Interstate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.
• Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than
those in the opposite direction.

DERIVATIVES INSTRUMENTS IN INDIA

The first derivative product to be introduced in the Indian securities market is going to be
"INDEX FUTURES". In the world, first index futures were traded in U.S. on Kansas City
Board of Trade (KCBT) on Value Line Arithmetic Index (VLAI) in 1982.
Organized exchanges began trading options on equities in 1973, where as exchange traded
debt options did not appear until 1982, on the other hand fixed income futures began trading in
1975, but equity related futures did not begin until 1982.

DERIVATIVES SEGMENT IN BSE & NSE

On June 9,2000 BSE & NSE became the first exchanges in India to introduce trading in
exchange traded derivative product with the launch of index futures on sense and Nifty futures
respectively.
Index futures was follows by launch of index options in June 2001, stock options in July
2001 and stock futures in Nov 2001.Presently stock futures and options available on 41 well-
capitalized and actively traded scripts mandated by SEBI.
Nifty is the underlying asset of the Index Futures at the Futures & Options segment of NSE
with a market lot of 200 and the BSE 30 Sensex is the underlying stock index with the market
lot of 50. This difference of market lot arises due to a minimum specification of a contract
value of Rs. 2 lakhs by Securities Exchange Board of India. A contract value is contracting
Index laid by its market lot. For e.g. If Sensex is 4730 then the contract value of a futures Index
having Sensex as underlying asset will Be 50 x 4730 = Rs. 2,36,500. Similarly if Nifty is
1462.7, its futures contract value will be 200 x 1462.7 = Rs.2, 92,540/-.
Every transaction shall be in multiple of market lot. Thus, Index futures at NSE shall be
traded in multiples of 200 and at BSE in multiples of 50

CONTRACT PERIODS
At any point of time there will always be available near three months contract periods. For
e.g. in the month of June 2009 one can enter into either June Futures contract or July Futures
contract or August Futures Contract. The last Thursday of the month specified in the contract
shall be the final settlement date for that contract at both NSE as well BSE. Thus June 29, July
27 and August 31 shall be the last trading day or the final settlement date for June Futures
contract, July Futures Contract and August Futures Contract respectively.
When one futures contract gets expired, a new futures contract will get introduced
automatically. For instance, on 30th June, June futures contract becomes invalidated and a
September Futures Contract gets activated.

SETTLEMENT

Settlement of all Derivatives trades is in cash mode. There is Daily as well as Final
Settlement. Outstanding positions of a contract can remain open till the last Thursday of that
month. As long as the position is open, the same will be marked to Market at the Daily
Settlement Price, the difference will be credited or debited accordingly and the position shall
be brought forward to the next day at the daily settlement price. Any position which remains
open at the end of the final settlement day (i.e., last Thursday) shall be closed out by the
Exchange at the Final Settlement Price which will be the closing spot value of the underlying
(Nifty or Sensex, or respective stocks as the case may be).

REGULATIONS FOR DERIVATIVES TRADING

SEBI set up a 24-member committee under Chairmanship of Dr. L.C. Gupta to
develop the appropriate regulatory framework for derivatives trading in India. The committee
submitted its report in March 1998. On May 11, 1998 SEBI accepted the recommendations of
the committee and approved the phased introduction of derivatives trading in India beginning
with stock index futures. SEBI also approved the “suggestive bye-laws” recommended by the
committee for regulation and control of trading and settlement of derivatives contracts.
The provisions in the SC(R) A and the regulatory framework developed there under
govern trading in securities. The amendment of the SC(R) A to include derivatives within the
ambit of ‘securities’ in the SC(R) A made trading in derivatives possible within the framework
of the Act.
• Any exchange fulfilling the eligibility criteria as prescribed in the L C Gupta committee
report may apply to SEBI for grant of recognition under Section 4 of the SC(R) a, 1956 to
start trading derivatives. The derivatives exchange/segment should have a separate
governing council and representation of trading / clearing members shall be limited to
maximum of 40% of the total members of the governing council. The exchange shall
regulate the sales practices of its members and will obtain approval of SEBI before start of
trading in any derivative contract
• The exchange shall have minimum 50 members.
• The members of an existing segment of the exchange will not automatically become the
members of derivative segment. The members of the derivative segment need to fulfill the
eligibility conditions as laid down by the L C Gupta committee.
• The clearing and settlement of derivatives trades shall be through a SEBI approved clearing
corporation / house. Clearing corporation / houses complying with the eligibility conditions
as laid down by the committee have to apply to SEBI for grant of approval.
• Derivative brokers/dealers and clearing members are required to seek registration from
SEBI.
• The minimum contract value shall not be less than Rs. 2 Lakh. Exchanges should also
submit details of the futures contract they propose to introduce.
• The trading members are required to have qualified approved user and sales person who
have passed a certification programme approved by SEBI.
While from the purely regulatory angle, a separate exchange for trading would be a
better arrangement. Considering the constraints in infrastructure facilities, the existing stock
(cash) exchanges may also be permitted to trade derivatives subject to the following conditions.
• Trading should take place through an on-line screen based trading system.
• An independent clearing corporation should do the clearing of the derivative market.
• The exchange must have an online surveillance capability, which monitors positions,
price and volumes in real time so as to deter market manipulation price and position limits
should be used for improving market quality.
• Information about trades quantities, and quotes should be disseminated by the exchange
in the real time over at least two information-vending networks, which are accessible to
investors in the country.
• The exchange should have at least 50 members to start derivatives trading.
• The derivatives trading should be done in a separate segment with separate membership;
That is, all members of the cash market would not automatically become members of the
derivatives market.
• The derivatives market should have a separate governing council which should not have
representation of trading by clearing members beyond whatever percentage SEBI may
prescribe after reviewing the working of the present governance system of exchanges.
• The chairman of the governing council of the derivative division / exchange should be a
member of the governing council. If the chairman is broker / dealer, then he should not
carry on any broking or dealing on any exchange during his tenure.
• No trading/clearing member should be allowed simultaneously to be on the governing
council both derivatives market and cash market.

FUTURES
Futures contract is a firm legal commitment between a buyer & seller in which they agree
to exchange something at a specified price at the end of a designated period of time. The buyer
agrees to take delivery of something and the seller agrees to make delivery.

STOCK INDEX FUTURES

Stock Index futures are the most popular financial futures, which have been used to hedge
or manage the systematic risk by the investors of Stock Market. They are called hedgers who

own portfolio of securities and are exposed to the systematic risk. Stock Index is the apt
hedging asset since the rise or fall due to systematic risk is accurately shown in the Stock Index.
Stock index futures contract is an agreement to buy or sell a specified amount of an underlying
stock index traded on a regulated futures exchange for a specified price for settlement at a
specified time future.
Stock index futures will require lower capital adequacy and margin requirements as
compared to margins on carry forward of individual scrips. The brokerage costs on index
futures will be much lower.
Savings in cost is possible through reduced bid-ask spreads where stocks are traded in
packaged forms. The impact cost will be much lower in case of stock index futures as opposed
to dealing in individual scrips. The market is conditioned to think in terms of the index and
therefore would prefer to trade in stock index futures. Further, the chances of manipulation are
much lesser.
The Stock index futures are expected to be extremely liquid given the speculative nature
of our markets and the overwhelming retail participation expected to be fairly high. In the near
future, stock index futures will definitely see incredible volumes in India. It will be a
blockbuster product and is pitched to become the most liquid contract in the world in terms of
number of contracts traded if not in terms of notional value. The advantage to the equity or
cash market is in the fact that they would become less volatile as most of the speculative activity
would shift to stock index futures. The stock index futures market should ideally have more
depth, volumes and act as a stabilizing factor for the cash market. However, it is too early to
base any conclusions on the volume or to form any firm trend.
The difference between stock index futures and most other financial futures contracts
is that settlement is made at the value of the index at maturity of the contract.

FUTURES TERMINOLOGY

Contract Size
The value of the contract at a specific level of Index. It is Index level * Multiplier.
• Multiplier
It is a pre-determined value, used to arrive at the contract size. It is the price per index
point.
• Tick Size
It is the minimum price difference between two quotes of similar nature.
• Contract Month
The month in which the contract will expire.
• Expiry Day
The last day on which the contract is available for trading.

Open interest
Total outstanding long or short positions in the market at any specific point in time. As
total long positions for market would be equal to total short positions, for calculation of open
Interest, only one side of the contracts is counted.
• Volume
 No. Of contracts traded during a specific period of time. During a day, during a week or
during a month.
• Long position: Outstanding/unsettled purchase position at any point of time.
• Short position: Outstanding/ unsettled sales position at any point of time.
• Open position: Outstanding/unsettled long or short position at any point of time.
• Physical delivery: Open position at the expiry of the contract is settled through delivery
of the underlying. In futures market, delivery is low.
• Cash settlement
Open position at the expiry of the contract is settled in cash. These contracts
Alternative Delivery Procedure (ADP) - Open position at the expiry of the contract is
settled by two parties - one buyer and one seller, at the terms other than defined by the
exchange. World wide a significant portion of the energy and energy related contracts
(crude oil, heating and gasoline oil) are settled through Alternative Delivery Procedure.
Payoff for futures
A Pay off is the likely profit/loss that would accrue to a market participant with change in
the price of the underlying asset. Futures contracts have linear payoffs. In simple words, it
means that the losses as well as profits, for the buyer and the seller of futures contracts, are
unlimited.
• Payoff for Buyer of futures: (Long futures)
The pay offs for a person who buys a futures contract is similar to the pay off for a person
who holds an asset. He has potentially unlimited upside as well as downside. Take the case
of a speculator who buys a two-month Nifty index futures contract when the Nifty stands
at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves up,
the long futures position starts making profits and when the index moves down it starts
making losses.
• Payoff for seller of futures: (short futures)
The pay offs for a person who sells a futures contract is similar to the pay off for a person
who shorts an asset. He has potentially unlimited upside as well as downside. Take the case
of a speculator who sells a two-month Nifty index futures contract when the Nifty stands
at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves
down, the short futures position starts making profits and when the index moves up it starts
making losses.
OPTIONS
An option agreement is a contract in which the writer of the option grants the buyer of
the option the right to purchase from or sell to the writer a designated instrument at a specific
price within a specified period of time.
Certain options are short term in nature and are issued by investors another group of
options are long-term in nature and are issued by companies.
OPTIONS TERMINOLOGY
• Call option: A call is an option contract giving the buyer the right to purchase the stock.
• Put option: A put is an option contract giving the buyer the right to sell the stock.
 • Expiration date: It is the date on which the option contract expires.
• Strike price: It is the price at which the buyer of a option contract can purchase or sell
the stock during the life of the option
• Premium: Is the price the buyer pays the writer for an option contract.
• Writer: The term writer is synonymous to the seller of the option contract.
• Holder: The term holder is synonymous to the buyer of the option contract.
• Straddle: A straddle is combination of put and calls giving the buyer the right to either
buy or sell stock at the exercise price.
• Strip: A strip is two puts and one call at the same period.
• Strap: A strap is two calls and one put at the same strike price for the same period.
• Spread: A spread consists of a put and a call option on the same security for the same
time period at different exercise prices.

The option holder will exercise his option when doing so provides him a benefit over buying
or selling the underlying asset from the market at the prevailing price. These are three
possibilities.
• In the Money: An option is said to be in the money when it is advantageous to exercise it.
• Out of the money: The option is out of money if it not advantageous to exercise it.

• At the money: IF the option holder does not lose or gain whether he exercises his option
or buys or sells the asset from the market, the option is said to be at the money. The
exchanges initially created three expiration cycles for all listed options and each issue was
assigned to one of these three cycles.

• January, April, July, October.

• February, March, August, November.
• March, June, September, and December.
In India, all the F and O contracts whether on indices or individual stocks are available for
one or two or three months series and they expire on the Thursday of the concerned month.

CALL OPTION
An option that grants the buyer the right to purchase a designated instrument is
called a call option. A call option is a contract that gives its owner the right, but not the
obligation, to buy a specified price on or before a specified date.
An American call option can be exercised on or before the specified date only.
European options can be exercised on the specified date only.
PUT OPTION
An option contract giving the owner the right, but not the obligation, to sell a specified amount
of an underlying security at a specified price within a specified time. This is the opposite of a
call option, which gives the holder the right to buy shares.
A put becomes more valuable as the price of the underlying stock depreciates relative
to the strike price. For example, if you have one Mar 09 Taser 10 put, you have the right to sell
100 shares of Taser at $10 until March 2008 (usually the third Friday of the month). If shares
of Taser fall to $5 and you exercise the option, you can purchase 100 shares of Taser for $5 in
the market and sell the shares to the option's writer for $10 each, which means you make $500
(100 x ($10-$5)) on the put option. Note that the maximum amount of potential proft in this
example ignores the premium paid to obtain the put option.

FACTORS DETERMINIG OPTION VALUE

• Stock price
• Strike price
• Time to expiration
• Volatility
• Risk free interest rate
• Dividend

PARTIES IN AN OPTION CONTRACT

BUYER/HOLDER/OWNER OF AN OPTION

The buyer of an option is one who by paying option premium buys the right but not the
obligation to exercise his option on seller/writer.

SELLER/WRITER OF AN OPTION
The writer of the call /put options is the one who receives the option premium and is there by
obligated to sell/buy the asset if the buyer exercises on him

TYPES OF OPTIONS
The options are classified into various types on the basis of various variables. The following
are the various types of options.

I. ON THE BASIS OF THE UNDERLYING ASSET

On the basis of the underlying asset the option are divided into two types:

INDEX OPTIONS
These options have the index as the underlying. Some options are European while others are
American. Like index futures contract, index options contracts are also cash settled.

STOCK OPTIONS
Stock options are options on the individual stocks. Options currently trade on over 500 stocks
in the United States. A contract gives the holder the right to buy or sell shares at the specified
price

II. ON THE BASIS OF THE MARKET MOVEMENTS

On the basis of the market movements the option are divided into two types. They are:
 CALL OPTION: A call option is bought by an investor when he seems that the stock price
moves upwards. A call option gives the holder of the option the right but not the obligation to
buy an asset by a certain date for a certain price.
PUT OPTION: A put option is bought by an investor when he seems that the stock price
moves downwards. A put option gives the holder of the option right but not the obligation to
sell an asset by a certain date for a certain price.

III. ON THE BASIS OF EXERCISE OF OPTION

On the basis of the exercised of the option, the options are classified into two categories.

AMERICAN OPTION: American options are options that can be exercised at any time up
to the expiration date, most exchange-traded option are American.

EUOROPEAN OPTION: European options are options that can be exercised only on the
expiration date itself. European options are easier to analyze than American options, and
properties of an American option are frequently deduced from those of its European
counterpart.

FACTORS EFFECTING THE PRICE OF AN OPTION

The following are the various factors that affect the price of an option they are:
Stock price:
The pay–off from a call option is a amount by which the stock price exceeds the strike price.
Call options therefore become more valuable as the stock price increases and vice versa. The
pay-off from a put option is the amount; by which the strike price exceeds the stock price. Put
options therefore become more valuable as the stock price increases and vice versa.
Strike price:
In case of a call, as a strike price increases, the stock price has to make a larger upward move
for the option to go in-the-money. Therefore, for a call, as the strike price increases option
becomes less valuable and as strike price decreases, option become more valuable.
Time to expiration:
Both put and call American options become more valuable as a time to expiration increases.
Volatility:
The volatility of a stock price is measured of uncertain about future stock price movements. As
volatility increases, the chance that the stock will do very well or very poor increases. The
value of both calls and puts therefore increase as volatility increase.
Risk-free interest rate:
The put options prices decline as the risk-free rate increases where as the prices of call always
increase as the risk-free interest rate increases.
Dividends:
Dividends have the effect of reducing the stock price on the x-dividend rate. This has a
negative effect on the value of call options and a positive effect on the value of put options.

DIFFERENCES BETWEEN FUTURES & OPTIONS

 FUTURES OPTIONS

1.Exchange traded, with Novation 1.Same in nature

2.Exchange defines the product 2.Same in nature
3.Price is zero, strike Price moves 3.Strike price is fixed, price moves
4.Price is zero 4.Price is always positive
5.Linear payoff 5.Nonlinear payoff
6.Both long & Short at risk 6.only short at risk

ADVANTAGES OF OPTION TRADING

• Risk management: put option allow investors holding shares to hedge against a
possible fall in their value. This can be considered similar to taking out insurance
against a fall in the share price.
• Time to decide: By taking a call option, the purchase price for the shares is locked in.
This gives the call option holder until the Expiry day to decide whether or exercised the
option and buys the shares. Likewise the taker of a put option has time to decide whether
or not to sell the shares.
• Speculations: The ease of trading in and out of option position makes it possible to
trade options with no intention of ever exercising them. If investor expects the market
to rise, they may decide to buy call options. If expecting a fall, they may decide to buy
put options. Either way the holder can sell the option prior to expiry to take a profit or
limit a loss. Trading options has a lower cost than shares, as there is no stamp duty
payable unless and until options are exercised.
• Leverage: Leverage provides the potential to make a higher return from a smaller initial
outlay than investing directly however leverage usually involves more risks than a
direct investment in the underlying share. Trading in options can allow investors to
benefit from a change in the price of the share without having to pay of the share.

Summary of options
Call option buyer Call option writer (seller)
• Pays premium • Receives premium
• Right to exercise and buy the share • Obligation to sell shares if exercised
• Profits from rising prices • Profits from falling prices or remaining
• Limited losses, potentially neutral
unlimited gain • Potentially unlimited losses, limited
gain
Put option buyer Put option writer (seller)
• Pays premium • Receives premium
 • Right to exercise and sell shares • Obligation to buy shares if exercised
• Profits from falling prices • Profits from rising prices or remaining
• Limited losses, potentially neutral
unlimited gain • Potentially unlimited losses, limited
gain

Currency Derivatives as a tool for Currency Risk Management

“By far the most significant event in finance during the past decade has been the extraordinary
development and expansion of financial derivatives. These instruments enhance the ability to
differentiate risk and allocate it to those investors most able and willing to take it – a process
that has undoubtedly improved national productivity growth and standard of living.” ......Alan
Greenspan (Former Chairman, Board of Governors of the US Federal System)
To understand better the concept of currency derivatives, one needs to conceptualize the
meaning of derivatives contracts. Derivatives are financial instruments, the value of which is
derived from underlying assets. Where the underlying asset is a financial instrument; it is
termed as financial derivatives. A currency derivative is derivatives contract where the
underlying asset is a currency. Among currency derivatives, currency future is the most
efficient and effective tools for currency risk management. Various risks related to the
exchange rate volatility (currency risk) can be managed with the help of currency derivatives.
Following are type of currency derivatives separately as below:
a) Currency Swaps:
As the name signifies, currency risk is a risk that involves exchange rates. It occurs
when transactions are done in foreign currency and the main reason for it is the
volatility in the exchange rates. Currency swaps were first introduced in 1970s in the
United Kingdom. It was the time when the UK companies had to pay a premium to
borrow in US Dollars. Later, they found a solution for this. UK companies set up
back-to-back loan agreements with US companies wishing to borrow Sterling.
 A currency swap is a foreign-exchange agreement between two parties to exchange
the principal or the interest of a loan in one currency for equivalent the principal or
the interest of an equal in net present value loan in another currency. Suppose a
person holds a debt in one currency, he can exchange it with another person who
holds a debt in a different currency. The parties exchange no cash initially but they are
entitled to exchange future cash flows. Globalization has led to the necessity of
currency swaps in order to mitigate the currency risk involved in international
transactions. A company which intends to invest in foreign markets will also need to
finance its operations with foreign currency. Thus, in order to mitigate the currency
risk, currency swaps will necessarily be useful.

A firm involved in such activities globally, can use currency swaps by borrowing in a
domestic currency and then swapping it to a foreign currency. Currency swaps with a
longer maturity, helps the firms easily achieve the risk management objectives. I order
to understand more clearly let us go through an example. A company based in India
has its branch situated in USA. For the operations in USA, the company will
necessarily need US Dollars. In order to meet out its needs, the company will have to
borrow US currency and accordingly pay interest on such loan. In this case there will
be an exposure to currency risk. Suppose, another company based in USA has its
branch in India. This company will need INR in order to operate its branch in India.
This company, too, will face the exposure to currency risk.

If both the companies enter into an agreement of currency swapping, they will be
able to manage their currency risk. This can be done in two ways: Firstly, if the
companies have already borrowed in the currencies each needs the principal in; they
can agree to swap the cash flows only, so that each company's finance cost is in that
company's domestic currency. Secondly, the companies could borrow in their own
domestic currencies, and then get the principal in the currency they desire by agreeing
to swap only the principal amount of the loan. However, the second option is possible
only if they have some comparative advantage. However, through this instrument, one
finances its activities with its domestic currency and a currency swap and thus, is able
to reduce the cost that would have been incurred in case it had used only the foreign
currency.

b) Forward Contracts:
A forward contract is a non-standardized contract between two parties to buy or sell
an underlying asset at a specified future time at a price agreed upon today.
Investopedia defines a forward contract as a cash market transaction in which delivery
of the commodity is deferred until after the contract has been made. Although the
delivery is made in the future, the price is determined on the initial trade date.
Forward contracts are traded on the over-the-counter exchange. A currency forward
contract is a contract between two parties where the exchange of currencies would
take place at a future date at a rate of exchange decided upon at the time of agreement.
The sole idea of entering a forward contract is to avoid exchange rate risk.
 A company that has invested or borrowed in foreign currency will definitely face the
exchange rate risk. For example, if a person borrows US $ 100 on a particular date
when the value of 1$ be Rs. 45. After a year when he pays back the loan, the
exchange rate may be a different one and the person may either lose or gain. But if he
hedges this risk with the help of a forward contract, he can minimize his loss. In order
to understand this better, let us go through an example and see how forwards help in
managing risk. Suppose a firm intends to purchase machinery for US $5000 from
another firm after three months.

If the exchange rate currently is Rs. 45/$, his purchase amount is Rs. 2,25,000/- and
if after three months the exchange rate be Rs. 50/$ then the firm though pays $5000
but this costs to Rs. 2,50,000/-, thus, Rs. 25,000/- is the loss to him due to exchange
rate volatility. In order to mitigate this loss, the firm can opt to buy a 3 months
forward contract with a bank. With this forward contract, on the date of maturity the
firm will pay Rs. 2,25,000/- to the bank and the bank will pay to the firm $5000 which
it will then pay to the seller. In this way, the firm would be able to mitigate its loss of
Rs.25,000/- that would have been occurred if no forward contract was used for
hedging the risk.

c) Futures Contracts:
A futures contract is a standardized form of forwards contracts. Currency futures are
exchange traded financial derivatives contracts. A Futures contract is a standardized
contract between two parties to buy or sell a specified asset of standardized quantity
and quality for a price agreed upon today with delivery and payment occurring at a
specified future date, the delivery date.
Where the specified asset is an exchange rate, it is referred to as a currency future. A
currency future is a futures contract to exchange one currency for another at a
specified date in the future at a price (exchange rate) that is fixed on the purchase
date. Currency futures have significantly gained importance all over the world since
the first currency futures contract was traded in the year 1972. Since the, the currency
futures is most significantly used as a risk management tool by the hedgers. It is also
used for speculation.

Currency futures are safer than forward contracts because forward contracts holds
counter-party risk because of unavailability of clearing houses; in case of currency
futures, initial margins are held from both parties and so the risk of counter-party
denying the contract on maturity is eliminated. Let us consider the following example
to understand how a firm or financial institution can hedge risk by using currency
futures. Suppose that an Indian firm has to receive US $5000 due from a transaction
after one year.

The current exchange rate be Rs. 50/$. The firm may sell currency futures contracts
worth US $5000 and at the expiry of the contract, the firm will receive Rs. 2,50,000/-
irrespective of the fact that the exchange rate has gone up or down. In this way, the
firm would be able to mitigate its risk due to the exchange rate volatility. In the
 globalized business environment, firms necessarily need to hedge their risks using
currency futures.

d) Options Contracts:
Option is a derivative contract between two people where one person grants the other
person the right to buy or sell a specific asset at a specific price within a specific time
period, without an obligation. The person, who has received the right, must pay for
this right as premium, is known as option buyer. The person who has sold the right,
and received the premium, is known as option writer. There are two types of options:
Call option & Put option. A call option is an option that gives the buyer the right to
buy a specific asset at specified price within a specified price without an obligation.

A put option is an option that gives the buyer the right to sell a specific asset at
specified price within a specified price without an obligation. A currency option is
such an option where the specified asset is a currency. A firm or financial institution
that is to receive some payments in foreign currency may purchase a currency put
option. In case the foreign currency depreciates, the put option will be exercised so
that the firm gets its expected amount unchanged and the loss is, thus, averted. In case
the foreign currency appreciates, the firm will not exercise the put option and will,
thus, reap the benefits of the increased yields and that, too, at a cost of the contract
premium. In this way, the firm will be able to mitigate its currency risk by hedging in
currency options Currency Risk Management Process using Currency Futures.

Currency futures are the most efficient and effective tool for hedging currency risk. Currency
risks can be managed with the help of an appropriate hedging strategy. The most essential
two steps in considering a hedging strategy:
a) Assess the amount of currency risk exposure: The first and foremost thing that must be
carefully assessed while hedging currency risk is the amount of risk exposure.
b) Determination of hedge ratio: The hedge ratio is very simple to be determined. It is just
the linear function of the value of the risk exposure relative to the futures contract size. It can
be arrived at by the following equation:
Hedge Ratio = Value of risk exposure / Futures contract size