FN - 04

Course: -PGDM Subject: - FINANCIAL DERIVATIVES
Semester: -5th Code: - FN-04
ASSIGNMENT
Q1.: - What do you mean by Derivative Instruments? Define the various

derivative instrument.
A derivative is a financial security with a value that is reliant upon or derived

from, an underlying asset or group of assets—a benchmark. The derivative itself
is a contract between two or more parties, and the derivative derives its price
from fluctuations in the underlying asset.
The most common underlying assets for derivatives are stocks, bonds,
commodities, currencies, interest rates, and market indexes. These assets are
commonly purchased through brokerages.
There are many different types of derivatives that can be used for risk
management, for speculation, and to leverage a position. Hence, the various
derivative instruments are as follows:
Futures contracts—also known simply as futures—are an agreement between

two parties for the purchase and delivery of an asset at an agreed upon price at a
future date. Futures trade on an exchange, and the contracts are standardized.
Traders will use a futures contract to hedge their risk or speculate on the price
of an underlying asset. The parties involved in the futures transaction are
obligated to fulfil a commitment to buy or sell the underlying asset.
Forward contracts—known simply as forwards—are similar to futures, but do

not trade on an exchange, only over-the-counter. When a forward contract is
created, the buyer and seller may have customized the terms, size and settlement
process for the derivative. As OTC products, forward contracts carry a greater
degree of counterparty risk for both buyers and sellers.
Swaps are another common type of derivative, often used to exchange one kind
of cash flow with another. For example, a trader might use an interest rate
swap to switch from a variable interest rate loan to a fixed interest rate loan, or
vice versa.
An options contract is similar to a futures contract in that it is an agreement

between two parties to buy or sell an asset at a predetermined future date for a
specific price. The key difference between options and futures is that, with an
option, the buyer is not obliged to exercise their agreement to buy or sell. It is
an opportunity only, not an obligation—futures are obligations.
Q2.: - “The forward contract can be used by different type of investors

with different objectives.” Define with related examples.
A forward contract is a customized contract between two parties to buy or sell

an asset at a specified price on a future date.
The forward contract can be used by different type of investors with different
objectives such as,
 Hedgers
These are risk-averse traders in stock markets. They aim at derivative markets
to secure their investment portfolio against the market risk and price
movements. They do this by assuming an opposite position in the derivatives
market. In this manner, they transfer the risk of loss to those others who are
ready to take it. In return for the hedging available, they need to pay a premium
to the risk taker.
Imagine that you hold 100 shares of XYZ company which are currently priced
at Rs. 120. Your aim is to sell these shares after three months. However, you
don’t want to make losses due to a fall in market price. At the same time, you
don’t want to lose opportunity to earn profits by selling them at a higher price in
future. In this situation, you can buy a put option by paying a nominal premium
that will take care of both the above requirements.
 Speculators
These are risk-takers of the derivative market. They want to embrace risk in
order to earn profits. They have a completely opposite point of view as
compared to the hedgers. This difference of opinion helps them to make huge
profits if the bets turn correct. In the above example, you bought a put option to
secure yourself from a fall in the stock prices. Your counterparty i.e. the
speculator will bet that the stock price won’t fall. If the stock prices don’t fall,
then you won’t exercise your put option. Hence, the speculator keeps the
premium and makes a profit.
 Margin traders
A margin refers to the minimum amount that you need to deposit with the
broker to participate in the derivative market. It is used to reflect your losses
and gains on a daily basis as per market movements. It enables to get a leverage
in derivative trades and maintain a large outstanding position. Imagine that with
a sum of Rs. 2 lakh you buy 200 shares of ABC Ltd. of Rs 1000 each in the
stock market. However, in the derivative market you can own a three times
bigger position i.e. Rs 6 lakh with the same amount. A slight price change will
lead to bigger gains/losses in the derivative market as compared to stock
market.
 Arbitrageurs
These utilize the low-risk market imperfections to make profits. They
simultaneously buy low-priced securities in one market and sell them at higher
price in another market. This can happen only when the same security is quoted
at different prices in different markets. Suppose an equity share is quoted at Rs
1000 in stock market and at Rs 105 in the futures market. An arbitrageur would
buy the stock at Rs 1000 in the stock market and sell it at Rs 1050 in the futures
market. In this process he/she earns a low-risk profit of Rs 50.
Q3.: - SEBI has laid down the various eligibility conditions for derivative
exchange to enhance the protection of investor in the derivative market.
What are these? Explain.
SEBI has laid the following eligibility conditions
1. Derivative trading to take place through an on-line screen-based

Trading System.
2. The Derivatives Exchange/Segment shall have on-line surveillance
capability to monitor positions, prices, and volumes on a real time
basis so as to deter market manipulation.
3. The Derivatives Exchange/ Segment should have arrangements for
dissemination of information about trades, quantities and quotes on a
real time basis through at least two information vending networks,
which are easily accessible to investors across the country.
4. The Derivatives Exchange/Segment should have arbitration and
investor grievances redressal mechanism operative from all the four
areas/regions of the country.
5. The Derivatives Exchange/Segment should have satisfactory system of
monitoring investor complaints and preventing irregularities in trading.
6. The Derivative Segment of the Exchange would have a separate
Investor Protection Fund.
7. The Clearing Corporation/House shall perform full novation, i.e., the
Clearing Corporation/House shall interpose itself between both legs of
every trade, becoming the legal counterparty to both or alternatively
should provide an unconditional guarantee for settlement of all trades.
8. The Clearing Corporation/House shall have the capacity to monitor the
overall position of Members across both derivatives market and the
underlying securities market for those Members who are participating
in both.
9. The level of initial margin on Index Futures Contracts shall be related
to the risk of loss on the position. The concept of value-at-risk shall be
used in calculating required level of initial margins. The initial margins
should be large enough to cover the one-day loss that can be
encountered on the position on 99 per cent of the days.
10.The Clearing Corporation/House shall establish facilities for electronic
funds transfer (EFT) for swift movement of margin payments.
11.In the event of a Member defaulting in meeting its liabilities, the
Clearing Corporation/House shall transfer client positions and assets to
another solvent Member or close-out all open positions.
12.The Clearing Corporation/House should have capabilities to segregate
initial margins deposited by Clearing Members for trades on their own
account and on account of his client. The Clearing Corporation/House
shall hold the clients’ margin money in trust for the client purposes
only and should not allow its diversion for any other purpose.
13.The Clearing Corporation/House shall have a separate Trade
Guarantee Fund for the trades executed on Derivative
Exchange/Segment
Q4.: - For taking the benefit of price change different type of contracts are
available in the financial market. What are these? Explain.
There are mainly four types of derivates contracts available in the market. They
are-
Options
Options are derivative contracts which gives the buyer a right to buy/sell the
underlying asset at the specified price during a certain period of time. The buyer
is not under any obligation to exercise the option. The option seller is known as
the option writer. The specified price is known as strike price. You can exercise
American options at any time before the expiry of the option period. European
options, however, can be exercised only on the date of expiration date.
Futures
Futures are standardised contracts which allow the holder to buy/sell the asset at
an agreed price at the specified date. The parties to the future contract are under
an obligation to perform the contract. These contracts are traded on the stock
exchange. The value of future contracts is marked-to-market every day. It
means that the contract value is adjusted according to market movements till the
expiration date.
Forwards
Forwards are like futures contracts wherein the holder is under an obligation to
perform the contract. But forwards are unstandardized and not traded on stock
exchanges. These are available over-the-counter and are not marked-to-market.
These can be customised to suit the requirements of the parties to the contract.
Swaps
Swaps are derivative contracts wherein two parties exchange their financial
obligations. The cash flows are based on a notional principal amount agreed
between both the parties without exchange of principal. The amount of cash
flows is based on a rate of interest. One cash flow is generally fixed and the
other changes on the basis of a benchmark interest rate. Interest rate swaps are
the most commonly used category. Swaps are not traded on stock exchanges
and are over-the-counter contracts between businesses or financial institutions.

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Course: -PGDM Subject: - FINANCIAL DERIVATIVES

Semester: -5th Code: - FN-04

Q1.: - What do you mean by Derivative Instruments? Define the various

A derivative is a financial security with a value that is reliant upon or derived

Futures contracts—also known simply as futures—are an agreement between

Forward contracts—known simply as forwards—are similar to futures, but do

An options contract is similar to a futures contract in that it is an agreement

Q2.: - “The forward contract can be used by different type of investors

A forward contract is a customized contract between two parties to buy or sell

SEBI has laid the following eligibility conditions

1. Derivative trading to take place through an on-line screen-based

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