KCE’S COLLEGE OF ENGINEERING AND MANAGEMENT, JALGAON 2024 Kavayitri Bahinabai Chaudhari

North Maharashtra University, Jalgaon (NAAC Reaccredited ‘A’ Grade University) FACULTY OF
COMMERCE & MANAGEMENT New Syllabus: M.B.A. FinTech w.e.f. AY 2024-25 SEMESTER: III Paper:
FT303: Financial Derivatives 60+40 Pattern: External Marks 60+Internal Marks 40=Maximum Total
Marks: 100 Required Lectures: 48 hours Course Description This course aims at providing an in-depth
understanding of financial derivatives in terms of concepts, instruments, and Mechanism for Trading,
Clearing and Settlement. Course Objectives:  Know the basics of the Indian equity derivatives market. 
Understand the various trading strategies that can be built using futures and options on both stocks and
stock indices.  Understand the clearing, settlement and risk management as well as the operational
mechanism related to equity derivatives markets Course Outcomes: After Completion of this course,
Students will be able to CO1. Describe the basic concepts of financial derivatives. CO2. Explain the
various derivative instruments operating in the Indian Derivatives market along with their features and
terminologies. CO3. Determine the various trading & hedging strategies that can be built using futures
and options on both stocks and stock indices. CO4. Explain the Mechanism of Trading, Clearing and
Settlement in Derivatives Market Unit I: Basics of Derivatives (08) 1.1. Financial Derivatives – Definition
and Meaning 1.2 Derivatives Market – History and Evolution 1.3 Derivatives Market in India 1.4 Types of
Derivatives – Forwards, Futures, Options, Swaps 1.5 Participants in Derivatives Market 1.6 Uses of
Derivatives, Critiques of Derivatives Unit II: Forward and Futures Contract (08) 2.1. Forwards Contract
and Futures Contract- Meaning and Features 2.2 Terminologies in Futures Contract –Spot Price, Futures
Price, Contract Cycle, Expiration day, Contract Size & Contract Value, Tick Size. 2.3 Forward Vs Future
Contracts, Functions and types of Future Contracts 2.4 Hedging Strategies using futures 2.5 Futues
Trading on BSE & NSE Asst.Prof. Devendra S. Patil Page 1 KCE’S COLLEGE OF ENGINEERING AND
MANAGEMENT, JALGAON 2024 Unit III: Options Contract (12) 3.1. Options- Concept 3.2 Option
Terminology- Option Buyer, Option Writer, Option Price/ Premium, Expiration Day, Lot Size, Spot Price,
Strike Price/ Exercise Price. 3.3 Types of Options – Call & Put, European & American, Exchange Traded &
OTC 3.4 Distinction between Options and Futures Contracts 3.5 Intrinsic Value and Time Value of
Options 3.6 Factors affecting Option Pricing 3.7 Option Greeks- Delta, Gamma, Theta, Vega, Rho 3.8
Option Trading Strategies Unit IV: Trading Mechanism (08) 4.1 Trading Mechanism – Entities Involved in
trading of Futures and Options, Market timing of Derivative Segment, Order types and Conditions, Order
Matching rules 4.2 Eligibility criteria for selection of stocks for derivatives trading 4.3 Selection criteria of
Index for Trading 4.4 Adjustments for corporate actions 4.5 Trading Costs 4.6 Algorithmic trading 4.7
Tracking Futures and Options data Unit V: Futures and Option clearing and settlement (04) 5.1 Clearing
Members 5.2 Clearing Mechanism, Settlement Mechanism 5.3 Risk Management 5.4 Margining and
Mark to Market under SPAN Unit VI: 6. Swaps (08) 6.1 Swaps - Concept and Meaning 6.2 Evolution of
Swap Market, Features of Swaps 6.3 Types of Swaps- Interest rate swaps, Currency Swaps, Commodity
Swaps, Debt- Equity Swaps 6.4 Economic Functions of Swap Market REFERENCE BOOKS: 1. Financial
Derivatives: Theory concepts & problems – S.L.Gupta – Prentice Hall of India (PHI) 2. Derivatives And
Risk Management – Dr R. P Rustagi – Taxmann’s 3. Options, Futures & Other Derivatives - Hull C John,
Sankarshan Basu – Pearson Educations Publishers 4. Derivatives and Risk Management – Jayanth Verma-
Tata Mcgraw Hill 5. Futures Markets: theory & practice” – Sunil K Parmeswaran – Tata McGraw Hill. 6.
Financial Derivatives – Bishnupriya Mishra, Swaroop – Excel Books 7. Fundamentals of Financial
Derivatives – N.R. Parsuraman – Wiley India 8. Derivatives – T.V.Somnathan - Tata McGraw Hill. 9.
Financial Derivative & Risk Management – O.P.Agrawal – Himalaya Publication 10. Work book for NISM
Series VIII: Equity Derivatives Certification Examination Asst.Prof. Devendra S. Patil Page 2 KCE’S
COLLEGE OF ENGINEERING AND MANAGEMENT, JALGAON 2024 Chapter 1: Basics of Derivatives 1.1
Financial Derivatives – Definition and Meaning Financial derivatives are financial contracts whose value
is derived from the price of an underlying asset, index, or rate. These underlying entities can include
stocks, bonds, commodities, currencies, interest rates, and market indices. Definitions A financial
derivative is a contract between two or more parties whose value is based on an agreed-upon
underlying financial asset, index, or security. The most common types of derivatives are futures, options,
forwards, and swaps. Derivatives can be used for various purposes, including hedging risk, speculation,
and arbitrage. Derivatives are financial contracts whose value/price is dependent on the behaviour of
the price of one or more basic underlying assets (often simply known as the underlying). These contracts
are legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in
future. The asset can be a share, index, interest rate, bond, rupee dollar exchange rate, sugar, crude oil,
soyabean, cotton, coffee and what you have. Meaning Thus, a 'derivative' is a financial instrument, or
contract, between two parties that derived its value from some other underlying asset or underlying
reference price, Lex. A derivative by itself does not constitute ownership, instead it interest rate, or
index. A derivative by itself does not constitute ownership, instead it is a promise to convey ownership.
The essence of financial derivatives lies in their function as instruments to manage risk or to leverage
positions. They enable investors and companies to protect themselves against price fluctuations in the
market or to speculate on future price movements without the need to own the underlying asset
directly. Derivatives are instruments in respect of which trading is carried out as a right on an underlying
asset. In normal trading, an asset is acquired or sold. When we deal with derivatives, the asset itself is
not traded, but the right to buy or sell the asset is traded. Thus a derivative instrument does not directly
result in a trade but gives a right to a person which may ultimately result in trade. A buyer of a derivative
gets a right over the asset which after or during a particular period of time might result in the buyer
buying or selling the asset. A derivative instrument is based on an underlying asset. The asset may be a
commodity, a stock or a foreign currency. A right is bought either to buy or sell the underlying asset
after or during a specified time. The price at which the transaction is to be carried out is also spelt out in
the beginning itself  Hedging: For example, a company that expects to receive payments in a foreign
currency may use currency derivatives to lock in an exchange rate, thus protecting against the risk of
currency fluctuations. Asst.Prof. Devendra S. Patil Page 3 KCE’S COLLEGE OF ENGINEERING AND
MANAGEMENT, JALGAON 2024  Speculation: A trader might use derivatives to bet on the future
movement of an asset's price. If the bet is correct, the trader can earn significant profits; if not, the
losses can be equally significant.  Arbitrage: Traders might use derivatives to exploit price differences
between markets. For example, if the price of an asset differs in two markets, a trader could buy the
asset in one market and simultaneously sell it in the other, locking in a profit. Types of Financial
Derivatives 1. Futures Contracts: Standardized contracts traded on exchanges to buy or sell an asset at a
future date for a predetermined price. 2. Options Contracts: Provide the buyer the right, but not the
obligation, to buy or sell an asset at a set price before a certain date. 3. Swaps: Agreements between
parties to exchange sequences of cash flows, such as interest rate swaps. 4. Forwards Contracts:
Customizable contracts similar to futures but traded over-the counter and not on exchanges.
Importance Financial derivatives play a crucial role in modern financial markets and serve several
important functions. These financial instruments derive their value from an underlying asset, index, or
rate, such as stocks, bonds, commodities, or interest rates. Here are some key reasons why financial
derivatives are important: 1. Risk Management (Hedging)  Hedging against price fluctuations:
Derivatives allow businesses and investors to protect themselves against price volatility in the markets.
For example, a company exposed to fluctuations in commodity prices (e.g., oil or metals) can use futures
contracts to lock in a future price, thus minimizing the risk of adverse price movements.  Currency and
Interest Rate Risk: Companies with international operations often face currency risk. Derivatives like
forward contracts and swaps can mitigate this risk by fixing exchange rates. Similarly, interest rate swaps
help manage fluctuations in borrowing costs. 2. Speculation and Arbitrage  Speculative Gains: Traders
use derivatives to take positions based on their expectations of future price movements. Since
derivatives often require less capital upfront (due to leverage), they can amplify returns—but also
magnify losses.  Arbitrage Opportunities: Investors use derivatives to exploit price differences between
markets or related assets, contributing to market efficiency. For instance, if the price of a stock differs in
two exchanges, traders can use derivatives to profit from this price discrepancy. 3. Price Discovery 
Market Sentiment: Derivatives markets provide valuable insights into market expectations about future
prices. The prices of futures contracts, options, or other Asst.Prof. Devendra S. Patil Page 4 KCE’S
COLLEGE OF ENGINEERING AND MANAGEMENT, JALGAON 2024 derivatives can reflect collective
forecasts about commodity prices, stock indices, or interest rates.  Efficient Markets: Because
derivative prices adjust quickly based on supply and demand, they contribute to more efficient price
discovery, helping to integrate various market expectations and conditions. 4. Liquidity  High Volume
Trading: Derivative markets, especially futures and options markets, are highly liquid. This liquidity
enables participants to enter and exit positions more easily, improving the overall functioning of
financial markets.  Capital Efficiency: Derivatives often require only a fraction of the capital needed to
trade the underlying asset (due to margin requirements). This allows traders and companies to manage
larger positions with smaller initial investments, contributing to liquidity. 5. Access to Markets  Broader
Participation: Derivatives enable market participants to gain exposure to a wide range of assets without
needing to own the underlying asset directly. For instance, an investor can speculate on oil prices
without owning physical oil.  Customization of Financial Needs: Companies can tailor derivative
contracts to meet their specific needs. This flexibility can make derivatives an effective tool for managing
risks associated with complex financial and operational activities. 6. Enhancing Portfolio Performance 7.
Regulatory Benefits  Diversification: Derivatives provide opportunities for diversification by offering
exposure to asset classes that might be difficult to trade directly, such as foreign currencies or specific
commodities.  Risk-Adjusted Returns: By using derivatives to hedge risks, investors can improve the
risk-return profile of their portfolios, potentially reducing overall volatility and enhancing long-term
performance.  Managing Compliance: In some cases, regulatory frameworks mandate the use of
derivatives for hedging purposes. For instance, insurers and pension funds may be required to use
derivatives to manage interest rate or longevity risks as part of their financial management obligations.
However, derivatives also carry risks, including counterparty risk (the risk that the other party in the
contract may default), market risk (the risk of adverse price movements), and liquidity risk (the risk that
a position cannot be sold or bought quickly enough to prevent a loss). These risks were highlighted
during the 2008 financial crisis, which led to increased regulation and scrutiny of derivative markets.
Asst.Prof. Devendra S. Patil Page 5 KCE’S COLLEGE OF ENGINEERING AND MANAGEMENT, JALGAON
2024 1.2 Derivatives Market – History and Evolution The derivatives market has a long and complex
history, evolving from simple contracts used in ancient civilizations to a sophisticated global market that
plays a crucial role in modern finance. Here’s a look at the history and evolution of the derivatives
market: 1. Early Beginnings  Ancient Civilizations: The concept of derivatives can be traced back to
ancient times. For example, in ancient Mesopotamia, farmers used contracts to lock in prices for future
deliveries of crops, similar to modern forward contracts. The Greek philosopher Thales is often credited
with using an early form of options in 600 BCE by securing the right to use olive presses in the future at a
fixed price.  Medieval Europe: During the middle Ages, contracts resembling modern derivatives were
used in Europe, particularly in agricultural markets. These contracts allowed merchants to lock in prices
for future deliveries of goods. 2. 17th to 19th Century 3. 20th Century  The Amsterdam Stock Exchange
(1602): The Dutch East India Company issued the first shares on the Amsterdam Stock Exchange, and
soon after, investors began trading Options on these shares. This is one of the earliest recorded
instances of organized derivatives trading.  Rice Futures in Japan (1730s): The Dojima Rice Exchange in
Osaka, Japan, is recognized as one of the first futures markets. Rice merchants and samurai used futures
contracts to hedge against price fluctuations.  Chicago Board of Trade (CBOT, 1848): The CBOT was
established to standardize the trading of grain contracts, leading to the creation of the first standardized
futures contracts. This was a significant development in the evolution of the derivatives market. 
Expansion of Futures Markets: By the early 20th century, futures markets had expanded to include a
variety of agricultural commodities, metals, and other physical goods.  Development of Financial
Derivatives (1970s): The derivatives market underwent a significant transformation in the 1970s with
the creation of financial derivatives, including futures and options on financial assets such as currencies,
interest rates, and stock indices. The Chicago Mercantile Exchange (CME) introduced currency futures in
1972, and in 1973, the Chicago Board Options Exchange (CBOE) was founded, introducing standardized
options contracts.  The Black-Scholes Model (1973): The introduction of the Black-Scholes model for
pricing options revolutionized the derivatives market by providing a theoretical framework for valuing
options, which led to the rapid growth of options trading. Asst.Prof. Devendra S. Patil Page 6 KCE’S
COLLEGE OF ENGINEERING AND MANAGEMENT, JALGAON 2024 4. Late 20th Century to Present 
Proliferation of Derivatives: The 1980s and 1990s saw an explosion in the use and variety of derivatives,
including interest rate swaps, credit default swaps, and a range of complex structured products. This
period also saw the rise of over-the-counter (OTC) derivatives, which allowed for more customized and
flexible contracts.  Globalization: The derivatives market became truly global, with exchanges and OTC
markets operating around the world. Financial innovations and deregulation further fueled the growth
of the market.  2008 Financial Crisis: The extensive use of derivatives, particularly credit default swaps
(CDS) and mortgage-backed securities (MBS), played a significant role in the 2008 financial crisis. The
crisis exposed the risks associated with derivatives, especially in the OTC market, leading to calls for
greater regulation.  Post-Crisis Regulation: In response to the financial crisis, major regulatory reforms
were introduced globally, including the Dodd-Frank Act in the United States. These reforms aimed to
increase transparency, reduce counterparty risk, and bring more derivatives trading onto regulated
exchanges and clearinghouses. 5. 21st Century Developments 6. Current Trends  Technological
Advances: The rise of electronic trading platforms and algorithmic trading has transformed the
derivatives market, making it more accessible and efficient. Blockchain technology and smart contracts
are also being explored for their potential to further revolutionize the market.  Environmental and
Ethical Derivatives: With the growing focus on sustainability, derivatives related to carbon credits,
renewable energy, and other environmental factors have emerged. Additionally, social and governance
factors are increasingly being integrated into derivatives markets.  COVID-19 Pandemic: The pandemic
caused significant market volatility, leading to increased use of derivatives for hedging and risk
management. The crisis also highlighted the importance of robust clearing and settlement mechanisms
in derivatives markets.  Growth of Exchange-Traded Products: Exchange-traded derivatives, including
futures and options, continue to grow, driven by demand for transparency and standardized contracts. 
Innovation in Derivatives Products: New products, such as volatility derivatives and crypto currency
derivatives, are emerging to meet the evolving needs of investors.  Regulatory Evolution: The
regulatory landscape continues to evolve, with ongoing efforts to balance market innovation with the
need for stability and transparency. The derivatives market has come a long way from its humble
beginnings in ancient civilizations to becoming a cornerstone of modern finance. Its history reflects the
constant interplay between innovation, risk management, and regulation. Asst.Prof. Devendra S. Patil
Page 7 KCE’S COLLEGE OF ENGINEERING AND MANAGEMENT, JALGAON 2024 1.3 Derivatives Market in
India In India, derivatives have been actively traded over the last decade. The use of derivatives in the
commodity segment has been existent over several years, but these were mostly confined to futures
and forwards transactions. Options contracts in the stock markets have become very popular in recent
years and have given a new facet to share portfolio management. In the foreign exchange market, over-
the-counter forwards have been prevalent for long, but formalized futures and options are yet to take
shape. Trading of interest rate derivatives has been formally introduced in the stock exchanges but
these are yet to capture the imagination of the common investor. Swap transactions have been reported
more on a customized one-to-one basis rather than being taken as formal standardized instruments.
Credit derivatives have made an entry but are yet to become very popular. Stock mark find derivative
instruments very useful, and portfolio managers find a number of uses from these for protecting and
enhancing their stock holdings. The rising volumes of index based and individual securities are an
indication of their growing popularity. The fact remains, however, that most of the deals are speculative
in nature and are not necessary for risk management. However, this by itself need not be taken as an
adverse factor, because in most world markets initial trades on derivative instruments have been
basically speculative. Besides, the existence of a large number of speculators enables the genuine risk
manager to put through his deals comfortably and volumes will not suffer for want of traders. 1. History
and Evolution The regulation of the derivatives segments has been handled by the Securities and
Exchange Board of India and the stock exchanges. Strict margins and deposits are taken from the trading
members to avoid defaults and payment problems.  Early Beginnings (Before 2000): The concept of
derivatives trading in India can be traced back to informal trading practices in commodities markets.
However, formal derivatives trading in the financial markets was non-existent before the 2000s. 
Introduction of Financial Derivatives (2000): The derivatives market in India officially began in June 2000
with the introduction of index futures on the Bombay Stock Exchange (BSE) and the National Stock
Exchange (NSE). This was followed by the launch of index options, stock futures, and stock options. 
Commodities Derivatives (2003): The government of India reintroduced commodities futures trading in
2003, which had been banned since the 1960s. The establishment of multi commodity exchanges like
the Multi Commodity Exchange (MCX) and the National Commodity and Derivatives Exchange (NCDEX)
marked the formalization of the commodities derivatives market. 2. Key Segments of the Indian
Derivatives Market  Equity Derivatives: Asst.Prof. Devendra S. Patil Page 8 KCE’S COLLEGE OF
ENGINEERING AND MANAGEMENT, JALGAON 2024 o Index Futures and Options: These are based on
major stock indices like the Nifty 50 and Sensex. They are among the most actively traded derivatives in
India. o Stock Futures and Options: These allow traders to take positions on individual stocks. They have
gained popularity among retail and institutional investors.  Currency Derivatives: Introduced in 2008,
currency futures and options allow participants to hedge against currency risk. The most traded
contracts are based on the USD-INR pair, though other currencies like the Euro, Pound Sterling, and
Japanese Yen are also available.  Interest Rate Derivatives: Introduced in 2009, these derivatives are
based on government securities and interest rate benchmarks like the Mumbai Interbank Offer Rate
(MIBOR). They are used primarily by banks, financial institutions, and large corporations.  Commodity
Derivatives: o Agro-commodities: Derivatives on agricultural products like wheat, rice, and spices are
traded on commodity exchanges like NCDEX. o Non-agro Commodities: Metals, energy products like
crude oil and natural gas, and precious metals like gold and silver are actively traded on exchanges like
MCX. 3. Regulatory Framework  Securities and Exchange Board of India (SEBI): SEBI is the primary
regulator of the derivatives market in India. It oversees the functioning of the stock exchanges, the
introduction of new derivatives products, and the protection of investors’ interests.  Forward Markets
Commission (FMC): Until 2015, the FMC regulated commodity derivatives. However, it was merged with
SEBI in 2015, bringing all derivatives markets under a single regulatory umbrella.  Reserve Bank of India
(RBI): The RBI regulates the currency and interest rate derivatives markets, ensuring stability and
managing systemic risks. 4. Current Trends and Developments  Increased Participation: The Indian
derivatives market has seen a substantial increase in participation from retail investors, institutional
investors, and foreign portfolio investors (FPIs). This growth is driven by the need for risk management
and speculative opportunities.  Growth of Commodity Derivatives: The commodity derivatives market
has expanded, with MCX being one of the largest commodity exchanges globally by trading volume. The
introduction of options on commodities has further enhanced the market's depth.  Introduction of New
Products: SEBI has allowed the introduction of newer products, such as weekly options on indices, cross-
currency futures, and options on individual stocks, enhancing market liquidity and offering more
opportunities for hedging and speculation.  Technology and Algo Trading: The adoption of advanced
trading technologies and algorithmic trading has increased efficiency and trading volumes in the
derivatives market. Exchanges like NSE have become global leaders in terms of derivatives volume. 
Regulatory Reforms: Post-2008, SEBI has implemented stricter regulations to ensure market integrity,
transparency, and investor protection. These include tighter margin requirements, position limits, and
the introduction of the Securities Transaction Tax (STT) on derivatives transactions. Asst.Prof. Devendra
S. Patil Page 9 KCE’S COLLEGE OF ENGINEERING AND MANAGEMENT, JALGAON 2024 5. Challenges 
Market Volatility: High volatility in the derivatives market can pose risks to investors, particularly retail
investors who may not fully understand the complexities of these instruments.  Regulatory Compliance:
With the rapid evolution of the market, ensuring compliance with regulatory norms remains a challenge
for participants.  Financial Literacy: Despite the growth of the derivatives market, there is still a lack of
awareness and understanding among many retail investors, which can lead to misuse or losses. 6.
Future Outlook  Continued Growth: The Indian derivatives market is expected to continue growing,
driven by increasing market participation, the introduction of new products, and ongoing technological
advancements.  Integration with Global Markets: As India continues to liberalize its financial markets,
the integration of the Indian derivatives market with global markets is likely to increase, providing more
opportunities for cross-border trading and investment.  Focus on Education: To sustain growth, there
will be a need for greater emphasis on investor education and financial literacy, ensuring that
participants are well-informed about the risks and benefits of derivatives trading. 1. Forwards The
derivatives market in India has come a long way since its inception in 2000, evolving into a sophisticated
and integral part of the country's financial ecosystem. It continues to play a crucial role in risk
management, price discovery, and enhancing market efficiency. 1.4 Types of Derivatives – Forwards,
Futures, Options, Swaps Derivatives are financial contracts that derive their value from an underlying
asset, rate, or index. The most common types of derivatives are forwards, futures, options, and swaps.
Each type serves different purposes in financial markets, from hedging risks to speculating on price
movements. Here's a detailed overview:  Definition: A forward contract is an agreement between two
parties to buy or sell underlying assets at a pre determined future date at a price agreed when the
contract is entered into. Forward contracts are not staardized products. They are over-the-counter (not
traded in. recognized stock exchanges) derivatives that are tailored to meet specific user needs. The
underlying assets of this contract include:  Traditional agricultural or physical commodities  Currencies
(foreign exchange forwards)  Interest rates (forward rate agreements or FRAs) Asst.Prof. Devendra S.
Patil Page 10 KCE’S COLLEGE OF ENGINEERING AND MANAGEMENT, JALGAON 2024  Meaning A
Forward Contract is a contract made today for delivery of an asset at a prespecified time in the future at
a price agreed upon today. The buyer of a forward contract agrees to take delivery of an underlying
asset at a future time (T), at a price agreed upon today. No money changes hands until time T. The seller
agrees to deliver the underlying asset at a future time T, at a price agreed upon today. Again, no money
changes hands until time T. A forward contract, therefore, simply amounts to setting a price today for a
trade that will occur in the future. In other words, a forward contract is a contract between two parties
who agree to buy/sell a specified quantity of a financial instrument/commodity at a certain price at a
certain date in future.  Features: o Over-the-Counter (OTC): Forwards are traded OTC, meaning they
are not standardized or traded on exchanges. This allows for greater customization in terms of contract
size, expiration date, and underlying asset. o Settlement: The contract is settled on the agreed-upon
date, typically through the actual delivery of the underlying asset, though cash settlement is also
possible. o Counterparty Risk: Since forwards are OTC instruments, there is a risk that one party may
default on the contract, known as counterparty risk.  Uses: Forwards are often used by businesses and
investors to hedge against future price changes in commodities, currencies, or interest rates. 2. Futures
 Definition: A futures contract is a standardized agreement to buy or sell an asset at predetermined
price at a specified future date. Unlike forwards, futures are traded on exchanges.  Meaning: A futures
contract is a type of derivative instrument, or financial contract, in which two parties agree to transact a
set of financial instruments or physical commodities for future delivery at a particular price. If you buy a
futures contract, you are basically agreeing to buy Asst.Prof. Devendra S. Patil Page 11 KCE’S COLLEGE
OF ENGINEERING AND MANAGEMENT, JALGAON 2024 something that a seller has not yet produced for
a set price. But participating in the futures market does not necessarily mean that you will be
responsible for receiving or delivering large inventories of physical commodities remember, buyers and
sellers in the futures market primarily enter into futures contracts to hedge risk or speculate rather than
to exchange physical goods (which is the primary activity of the cash/spot market). That is why futures
are used as financial instruments by not only producers and consumers but also by speculators. A future
contract is a standardized agreement between the seller (short position) of the contract and the buyer
(long position), traded on a futures exchange, to buy or sell a certain underlying instrument at a certain
date in future, at a pre-set price. The future date is called the delivery date or final settlement date. The
pre-set price is called the futures price. The price of the underlying asset on the delivery date is called
the settlement price.Thus, futures is a standard contract in which the seller is obligated to deliver a
specified asset (security, commodity or foreign exchange) to the buyer on a specified date in future and
the buyer is obligated to pay the seller the then prevailing futures price upon delivery  Features: o
Standardization: Futures contracts are standardized in terms of contract size, expiration date, and
underlying asset. This standardization makes them more liquid than forwards. o Exchange-Traded:
Futures are traded on regulated exchanges such as the Chicago Mercantile Exchange (CME), which
reduces counterparty risk through the use of clearinghouses. o Mark-to-Market: The value of a futures
contract is marked to market daily, meaning gains and losses are settled at the end of each trading day.
o Margin Requirements: Participants must post a margin, a small percentage of the contract's value,
which serves as collateral to cover potential losses.  Uses: Futures are used for hedging risks in
commodities, currencies, and financial instruments. They are also popular among speculators who seek
to profit from price movements. 3. Options  Definition: An option is a contract that gives the buyer the
right, but not the obligation, to buy or sell an underlying asset at a predetermined price before or on a
specified date.  Meaning: Option contracts are a step ahead of the forwards/futures contract in that
they result in a right being Leated without a corresponding obligation. The buyer of an option contract
gets the right without the obligation to either buy or sell the underlying asset. There is a timeframe and
a price fixed for the contract For the privilege of going ahead with the contract as per the buyer's desire,
the option buyer has to pay the seller a premium upfront. If ultimately prices do not allow the options to
be exercised, then the premium is the only loss incurred by the buyer of the option contract. All the
detailed aspects of an options contract are covered in a later section.  Types: o Call Option: Gives the
holder the right to buy the underlying asset at a specified price (strike price). o Put Option: Gives the
holder the right to sell the underlying asset at a specified price. Asst.Prof. Devendra S. Patil Page 12
KCE’S COLLEGE OF ENGINEERING AND MANAGEMENT, JALGAON 2024  Features: o Premium: The buyer
of an option pays a premium to the seller (writer) for the right to exercise the option. o Expiration Date:
Options have an expiration date by which the holder must exercise the option, or it expires worthless. o
Intrinsic and Time Value: An option's value consists of intrinsic value (the difference between the
underlying asset's price and the strike price) and time value (the potential for the asset’s price to change
before expiration).  Uses: Options are used for hedging, speculating, and income generation (through
strategies like covered calls). They offer more flexibility than forwards and futures due to the right, but
not the obligation, to execute the contract. 4. Swaps  Definition: A swap is a derivative contract in
which two parties agree to exchange cash flows or other financial instruments over a specified period. 
Meaning: In a swap transaction the two parties thereto exchange, their respective obligations on
predetermined terms. In its simplest version, two companies (say, A and B) having different obligations
of interest payments (with Company A obliged to pay a fixed rate of interest to its bankers and Company
B having to pay a floating rate of interest) enter into a contract whereby they exchange their obligations.
This exchange of their obligations results in Company A getting the fixed interest from Company B to be
used for satisfying its obligation. In turn Company A passes on a floating rate of interest to the
counterparty Company B to satisfy the latter's floating' interest obligation. The principal amount to be
reckoned for the purpose of calculating the two interests (called the Notional principal) and the
benchmark interest rate to be used for the purpose of determining the floating rate are decided at the
time of entering into the contract. Swaps are dealt with in detail in a later section.  Types: o Interest
Rate Swaps: The most common type, where parties exchange fixed interest rate payments for floating
rate payments or vice versa. o Currency Swaps: Parties exchange cash flows in different currencies, often
involving the exchange of principal amounts at the beginning and end of the contract. o Commodity
Swaps: Involve the exchange of cash flows related to commodity prices. o Credit Default Swaps (CDS): A
type of insurance against the default of a borrower, where one party pays a premium, and the other
pays if the borrower defaults.  Features: o Over-the-Counter (OTC): Like forwards, swaps are usually
OTC contracts, allowing for customization. o Counterparty Risk: Since swaps are OTC, they carry
counterparty risk, though this can be mitigated through collateral or using a central clearing party. o
Periodic Payments: Swaps typically involve a series of payments over time rather than a single payment
at maturity.  Uses: Swaps are used by corporations, financial institutions, and investors to manage
interest rate, currency, and credit risks. For example, a company with a floating rate loan might use an
interest rate swap to lock in a fixed interest rate. Asst.Prof. Devendra S. Patil Page 13 KCE’S COLLEGE OF
ENGINEERING AND MANAGEMENT, JALGAON 2024 Summary of Differences:  Forwards vs. Futures:
Both involve an agreement to buy or sell an asset in the future, but forwards are customized and traded
OTC, while futures are standardized and traded on exchanges.  Options vs. Forwards/Futures: Options
give the right but not the obligation to execute the contract, offering more flexibility but requiring
payment of a premium.  Swaps vs. Others: Swaps involve the exchange of cash flows rather than a
single transaction and are typically used for longer-term risk management. These derivatives provide
various tools for managing financial risk, speculating on market movements, or capitalizing on price
discrepancies, making them essential instruments in global financial markets. 1.5 Participants in
Derivatives Market The derivatives market is composed of various participants, each with different
objectives, strategies, and roles. These participants can be broadly classified into four main categories:
hedgers, speculators, arbitrageurs, and margin traders. Understanding the roles of these participants is
essential to grasp the dynamics of the derivatives market. 1. Hedgers  Definition: Hedgers are
participants who use derivatives to manage or mitigate risk associated with the price movement of an
underlying asset. They enter into derivatives contracts to protect themselves against adverse price
changes.  Examples: o Corporations: A company that exports goods might use currency futures or
options to lock in exchange rates, protecting against unfavorable currency fluctuations. o Farmers and
Producers: A farmer might use commodity futures to lock in a price for their crop before harvest,
securing revenue regardless of future price movements. o Financial Institutions: Banks might use
interest rate swaps to manage the risk associated with fluctuating interest rates on loans or deposits.
Asst.Prof. Devendra S. Patil Page 14 KCE’S COLLEGE OF ENGINEERING AND MANAGEMENT, JALGAON
2024 o Objective: The primary goal of hedgers is to reduce or eliminate the risk of price changes in the
underlying asset, ensuring stability in their financial operations. 2. Speculators  Definition: Speculators
are participants who enter the derivatives market primarily to profit from anticipated price movements
of the underlying asset. They take on risk in the hope of making gains, rather than trying to mitigate
existing risk.  Examples: o Individual Traders: A trader might buy call options on a stock if they believe
the stock price will rise, hoping to profit from the increase. o Hedge Funds: Hedge funds often engage in
speculative activities using derivatives to achieve higher returns, leveraging their positions to amplify
potential gains.  Objective: The main objective of speculators is to earn profits by correctly predicting
future price movements. They provide liquidity to the market, making it easier for hedgers to enter and
exit positions. 3. Arbitrageurs  Definition: Arbitrageurs are participants who exploit price discrepancies
between different markets or derivatives contracts to earn risk-free profits. They engage in arbitrage by
buying and selling the same asset or equivalent assets simultaneously in different markets.  Examples:
4. Margin Traders o Price Discrepancy Arbitrage: An arbitrageur might buy a futures contract on one
exchange where it is undervalued and sell an identical contract on another exchange where it is
overvalued, locking in a risk-free profit. o Convertible Bond Arbitrage: An investor might simultaneously
buy a convertible bond (which can be converted into a fixed number of shares) and sell the underlying
stock, profiting from price differences between the bond and the stock.  Objective: Arbitrageurs aim to
profit from temporary inefficiencies in the market by ensuring that prices in different markets converge,
thus contributing to market efficiency.  Definition: Margin traders are participants who trade
derivatives using borrowed funds (leverage). By using margin, traders can control larger positions with a
smaller initial investment, potentially increasing both profits and losses.  Examples: o Leverage Use: A
trader with $10,000 in their account might use margin to take a position worth $100,000 in futures
contracts, magnifying potential gains or losses. o Risk Management: Margin traders are required to
maintain a certain level of equity in their accounts, known as the margin requirement. If the market
moves against them, they may face margin calls, requiring them to deposit additional funds. Asst.Prof.
Devendra S. Patil Page 15 KCE’S COLLEGE OF ENGINEERING AND MANAGEMENT, JALGAON 2024 
Objective: The objective of margin traders is to amplify returns by using leverage. However, this also
increases the risk of significant losses. 5. Market Makers  Definition: Market makers are participants
who provide liquidity to the derivatives market by being ready to buy or sell at any given time. They
quote both buy (bid) and sell (ask) prices for derivatives contracts, facilitating smooth trading. 
Examples: o Broker-Dealers: Financial institutions or specialized firms often act as market makers,
continuously providing quotes for options and futures contracts. o Electronic Market Makers: With the
advent of algorithmic trading, electronic market makers use sophisticated algorithms to provide liquidity
and ensure tight bid-ask spreads.  Objective: Market makers aim to profit from the bid-ask spread,
while also earning a return on the inventory of derivatives they hold. They play a crucial role in ensuring
market liquidity and stability. 6. Clearinghouses 7. Regulators  Definition: Clearinghouses are
intermediaries between buyers and sellers in derivatives markets. They ensure that trades are settled
correctly and manage the risk of default by either party.  Examples: o Central Counterparties (CCPs): In
futures markets, clearinghouses act as central counterparties, meaning they become the buyer to every
seller and the seller to every buyer, effectively guaranteeing the performance of the contract. o
Settlement Services: Clearinghouses manage the daily settlement of gains and losses (mark-to-market),
ensure margin requirements are met, and handle the physical delivery of underlying assets if applicable.
 Objective: The primary goal of clearinghouses is to reduce counterparty risk and ensure the integrity
and stability of the derivatives market.  Definition: Regulators are government or independent agencies
responsible for overseeing the derivatives market, ensuring compliance with laws and regulations, and
protecting investors.  Examples: o Securities and Exchange Board of India (SEBI): In India, SEBI regulates
the derivatives market, ensuring transparency and fairness in trading practices. o Commodity Futures
Trading Commission (CFTC): In the United States, the CFTC oversees futures and options markets,
ensuring market integrity and protecting against fraud and manipulation. Asst.Prof. Devendra S. Patil
Page 16 KCE’S COLLEGE OF ENGINEERING AND MANAGEMENT, JALGAON 2024  Objective: Regulators
aim to maintain market stability, protect investors, and promote fair and efficient markets by enforcing
rules, monitoring market activities, and implementing necessary reforms. 1.6 Uses of Derivatives,
Critiques of Derivatives Derivatives are powerful financial instruments used for various purposes, but
they also come with significant risks and have been the subject of much criticism. Below is an overview
of the uses of derivatives and the critiques associated with them.  Uses of Derivatives 1. Hedging Risk o
Definition: Hedging involves using derivatives to protect against potential losses in an underlying asset
due to unfavorable price movements. o Examples:  Currency Risk: A company with significant
international operations might use currency futures or options to hedge against fluctuations in exchange
rates.  Commodity Risk: Airlines often use fuel futures to lock in prices for jet fuel, protecting against
the risk of rising fuel costs.  Interest Rate Risk: Banks might use interest rate swaps to manage the risk
associated with fluctuating interest rates on their loans and deposits. o Benefit: By hedging, companies
and investors can stabilize their costs, revenues, or investment returns, leading to greater financial
predictability. 2. Speculation o Definition: Speculation involves taking on risk by using derivatives to bet
on the future price movements of an underlying asset, with the aim of making a profit. o Examples: 
Stock Options: An investor might buy call options on a stock, speculating that the stock’s price will rise,
allowing them to buy at a lower price.  Futures Trading: A trader might take a long position in crude oil
futures, speculating that the price of oil will increase. o Benefit: Speculation can lead to significant
profits if the price movement is correctly anticipated. It also adds liquidity to the market, making it
easier for other participants to enter and exit positions 3. Arbitrage o Definition: Arbitrage involves using
derivatives to exploit price differences between different markets or instruments to earn a risk-free
profit. o Examples:  Interest Rate Arbitrage: An arbitrageur might exploit differences in interest rates
between two countries by using currency swaps or forward contracts.  Commodity Arbitrage: A trader
might buy a commodity in one market where it is undervalued and simultaneously sell it in another
market where it is overvalued, using futures contracts to secure both transactions. Asst.Prof. Devendra
S. Patil Page 17 KCE’S COLLEGE OF ENGINEERING AND MANAGEMENT, JALGAON 2024 o Benefit:
Arbitrage ensures that prices remain aligned across markets, contributing to market efficiency. 4.
Enhancing Yield o Definition: Some investors use derivatives to enhance the yield of their portfolios,
either by writing options or using leverage through futures contracts. o Examples:  Covered Call
Writing: An investor holding a stock might sell call options on that stock, earning the premium as
additional income, which enhances the yield of the investment.  Leveraged Investments: An investor
might use futures contracts to gain exposure to a larger position than they could afford with the
underlying asset alone, potentially increasing returns. o Benefit: Derivatives can offer opportunities to
increase returns without requiring a significant increase in the underlying investment capital. 5. Access
to Hard-to-Reach Markets or Assets o Definition: Derivatives allow investors to gain exposure to markets
or assets that might otherwise be difficult to access. o Examples:  Emerging Markets: Investors can use
derivatives like swaps or futures to gain exposure to emerging markets without directly investing in
those markets.  Commodities: Investors who are unable to directly invest in physical commodities like
oil or gold can gain exposure through commodity futures or options. o Benefit: Derivatives provide
flexibility and access to a broader range of investment opportunities  Critiques of Derivatives 1.
Complexity and Lack of Transparency o Critique: Derivatives can be highly complex financial instruments
that are difficult to understand, even for sophisticated investors. This complexity can lead to a lack of
transparency, making it challenging to assess the risks involved. o Examples:  Structured Derivatives:
Instruments like collateralized debt obligations (CDOs) or credit default swaps (CDS) can be opaque and
difficult to value, leading to significant risks that are not easily identifiable. o Consequence: The
complexity of derivatives has been linked to financial crises, as seen during the 2008 global financial
crisis when the collapse of mortgage-backed securities and related derivatives triggered widespread
economic turmoil. 2. High Leverage o Critique: Derivatives often allow for high levels of leverage,
meaning that investors can control large positions with relatively little capital. While leverage can
amplify gains, it can also magnify losses, leading to significant financial distress. o Examples:  Futures
Trading: A trader using leverage might face substantial losses if the market moves against their position,
potentially losing more than their initial investment. Asst.Prof. Devendra S. Patil Page 18 KCE’S COLLEGE
OF ENGINEERING AND MANAGEMENT, JALGAON 2024 o Consequence: Excessive leverage was a key
factor in the downfall of major financial institutions during the 2008 crisis, as their highly leveraged
positions in derivatives markets led to catastrophic losses. 3. Systemic Risk o Critique: The widespread
use of derivatives can contribute to systemic risk, where the failure of one market participant can have a
cascading effect on the entire financial system. o Examples:  Interconnectedness: The collapse of
Lehman Brothers in 2008 highlighted the interconnectedness of the global financial system, where its
failure led to massive disruptions in derivatives markets and beyond. o Consequence: Systemic risk
poses a threat to the stability of the global financial system, leading to calls for greater regulation and
oversight of derivatives markets. 4. Speculative Excesses and Market Manipulation o Critique: The
speculative nature of derivatives can lead to market distortions and excesses, with some participants
engaging in manipulative practices to drive prices in their favor. o Examples:  Market Manipulation:
Cases of manipulation in derivatives markets, such as the manipulation of LIBOR (London Interbank
Offered Rate), have led to significant financial penalties and a loss of confidence in financial markets. o
Consequence: Speculative excesses can lead to bubbles and crashes, causing severe financial instability
and economic damage. 5. Potential for Large Losses o Critique: The potential for large, unexpected
losses is a significant risk associated with derivatives, especially when positions are not adequately
hedged or understood. o Examples:  Derivatives Disasters: High-profile losses, such as those by Barings
Bank (1995) due to unauthorized derivatives trading or AIG’s near-collapse (2008) due to massive
exposure to credit default swaps, illustrate the dangers of improper derivatives use. o Consequence:
These incidents highlight the risks of inadequate risk management and oversight, leading to calls for
stricter regulations and controls. Asst.Prof. Devendra S. Patil Page 19