Derivatives

vetrivel

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vaibh

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soham22

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soniagarg2

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INDEX
CHAPTERS
1 INTRODUCTION
2 JUSTIFICATION OF THE TOPIC
3 REVIEW OF EXISTING LITERATURE
4 OBJECTIVES OF THE STUDY
5 RESEARCH METHODOLOGY
6 FINANCIAL INNOVATIONS
7 FINDINGS AND CONCLUSION
8 SUGGESTIONS
9 CONSTRAINTS OF THE STUDY
10 BIBLIOGRAPHY
 

soniagarg2

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INTRODUCTION
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.
Financial markets are, by nature, extremely volatile and hence, the risk factor is an important concern for financial agents. To reduce the risk, the concept of derivatives comes into picture.

DERIVATION OF DERIVATIVES
Derivatives in the form of forwards and options have been around as long as there has been commerce because all commerce involves business risk. The history of derivatives can be traced far back to renaissance period (15th Century) where the Venetian spice traders waiting a cargo on high seas would enter into a forward contract.Forward contracts are also traced in Japanese and American markets for hundreds of years ago. The Futures trading on the commodities first started in Chicago way back in 1874. But the explosion of derivative markets in the form we see today can be attributed to volatility in the foreign exchange rates created due to collapse of Breton Woods system. (A system whereby all the exchange rates were pegged to US$ whereas there was fixed parity between US$ and Gold). It led to the introduction of the forward contracts in the foreign currency by 1972. The equity options were introduced in 1973. The early 80s’ also led to the introduction of few more derivative products viz. currency swaps, interest rate swaps, index futures and options, etc.
In India, the L.C.Gupta Committee was appointed in 1996 to develop appropriate regulatory framework for the equity-based derivatives trading. It submitted its report in 1998, which was later approved by SEBI. It has suggested introducing derivative products in a phased manner starting with Index Futures followed by Index Options and Options on shares. Pursuant to the same, Index Futures were introduced in India in June 2000 at Bombay Stock Exchange and National Stock Exchange, Delhi Stock Exchange has indicated to join them shortly.
Financial Derivatives have been in existence in the markets for over 150 years – in fact the first reference to some form of the modern day. Financial Derivative is found in the Futures markets that were function in Chicago in the 1850’s. Over the years a more formalized structure came into place – the most significant fillip in this regard was the seminal work of Fisher Black and Myron Scholes in 1973. Since then, the development of Financial Derivatives and its extensive use in the financial sector has been synonymous with the stupendous growth in the financial sector itself. The 1980’s and the 1990’s saw tremendous growth in the Financial Sector and a lot of it was directly fuelled by the growth and development of the use of derivatives in this area.
The liberalization in the Indian Financial Sector started more than a decade back. But it is only now that the Reserve Bank of India is looking at allowing the use of derivatives in the market in a wide scale. Though derivatives in the equity market were permitted in 2001, the currency and the interest rate sectors of the financial sector in India were kept immune for the use of derivatives. The only derivative that was allowed in the money market segment of the financial sector was Swaps and with a case-by-case approval from RBI some back-to-back foreign currency option deals. However, RBI is now keen to open up the segment and allow for options on both currency (the Indian Rupee) as well as the interest rate applicable in the Indian markets. In view of this, the traders of banks and financial institutions as well as corporate need to be aware of these techniques for both investment as well as risk management functions; especially given the highly volatile nature of the industry.
 

soniagarg2

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FINANCIAL DERIVATIVES
A derivative is a financial instrument whose value is derived from the price of a more basic asset called the underlying. The underlying may not necessarily be a tradable product. Examples of underlying are shares, commodities, currencies, credits, stock market indices, weather temperatures, sunshine, results of sport matches, wind speed and so on. Basically, anything which may have to a certain degree an unpredictable effect on any business activity can be considered as an underlying of a certain derivative.
All derivatives can be divided into two big classes.
1. Linear
2. Non-Linear
Linear are derivatives whose values depend linearly on the underlying’s value. This includes:
• Forwards and Futures
• Swaps
Non-linear are derivatives whose value is a non-linear function of the underlying. This includes:
• Options
• Convertibles
• Equity Linked Bonds
• Reinsurances

THE NEED FOR A DERIVATIVES MARKET:-
The derivatives market performs a number of economic functions:
1. They help in transferring risk from risk averse people to risk oriented people.
2. They help in the discovery of future as well as current prices.
3. They catalyze entrepreneurial activity.
4. They increase the volume traded in markets because of participation of risk averse people in greater numbers.
5. They increase savings and investment in the long run.
 

soniagarg2

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• Hedgers use futures or options markets to reduce or eliminate the risk associated with price of an asset.
• Speculators use futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture.
• Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for sample, 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.
 

soniagarg2

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FORWARDS: A forward contract is a 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.

WARRANTS: Options generally have lives of upto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.
 
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