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Introduction

Introduction. The Nature of Derivatives. A derivative is an instrument whose value depends on the values of other more basic underlying variables. Or A derivative is an instrument whose value is a function the values of other more basic underlying variables.

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Introduction

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  1. Introduction

  2. The Nature of Derivatives A derivative is an instrument whose value depends on the values of other more basic underlying variables. Or A derivative is an instrument whose value is a function the values of other more basic underlying variables.

  3. The Securities Contracts (Regulation) Act 1956 defines derivatives as under : • Derivative includes • Security derived from a debt instrument, share, 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

  4. Features of Financial Derivatives • A derivative instrument relates to the future contract between two parties • Value derived from the values of the other underlying assets. • Counter parties have specific obligation under the derivative contract. • Derivative contract can either be direct or thru exchange like options & futures. • Usually settled by offsetting rather than delivery of the asset. • Known as deferred delivery or deferred payment instrument, easier to take long & short positions. • Mostly secondary market instruments except warrants & convertibles.

  5. Derivatives Markets • Exchange traded • Traditionally exchanges have used the open-outcry system, but increasingly they have switched to electronic trading • Contracts are standard there is virtually no credit risk • Example of default: HKFE in October, 1987 • Over-the-counter (OTC) • A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers • Contracts can be non-standard and there is some small amount of credit risk • Defaults much bigger than exchanged based

  6. Examples of Derivatives • Forward Contracts • Futures Contracts • Swaps • Options

  7. Reasons for development of Derivatives - Increase in growth of International trade & Business due to Globalization & liberalization - Increase in volatility in the interest rates, stock prices at different financial markets - Increase in the risks associated with business & its recognition

  8. Ways Derivatives are Used • To hedge risks • To speculate (take a view on the future direction of the market) • To lock in an arbitrage profit • To change the nature of a liability • Interest rate swap to reduce mortgage risk in banks • To change the nature of an investment without incurring the costs of selling one portfolio and buying another

  9. Uses of Derivatives • To control , avoid, shift and manage efficiently different types of risks. • Serves as barometer of the future trends in the prices which results in the discovery of the new prices both in the spot & future markets. • Trading on margins ,enhances the liquidity & reduces the transaction costs. • Assists the investors to make proper asset allocation to increase their yields & achieve the other investment objectives. • Derivatives have smoothened out the price fluctuations, squeeze the price spread. • Derivative trading develop the market towards ‘complete market’

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