Introduction to Financial Derivatives 1

1 Introduction to Financial Derivatives12 Financial DerivativesMUMBAI NEW DELHI NAGPUR BENGALURU HYDERABAD CHENNAI PUNE LUCKNOW AHMEDABAD ERNAKULAM BHUBANESWAR INDORE KOLKATA GUWAHATIFINANCIALDERIVATIVESR. , MBA, , (Finance)Director & Professor,AJK Institute of Management(A Unit of AJK Institutions),Navakkarsi, Edition : 2014 Introduction to Financial Derivatives3 First Edition : 2014 Published by:Mrs. Meena Pandey for Himalaya Publishing House Pvt. Ltd., Ramdoot , Dr. Bhalerao Marg, Girgaon, Mumbai - 400 : 022-23860170/23863863, Fax: 022-23877178E-mail: Website: Offices:New Delhi: Pooja Apartments , 4-B, Murari Lal Street, Ansari Road, Darya Ganj,New Delhi - 110 002. Phone: 011-23270392, 23278631; Fax: 011-23256286 Nagpur:Kundanlal Chandak Industrial Estate, Ghat Road, Nagpur - 440 : 0712-2738731, 3296733; Telefax: 0712-2721216 Bengaluru:No.

2 16/1 (Old 12/1), 1st Floor, Next to Hotel Highlands, Madhava Nagar,Race Course Road, Bengaluru - 560 : 080-22286611, 22385461, 4113 8821, 22281541 Hyderabad:No. 3-4-184, Lingampally, Besides Raghavendra Swamy Matham, Kachiguda,Hyderabad - 500 027. Phone: 040-27560041, 27550139 Chennai:8/2 Madley 2nd street, T. Nagar, Chennai - 600 017. Mobile: 09320490962 Pune:First Floor, "Laksha" Apartment, No. 527, Mehunpura, Shaniwarpeth(Near Prabhat Theatre), Pune - 411 030. Phone: 020-24496323/24496333;Mobile: 09370579333 Lucknow:House No 731, Shekhupura Colony, Near Convent School, Aliganj,Lucknow - 226 022. Phone: 0522-4012353; Mobile: 09307501549 Ahmedabad:114, SHAIL , 1st Floor, Opp. Madhu Sudan House, Road, Navrang Pura,Ahmedabad - 380 009. Phone: 079-26560126; Mobile: 09377088847 Ernakulam:39/176 (New No: 60/251) 1st Floor, Karikkamuri Road, Ernakulam, Kochi : 0484-2378012, 2378016; Mobile: 09387122121 Bhubaneswar:5 Station Square, Bhubaneswar - 751 001 (Odisha).

3 Phone: 0674-2532129, Mobile: 09338746007 Indore:Kesardeep Avenue Extension, 73, Narayan Bagh, Flat No. 302, IIIrd Floor,Near Humpty Dumpty School, Indore - 452 007 ( ). Mobile: 09303399304 Kolkata:108/4, Beliaghata Main Road, Near ID Hospital, Opp. SBI Bank,Kolkata - 700 010, Phone: 033-32449649, Mobile: 7439040301 Guwahati:House No. 15, Behind Pragjyotish College, Near Sharma Printing Press, Bharalumukh, Guwahati - 781009, (Assam).Mobile: 09883055590, 08486355289, 7439040301 DTP by:SanhitaPrinted at:M/s. Charita Impressions, Hyderabad on behalf of HPH. AuthorNo part of this publication may be reproduced, stored in a retrieval system, or transmitted in any formor by any means, electronic, mechanical, photocopying, recording and/or otherwise, without the priorwritten permission of the Financial DerivativesPrefaceThis book is intended for all students of MBA (Finance) of various universities and managementinstitutes and the same can be used for CA, ICWA and ACS courses.

4 The objectives of the bookare to provide the student with a conceptual framework of Financial decisions taken with regard toinvestment decisions in Derivative Market. This Derivative Market covers Equity, Foreign Exchangeand commodity products. The purpose is to make students familiar with the unique economicfundamentals and Financial factors, which challenge the Financial manager in the international book covers the entire syllabus as approved by UGC on the subject of Financial increasing prospects on capital market and earnings through hedging, Derivative instrumentsassume significance. This book could be the perfect guide for the beginners who wish to invest inF&O (Futures and Options) segment. Besides, this book is presented in simple mathematical terms,easily understandable to the average has the advantage of harmonising the finance function with the investment function ofthe Financial manager on the one hand and integrating the domestic finance with international financeon the other.

5 At the cost of repetition, each chapter is made self-contained and related to otherchapters. But this is an added advantage to students who get a recap of some of the points material is kept as brief as possible, yet with a comprehensive coverage of all the modulesas approved by various universities and autonomous institutions and in accordance with their text book could be the perfect guide to the new beginners who want to know aboutDerivative Market in three classifications namely Equity Derivatives , Currency Derivatives andCommodity to Financial Derivatives5 AcknowledgementsI like to express my heartfelt gratitude and countless thanks to P. Krishna Das, Advocate andManaging Trustee, Nehru Group of Institutions, Coimbatore, for his kind support to complete will be failing in my duty, if am not thanking Dr.

6 P. Krishna Kumar, MBA, , ChiefExecutive Officer and Secretary of Nehru Group of Institutions, Coimbatore, due to his immenseinvolvement in promoting teaching and Research in Management am very thankful to Mr. Ajeet Kumar Lalmohan, Secretary and Managing Trustee, AJKI nstitution, Coimbatore, for his encouragement and positive am very grateful to the Principal, Nehru Institute of Information Technology and ManagementCoimbatore, Dr. R. Moses Daniel, MBA, without whose insiration, this task could have neverbeen wish to express my gratitute to Dr. R. Nanda Gopal, Director, PSG Institute of Management,Coimbatore, for his invaluable guidance on choosing Finance as the focus of express my thanks to Mr. S. Chandra Sekar, Librarian, PSGIM, Mrs.

7 A. Geetha, AssistantLibrarian, PSGIM, Coimbatore, for their worthy supply of books, materials and online Journals incompleting this book , I express heartfelt thanks to my father and friends, co-staff members and my studentson giving away all kids of motivation and cooperation in completing this book successfully. R. Amuthan6 Financial to Financial Derivatives1 Trading35 Trading Mechanism82 Pricing96 Markets166 Markets Pricing and Trading Mechanism200 Market237 in International Business245 Framework250 Studies on Mismanagement of Derivatives264 271 Trading PracticeGlossary272 282 Bibliography283 284 Appendix285 290 ContentsIntroduction to Financial Derivatives7 CHAPTER1 Introduction toFinancialDerivativesDerivatives are instruments in respect of which trading is carried out as a right on an underlyingasset.

8 In normal trading, an asset is acquired or sold. When we deal with Derivatives , the asset itselfis not traded, but the right to buy or sell the asset is traded. Thus, a derivative instrument does notdirectly result in a trade but gives a right to a person which may ultimately result in trade. A buyerof a derivative gets a right over the asset which, after or during a particular period of time, mightresult in the buyer buying or selling the derivative instrument is based on an underlying asset. The asset may be a commodity , a stockor a foreign currency. A right is bought either to buy or sell the underlying asset after or duringa specified time. The price at which the transaction is to be carried out is also spelt out in the emergence of the market for derivative products, most notably forwardss, futures andoptions, can be traced back to the willingness of risk-averse economic agents to guard themselvesagainst uncertainties arising out of fluctuations in asset price.

9 By their very nature, the financialmarkets are marked by a very high degree of volatility. Through the use of derivative products, itis possible to transfer partially or fully price risks by locking-in asset prices. As instruments of riskmanagement, these generally do not influence the underlying asset prices. However, by locking-inasset prices, derivative products minimise the impact of fluctuations in asset prices on the profitabilityand cash flow situation of risk-averse DEFINEDD erivative 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 underlyingasset can be equity, forex, commodity or any other asset. For example, wheat farmers may wishto sell their harvest at a future date to eliminate the risk of a change in prices by that date.

10 Sucha transaction is an example of a derivative. The price of this derivative is driven by the spot priceof wheat which is the underlying .(1)8 Financial DerivativesIn the Indian context the securities contracts (Regulation) Act, 1956 (SC(R)A) defines"derivative" to security derived from a debt instrument, share, loan whether secured or under secured,risk instrument or contract for differences or any other form of contract, which derives its value from the prices or underlying are securities under the SC(R)A and, hence, the trading of Derivatives is governedby the regulatory framework under the SC(R) , Participants and FunctionsDerivative contracts have several variants. The most common variants are forwardss, futures,options and swaps.