DERIVATIVES
A derivative is a financial instrument - or more simply, an agreement between two people or two parties - that has a value determined by the price of something else (called the underlying). It is a financial contract with a value linked to the expected future price movements of the asset it is linked to - such as a share or a currency. There are many kinds of derivatives, with the most notable being swaps, futures, and options. However, since a derivative can be placed on any sort of security, the scope of all derivatives possible is nearly endless. Thus, the real definition of a derivative is an agreement between two parties that is contingent on a future outcome of the underlying.
Some of the widely known underlying assets are: * Indexes (consumer price index (CPI), stock market index, weather conditions or inflation) * Bonds * Currencies * Interest rates * Exchange rates * Commodities * Stocks (equities)
Categorization
Derivatives are usually broadly categorized by the: * relationship between the underlying and the derivative (e.g., forward, option, swap) * type of underlying (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives or credit derivatives) * market in which they trade (e.g., exchange-traded or over-the-counter) * pay-off profile (Some derivatives have non-linear payoff diagrams due to embedded optionality)
Another arbitrary distinction is between: * vanilla derivatives (simple and more common) and * exotic derivatives (more complicated and specialized)
There is no definitive rule for distinguishing one from the other, so the distinction is mostly a matter of custom.

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Types of Derivatives
The range of derivatives is really wide. But some of the most commonly known derivatives are:

Forwards-This is a tailor-made contract between two parties. In case of this contract, a settlement is done on a scheduled future date at today's pre-decided rate.

Futures-When two entities decide to purchase or sell an asset at a given time in the future at a given price, it is called futures contract. Futures contracts can be said to be a special kind of forward contracts, as they are customized exchange-traded agreements.

Options-It is of two different kinds such as calls and puts. Those who take calls option, they are not obligated to purchase given quantity of the underlying variable, at a mentioned price on or prior to a scheduled future date. On the other hand, buyers in case of puts option may not necessarily sell a mentioned quantity of the underlying variable at a mentioned price on or prior to a given date.

Swaps-These are private contracts between two entities to deal in cash flows in the future following a pre-decided formula. They are somewhat like forward contracts' portfolios. Swaps are also of two types such as interest rate swaps and currency swaps.

Interest rate swaps-in this case, only interest related cash flows can be exchanged between the entities in one currency.

Currency swaps-in this case of swapping, principal and interest can be exchanged in one currency for the same in other form of currency.
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Importance of Derivatives
Financial transactions are fraught with several risk factors. Derivatives are instrumental in alienating those risk factors from traditional instruments and shifting risks to those entities that are ready to take them. Some of the basic risk components in derivatives business are: * Credit Risk: When one of the two parties fails to perform its role as per the agreement, this is called the credit risk. It can also be referred to as default or counterparty risk. It varies with different sources. * Market Risk: This is a kind of financial loss that takes place due to the adverse price movements of the underlying variable or instrument. * Liquidity Risk: When a firm is unable to devise a transaction at current market rates, it can be referred to as liquidity risk. There are two kinds of liquidity risks involved in the scenario. First is concerned with the liquidity of separate items and second is related to supporting the activities of the organization with funds comprising derivatives. * Legal Risk:Legal issues related with the agreement need to be scrutinized well, as one can deal in derivatives across the different judicial boundaries.
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Derivatives Markets in India
India had started with a controlled economic system and from there it moved on to become a destination that witnesses constant fluctuation in prices on a daily basis now. Persistent efforts of Reserve Bank of India (RBI) in building currency forward market and liberalization process provided the risk management agencies their much needed momentum. Derivatives are the indispensable components of liberalization process to handle risk. With National Stock Exchange (NSE) measuring the market demands, the process of launching derivative markets in India got started. In the year 1999, derivatives trading took place in India.

Indian derivatives markets can be divided into two types including 1) the transaction which depends on the exchange, and 2) the transaction which takes place 'over the counter' in one-to-one scenario. They can thus be referred to as: * Exchange Traded Derivatives * Over the Counter (OTC) Derivatives * Over the Counter (OTC) Equity Derivatives * Operators in the Derivatives Market
There are different kinds of traders in the derivatives market. These include: * Hedgers-traders who are interested in transferring a risk element of their portfolio. * Speculators-traders who deliberately go for risk components from hedgers in look out for profit.

* Arbitrators-traders who work in various markets at the same time in order to gain profit and do away with mis-pricing.

OTC and exchange-traded
In broad terms, there are two distinct groups of derivative contracts, which are distinguished by the way they are traded in the market: * Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts are difficult because trades can occur in private, without activity being visible on any exchange. According to the Bank for International Settlements, the total outstanding notional amount is $684 trillion (as of June 2008). Of this total notional amount, 67% are interest rate contracts, 8% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other. Because OTC derivatives are not traded on an exchange, there is no central counter-party. Therefore, they are subject to counter-party risk, like an ordinary contract, since each counter-party relies on the other to perform. * Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange. A derivatives exchange acts as an intermediary to all related transactions, and takes Initial margin from both sides of the trade to act as a guarantee. The world's largest derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), and CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade and the 2008 acquisition of the New York Mercantile Exchange). According to BIS, the combined turnover in the world's derivatives exchanges totaled USD 344 trillion during Q4 2005. Some types of derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments such as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges. Also, warrants (or "rights") may be listed on equity exchanges. Performance Rights, Cash xPRTs and various other instruments that essentially consist of a complex set of options bundled into a simple package are routinely listed on equity exchanges. Like other derivatives, these publicly traded derivatives provide investors access to risk/reward and volatility characteristics that, while related to an underlying commodity, nonetheless are distinctive.
Common derivative contract types
There are three major classes of derivatives: 1. Futures/Forwards are contracts to buy or sell an asset on or before a future date at a price specified today. A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold, whereas a forward contract is a non-standardized contract written by the parties themselves. 2. Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. The option contract also specifies a maturity date. In the case of a European option, the owner has the right to require the sale to take place on (but not before) the maturity date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity date. If the owner of the contract exercises this right, the counter-party has the obligation to carry out the transaction. 3. Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets.

Uses
Derivatives are used by investors to * provide leverage or gearing, such that a small movement in the underlying value can cause a large difference in the value of the derivative * speculate and to make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level) * hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out * obtain exposure to underlying where it is not possible to trade in the underlying (e.g., weather derivatives) * create optionability where the value of the derivative is linked to a specific condition or event (e.g., the underlying reaching a specific price level)

Some common examples of these derivatives are:

UNDERLYING | CONTRACT TYPES | | Exchange-traded futures | Exchange-traded options | OTC swap | OTC forward | OTC option | Equity | DJIA Index future
Single-stock future | Option on DJIA Index future
Single-share option | Equity swap | Back-to-back
Repurchase agreement | Stock option
Warrant
Turbo warrant | Interest rate | Eurodollar future
Euribor future | Option on Eurodollar future
Option on Euribor future | Interest rate swap | Forward rate agreement | Interest rate cap and floor
Swaption
Basis swap
Bond option | Credit | Bond future | Option on Bond future | Credit default swap
Total return swap | Repurchase agreement | Credit default option | Foreign exchange | Currency future | Option on currency future | Currency swap | Currency forward | Currency option | Commodity | WTI crude oil futures | Weather derivatives | Commodity swap | Iron ore forward contract | |

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Submitted by
Amit Retawade
Ashlesh Shinde
Amol Chavan
Ankit Thakker
Ankit Shah