Trading Strategies and Accounting Procedure of Derivatives 1.1 ABOUT THE DERIVATIVES A financial derivative in India is a growing subject in Indian capital market. Trading in financial derivatives started in National Stock Exchange (NSE) in June 2000, with tools like futures and options. My research in this field is still in its initial stage and there is lot of potential scope in the field of derivative. Trading strategies in derivatives studied in the project are the basic strategies used by investors to reduce risk and gain returns. There are different strategies used according to different market situations. The strategies are developed using combination of options, futures and spot. The accounting of derivative transactions is significant subject in derivative segment. Accounting procedures and standards ensures the reliability of derivative trading. Accounting of various derivative contracts have been studied in the project report. 1
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Trading Strtegies and Accounting Procedure of Derivatives
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Trading Strategies and Accounting Procedure of Derivatives
1.1 ABOUT THE DERIVATIVES
A financial derivative in India is a growing subject in Indian capital market. Trading
in financial derivatives started in National Stock Exchange (NSE) in June 2000, with tools
like futures and options. My research in this field is still in its initial stage and there is lot of
potential scope in the field of derivative.
Trading strategies in derivatives studied in the project are the basic strategies used by
investors to reduce risk and gain returns. There are different strategies used according to
different market situations. The strategies are developed using combination of options,
futures and spot.
The accounting of derivative transactions is significant subject in derivative segment.
Accounting procedures and standards ensures the reliability of derivative trading. Accounting
of various derivative contracts have been studied in the project report.
1
Trading Strategies and Accounting Procedure of Derivatives
1.2 OBJECTIVES OF STUDY
To get informed with various terminologies in the derivative market.
To understand Payoff patterns of Derivatives Contracts in real market conditions
To be familiar with preparation of various derivatives reports for clients.
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Trading Strategies and Accounting Procedure of Derivatives
1.3 SCOPE OF STUDY
Study covered the basic knowledge of different strategies in futures & options market:
Hedging
Speculation
Arbitrage
It also includes analysis of real market prices of for two months to make comparison between
theoretical strategies and practical returns.
It also covers comprehensive study of various accounting procedure of three derivatives
contract:
Futures Contract
Option Contract
Effects Of Derivatives In Financial Statements
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Trading Strategies and Accounting Procedure of Derivatives
1.4 REVIEW OF LITERATURE
Author: Chiara Oldani (Luiss Guido Carli)
A derivative is defined by the BIS (1995) as “a contract whose value depends on the
price of underlying assets, but which does not require any investment of principal in those
assets. As a contract between two counterparts to exchange payments based on underlying
prices or yields, any transfer of ownership of the underlying asset and cash flows becomes
unnecessary”. This definition is strictly related to the ability of derivatives of replicating
financial instruments. Derivatives can be divided into 5 types of contracts: Swap, Forward,
Future, Option and Repo, the last being the forward contract used by the ECB to manage
liquidity in the European inter-bank market. These 5 types of contracts can be combined with
each other in order to create a synthetic asset/liability, which suits any kind of need; this
extreme flexibility and freedom widely explain the incredible growth of these instruments on
world financial markets.
Author: Helios Herrera (Centro de Investigation Economical (CIE), Institute
Technologic Autonomous de Mexico (ITAM)) and Enrique Schroth (University of
Lausanne)
Investment banks develop their own innovative derivatives to underwrite corporate
issues but they cannot preclude other banks from imitating them. However, during the
process of underwriting an innovator can learn more than its imitators about the potential
clients. Moving first puts him ahead in the learning process. Thus, he develops an
information advantage and he can capture rents in equilibrium despite being imitated. In this
context, innovation can arise without patent protection. Consistently with this hypothesis,
case studies of recent innovations in derivatives reveal that innovators keep private some
details of their deals to preserve the asymmetry of information.
Author: Cohen, Benjamin H4
Trading Strategies and Accounting Procedure of Derivatives
It is sometimes suggested that trading in derivatives leads to excessive volatility in
underlying asset prices relative to what would be called for by fundamental values. These
effects are tested by comparing the variances of price changes over different time horizons
before and after the start of organized derivatives trading. It is found that ratios of the
variances of multi-day and daily price movements decline for bond prices in the United States
and Germany and for stock indices in the US, Japan and the UK, though no such effect is
found for Japanese bonds. Other indicators confirm that serial correlation has tended to
decline since the introduction of derivatives. While these results offer strong grounds for
rejecting predictions of the destabilizing effects of derivatives, an alternative view, that
derivatives accelerate the price-discovery functions of cash markets, cannot be definitively
confirmed, given ambiguous breakpoint results and the many other contemporaneous
developments in financial technology. Copyright 1999 by Blackwell Publishers Ltd.
1.5 RESEARCH METHODOLOGY5
Trading Strategies and Accounting Procedure of Derivatives
Research is defined as human activity based on intellectual application in the
investigation of matter. The primary purpose for applied research is discovering, interpreting,
and the development of methods and systems for the advancement of human knowledge on a
wide variety of scientific matters of our world and the universe
RESEARCH DESIGN:
A research design is the specification of methods and procedures for acquiring the
information needed. Research design can be exploratory research or descriptive research. For
this project I have used descriptive research.
A descriptive research design a fact finding investigation with adequate interpretation.
It involves gathering data that describe events and then organizes, tabulates, depicts, and
describes the data.
SOURCES OF DATA
Sources of data are means from where information is collected for the study and
analysis purpose. There are two sources of data collection,
1. Primary Data
2. Secondary Data.
For this project I have used only secondary data. Secondary data are those data which are
collected by the other person and which are used by the researcher for his present study. I
have used the secondary data to understand the basic concept of derivatives from the
reference book N.D. Vohra and B.R. Bagri.
2.1 HISTORY OF NJ INDIA INVESTS PVT. LTD.6
Trading Strategies and Accounting Procedure of Derivatives
NJ India Invest Pvt. Ltd. is one of the leading advisors and distributors of financial
products and services in India. Established in year 1994, NJ has over a decade of rich
exposure in financial investments space and portfolio advisory services. From a humble
beginning, NJ over the years has evolved out to be a professionally managed, quality
conscious and customer focused financial / investment advisory & distribution firm.
NJ prides in being a professionally managed, quality focused and customer centric
organization. The strength of NJ lies in the strong domain knowledge in investment
consultancy and the delivery of sustainable value to clients with support from cutting-edge
technology platform, developed in-house by NJ.
NJ Fundz Network was established in year 2003 as a dedicated platform offering
comprehensive services and support to the independent financial advisors. The services
offered by NJ Fundz Network are increasingly recognized as the best and most
comprehensive in nature. The scope, depth, and quality of the services and support is
unmatched in the industry. NJ Fundz Network is proud to be the pioneers in India in
providing the 360° Advisory platform to independent advisors. With this NJ has managed to
successfully transform the business of many independent financial advisors, bringing them on
equal footing or even better than the strongest competitors in the industry.
NJ has over 8,600* NJ Fundz Network Partners and over 4,500* normal advisors
associated with us. NJ presently has over Rs. 5,050* Crores of assets under advice. NJ has
over 130* PSCs (Partner Service Centers) in 22* states spread across India. The numbers are
reflections of the trust, commitment and value that NJ shares with its clients.
2.2 VISION & MISSON
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Trading Strategies and Accounting Procedure of Derivatives
Vision of NJ India Invest Pvt. Ltd.
“To be the leader in our field of business through,
Total Customer Satisfaction
Commitment to Excellence
Successful Wealth Creation of our Customers”
Mission of NJ India Invest Pvt. Ltd
“Ensure creation of the desired value for our customers, employees and associates,
through constant improvement, innovation and commitment to service & quality. To provide
solutions which meet expectations and maintain high professional & ethical standards along
with the adherence to the service.”
2.3 360° – ADVISORY PLATFORM OF NJ INDIA INVEST PVT. LTD.
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Trading Strategies and Accounting Procedure of Derivatives
NJ believes in “360° – Advisory Platform” philosophy …
The support functions are generally in the following areas …
Business Planning and Strategy
Training and Development – Self and of employees
Products and Service Offerings
Business Branding
Marketing
Sales and Development
Technology
Advisors Resources - Tools, Calculators, etc..
Research
Communications
With this comprehensive supporting platform, the NJ Fundz Partners stays ahead of the
curve in each respect compared to other Advisors/competitors in the market.
2.4 SERVICES OFFERED AT NJ INDIA INVEST PVT. LTD.9
Trading Strategies and Accounting Procedure of Derivatives
A good product/service offering, targeted at meeting the needs of the clients, lies at
the center of any business. With customers today expecting single window solutions and
services, successful and easy integration of products is the need of the hour.
At the basic product level NJ has a basket of the following:
Mutual funds – covering all AMCs & schemes
Life Insurance (Prudential ICICI)
Fixed deposits of companies
Government/RBI bonds
Infrastructure Bonds
2.5 CUSTOMER CARE AT NJ INDIA INVEST PVT. LTD.
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Trading Strategies and Accounting Procedure of Derivatives
NJ Customer Care offers a 'Single Service Point' to all the advisors to help solve their
customer queries. Our centralized team of Customer Care Executives solves your queries at
the earliest. You can also view the latest status of all your queries online.
As an NJ Advisor you may submit your queries to Customer Case Executives by …
Telephonic
Email or
Online directly through your Advisors (Partners) Desk
Query Management:-
Automated On-line Query Management Module is used to efficiently handle the
queries of our Advisors/Associates.
Query entered is automatically forwarded to the concerned person who can immediately
solve the same.
Status is updated online and turns around time for different types of queries defined.
3.1 CONCEPT AND DEFINATION OF DERIVATIVES
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Trading Strategies and Accounting Procedure of Derivatives
Derivatives Concept:
A word formed by derivation. It means, this word has been arisen by derivation.
Something derived; it means that some things have to be derived or arisen out of the
underlying variables. A financial derivative is an indeed derived from the financial market.
The term "Derivative" indicates that it has no independent value, i.e. its value is
entirely "derived" from the value of the underlying asset. The underlying asset can be
securities, commodities, bullion, currency, live stock or anything else. The derivative itself is
merely a contract between two or more parties. Its value is determined by fluctuations in the
underlying asset. The most common underlying assets include stocks,
bonds, commodities, currencies, interest rates and market indexes. Most derivatives are
characterized by high leverage.
A very simple example of derivatives is curd, which is derivative of milk. The price
of curd depends upon the price of milk which in turn depends upon the demand and supply of
milk.
The Underlying Securities for Derivatives are:
Commodities: Castor seed, Grain, Pepper, Potatoes, etc.
Precious Metal : Gold, Silver
Short Term Debt Securities : Treasury Bills
Interest Rates
Common shares/stock
Stock Index Value : NSE Nifty
Currency : Exchange Rate
In financial terms, 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.
Referring to derivatives as assets would be a misconception, since a derivative is
incapable of having value of its own. However, some more commonplace derivatives, such as
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Trading Strategies and Accounting Procedure of Derivatives
swaps, futures, and options, which have a theoretical face value that can be calculated using
formulas, such as Black-Scholes.
The Black–Scholes model is a mathematical description of financial markets and
derivative investment instruments. The model develops partial differential equations whose
solution, the Black–Scholes formula, is widely used in the pricing of European-style options.
Derivatives are generally used as an instrument to hedge risk, but can also be used
for speculative purposes. For example, a European investor purchasing shares of an American
company of an American exchange (using U.S. dollars to do so) would be exposed to
exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase
currency futures to lock in a specified exchange rate for the future stock sale and currency
conversion back into Euros.
Derivatives are meant essentially to facilitate temporarily hedging of price risk of
inventory holding or a financial/commercial transaction over a certain period. In practice,
every derivative "contract" has a fixed expiration date, mostly in the range of 3 to 12 months
from the date of commencement of the contract. In the market's language, they are "risk
management tools". The use of forward/futures contracts as hedging techniques is a well-
established practice in commercial and industrial operations.
DEFINATION OF FERIVATIVES
“A derivative is a contract between a buyer and a seller entered into today regarding a
transaction to be fulfilled at a future point in time.”
For example, the transfer of a certain amount of US dollars at a specified USD-EUR
exchange rate at a future date.
Over the life of the contract, the value of the derivative fluctuates with the price of the
so-called “underlying” of the contract – in our example, the USD-EUR exchange rate. The
life of a derivative contract, that is, the time between entering into the contract and the
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Trading Strategies and Accounting Procedure of Derivatives
ultimate fulfillment or termination of the contract, can be very long – in some cases more
than ten years. Given the possible price fluctuations of the underlying and thus of the
derivative contract itself, risk management is of particular importance.
Derivative is a product whose value is derived from the value of one or more basic
variables, called bases (underlying asset, index, r reference rate) in a contractual manner.
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 an interest, share, index,
commodities or foreign exchange, etc.
In the Indian Context the Securities Contracts (Regulations) Act, 1956 (SC(R) A) defines
"derivative" to include:
1. A security derived from a debt instrument, share, loan whether secured or unsecured,
risk instrument or contract for differences or any other form of security.
2. A contract which derives its value from the prices, or index of prices, of underlying
securities.
3.2 EVOLUTION OF DERIVATIVES
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Trading Strategies and Accounting Procedure of Derivatives
Derivatives are definitely not a modern invention. They were know and were used from
ancient times. Bernstien (1992) attributes the first option transaction to the Greek philosopher
Thales from Miletus who was adept at forecasting the harvest of olives in the ensuing season.
He predicted an outstanding next autumn and so also the demand for the olive presses.
Therefore he entered in to agreements with olive press owners before autumn for the
exclusive use of their presses. For this he paid the deposits in advance with an agreement that
he will not demand his money if the harvest is not good. When the harvest time came, there
was plenty of demand for the presses and since he had the rights to use them, he hired out
them at high prices and made big money. Though Thales was not interested in making
money, all he wanted was to prove that philosophers can make money if they do so desire.
This is a primitive form of derivatives where Thales knew well in advance that his maximum
loss will be the advance he paid while his profits depended on what he demand.
Most future markets have evolved from the basic commodity market and agricultural
futures were the foremost contracts that made their appearance long before financial futures.
Agricultural futures are not unfamiliar contracts- in most parts of the world, money lenders
used to compel most of their borrowers to sell their forthcoming crop at a price agreed upon
at the time of taking the loan. The way these agreements are futures but their price were not
determined at arm’s length distance nor the contract are liquid enough. Still they represent the
forerunners to the relatively organized future that evolved subsequently in the 18 th century in
the US. though there are reports of future trading on Amsterdam bourse after its creation in
1611.
3.2.1 DERIVATIVES INTRODUCTION IN INDIA
The first step towards introduction of derivatives trading in India was the
promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the
prohibition on options in securities. SEBI set up a 24 – member committee under the
chairmanship of Dr. L.C. Gupta on November 18, 1996 to develop appropriate regulatory
framework for derivatives trading in India, submitted its report on March 17, 1998. The
committee recommended that the derivatives should be declared as ‘securities’ so that
regulatory framework applicable to trading of ‘securities’ could also govern trading of
derivatives.
To begin with, SEBI approved trading in index futures contracts based on S&P CNX
Nifty and BSE-30 (Sensex) index. The trading in index options commenced in June 2001 and
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Trading Strategies and Accounting Procedure of Derivatives
the trading in options on individual securities commenced in July 2001. Futures contracts on
individual stocks were launched in November 2001.
3.3 NEED AND IMPORTANCE OF DERIVATIVES MARKET
The following points shoes the need for the derivative market:
1. To help in transferring risks from risk averse people to risk oriented people
2. To help in the discovery of future as well as current prices
3. To catalyze entrepreneurial activity
4. To increase the volume traded in markets because of participation of risk averse people
in greater numbers
5. To increase savings and investment in the long run
IMPORTANCE OF DERIVATIVES
India's three-year old futures and options market is the on the verge of fast becoming
a haven for retail investors. They are slowly emerging as instruments for mass investment,
hedging and speculation. What is noteworthy is that notwithstanding stringent margins, a
small set of scripts and surveillance and reporting requirements still the derivatives volume
have surpassed cash market volumes within such a short time. Derivatives have a number of
advantages such as hassle free settlement, lower transaction cost, flexibility in terms of
various permutations and combinations of trading strategies etc.
Managing risk
There are several risks inherent in financial transactions. Derivatives allow you to
manage these risks more efficiently by unbundling the risks and allowing either hedging or
taking only one risk at a time.
For example, If we buy a share of we take the following risks:
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Trading Strategies and Accounting Procedure of Derivatives
Price risk that share may go up or down due to company specific reasons
(unsystematic risk).
Price risk that share may go up or down due to reasons affecting the sentiments of the
whole market (systematic risk).
Liquidity risk, if our position is very large, that we may not be able to cover our
position at the prevailing price (called impact cost).
Cash out-flow risk that we may not able to arrange the full settlement value at the
time of delivery, resulting in default, auction and subsequent losses.
Once investor is long on share investor can hedge the systematic risk by going short
on share Futures. On the other hand, if investors do not want to take unsystematic risk on
anyone share, but wish to take only systematic risk - investor can go long on Index Futures,
without buying any individual shares.
Speculation
Derivatives offer an opportunity to make unlimited money by way of speculation.
Speculators are of two types. One type is of optimistic variety, and sees a rise in prices in
future. He is known as 'bull'. The other type is a pessimist, and he sees a fall in prices, in
future. He is known as 'bear'. They undertake 'futures' transactions with the intention of
making gains through difference in contracted prices and future cash market price prices. If,
in future, their expectations turn out to be true, they gain and if not they lose. Of course, they
may limit their losses through options.
High leverage
Leverage opportunities are often expensive and complicated to implement for many
investors in the cash market, or are simply not feasible. However, options and futures
represent (highly) levered investments in the underlying cash instruments. They require only
a small fraction of the investment in the underlying securities. The case is most obvious for
futures, where there is essentially no initial investment except margin payments.
17
Trading Strategies and Accounting Procedure of Derivatives
Arbitrage
Arbitrageurs profit from price differential existing in two markets by simultaneously
operating in two different markets. Arbitrage can be done between two instruments when
they are related to each other, but they are temporarily mispriced. For example, the futures
price and spot price are related by the interest rate, time to maturity and corporate benefit, if
any, in the interregnum.
Hedging mechanism
Derivatives provide an excellent mechanism to hedge the future price risk. Hedging is
a mechanism to reduce price risk inherent in open positions. Derivatives are widely used for
hedging. A hedge can help lock in existing profits. Its purpose is to reduce the volatility of a
portfolio, by reducing the risk. Hedging is used to protect portfolio volatility due to market
fluctuation during budget, elections and other political or corporate turmoil. The basic rule in
hedging is that the risk of loss in portfolio is offset by the gains in the futures or options.
Hence hedging is beneficial. Thus hedging helps to reduce risk by locking returns but does
not maximize them rather it minimizes the loss arising out of adverse situations. One needs to
keep in mind that hedging does not make money but removes unwanted risk by reducing the
losses.
They can also be important for,
1. Efficient Allocation of Risk
2. Lower Cost of Hedging
3. Liquidity
4. Risk Management
3.4 THE PARTICIPANTS IN A DERIVATIVES MARKET
18
Trading Strategies and Accounting Procedure of Derivatives
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 example, 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.
3.5 FUNCTIONS PERFORMED BY THE DERIVATIVE MARKET
Price Discovery19
Trading Strategies and Accounting Procedure of Derivatives
The futures and options market serve an all important functions of price discovery.
The individuals with better information and judgment are liable to participative in these
markets to take advantage of such information. When some new information arrives, perhaps
some good news about the economy, for instance, the actions of speculators quickly feed
their information into the derivatives markets causing changes in prices of the derivatives. As
these markets are usually the first ones to react because the transaction cost is much lower in
these markets than in the spot market. Therefore, these markets indicate what is likely to
happen and thus assist in better price discovery.
Risk Transfer
By their very nature, the derivative instruments do not themselves involve risk.
Rather, they merely redistribute the risk between the market participants. In this sense, the
whole derivatives market may be compared to a gigantic insurance
company providing means to hedge against adversities of unfavorable market
movements in return for a premium, and providing means and opportunities to those who are
prepared to take risks and make money in the process.
Market Completion
The existence of derivative instruments adds to the degree of completeness of the
market. A complete market implies that the number of independent securities is equal tithe
number of all possible future states of the economy. The derivative instruments of futures and
options are the instruments that provide the investor the ability to hedge against possible odds
in the economy. A market would be said to be complete if instruments may be created which
can, solely or jointly, provide a cover against all the possible adverse outcomes. It is held that
a complete market can be achieved only when, firstly, there is a consensus among all
investors in the economy as to the number of odds, or states, that the economy can land up
with, and, secondly, there should exists an 'efficient fund' on which simple options can be
traded. Here an efficient fund implies a portfolio of basic securities that exist in the market
with the property of having a unique return for every possible outcome, while a simple option
is one whose payoff depends only on one underlying return.
3.6 TYPES OF DERIVATIVES
20
Trading Strategies and Accounting Procedure of Derivatives
The modem derivatives market provides a wide range of products linked to the key
factors affecting financial and commercial performance. Whether it is a small domestic
importer or a transnational manufacturing giant, external risk is common to business. These
factors include interest rates, foreign exchange, equity values and commodity prices. The
power of derivative instruments manages and finds opportunity in risks.
Equity Linked Derivatives
The equity derivatives were almost usual in order for the risk and reward profile of
equity investments to remain competitive with the fixed income offered by debt instruments
such as bonds. Initially large institutional investors in Europe, Japan and the United States
were the primary users, but today, however, even small investors have a direct means to
manage equity risk. Equity derivative instruments allow investors to structure requirements in
terms of market timing and risk-reward profile. Importantly, the use of derivatives has
changed the nature of equity portfolio management. Traditional techniques such as
fundamental and technical analysis, diversification strategies and asset allocation strategies
now rank alongside the derivative risk management as means of achieving investment
objectives.
Interest Rate Swaps
Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. Interest rate swaps make use of one party's comparative advantage in the capital
market strong issuer of notes are able to borrow through fixed, cheap rate funds. Weaker
borrowers only have access to floating rate loans. By exchanging their payment obligations
through a swap, both parties are able to obtain a lower cost of funds.
From this pattern of strong issuer weak borrower and the source of capital markets for
credit, the swap market has developed into the primary method of managing interest rate risk.
This success has also encouraged intermediaries to introduce a diverse array of further
innovations, essentially derivatives upon derivatives, including interest rate caps, collars,
floors and options on interest rate swaps- known as swaptions.
Foreign Exchange Derivatives
21
Trading Strategies and Accounting Procedure of Derivatives
The main foreign exchange linked derivatives are currency swaps, long dated
forwards, currency options and combinations of the above. For borrowers, access to currency
derivatives ensures that they have access to the lowest cost capital markets around the world.
The international capital markets through foreign exchange derivatives markets, encourages a
competitive cost of capital. In addition to this integration role, foreign exchange derivatives
serve a very real purpose. Foreign exchange fluctuations affect the competitive positions of
companies, the cost of borrowings abroad and the returns on global investment portfolios.
Precise commercial and financial objectives can be managed through such derivatives.
Commodity Linked Derivatives
The commodity derivatives are designed to satisfy the needs of producers, refiner and
consumers of the world's materials. The original derivatives market, commodity derivatives
satisfy the needs of participants to manage price risk. Commodity price risk often forms the
core business of users of such derivatives. Liquidity, solvency and possibly even survival
demand the use of derivatives. Today, active users include oil producers, airline companies,
electricity generation companies, mining companies to mention a few. Commodity
derivatives are also being used with lenders and investors to ensure the returns and carrying
capacity of new projects.
3.7 TYPES OF DERIVATIVES CONTRACTS
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Trading Strategies and Accounting Procedure of Derivatives
In broad terms, there are two distinct groups of derivative contracts, which are
distinguished by the way they are traded in the market:
1.OTC and
2.Exchange-traded
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. 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. 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. 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.
FORWARD CONTRACTS
23
Trading Strategies and Accounting Procedure of Derivatives
A forward contract is the simplest mode of a derivative transaction. It is an agreement
to buy or sell an asset at a certain future time for a certain price. The essential idea of entering
into a forward contract is to peg the price and thereby avoid the price risk.
It is an agreement between a buyer and a seller in which the buyer has the right and
obligation to buy a specified assets on a specified date and at a specified price. The seller is
also under an obligation to perform as per the terms of the contract.
One of the parties to the contract assumes a long position and agrees to buy the
underlying asset on certain specified future date for a certain specified price. The other party
assumes a short position and agrees to sell on the same asset on the same date for same
specified price.
Features of forward contracts
They are the bilateral contracts and hence exposed to counter-party risk
Each contract is custom designed, and hence is unique in terms of contract size,
expiration date and the asset type and quality.
The contract is generally not available in public domain on the expiration date, the
contract has to be settled by delivery of the assets.
If the party wishes to reverse the contract, it has to compulsorily go to the same
counterparty, which often results in high prices being charged.
Limitations of forward contracts
Lack of centralization of trading
Illiquidity
Counter party risk
FUTURE CONTRACTS
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Trading Strategies and Accounting Procedure of Derivatives
Futures contracts designed to solve the problems that exist in forward markets.
Futures contracts are standardized contracts between two parties to buy or sell an asset at a
certain time in futures at certain price.
A future are also a kind of a forward which represent obligation on the part of the
buyer and seller but the term and condition of the contract are specified by the exchange
where they are actually traded.
They are entered into through exchange, traded on exchange and clearing
corporation/house provides the settlement guarantee for trades. Hence, futures markets are