MBA Introduction Derivatives Market Definition Short Model Sample Paper
MBA Introduction Derivatives Market Definition Short Model Sample Paper
Introduction to derivatives market; Definition, Evolution and features of derivatives, Types of derivatives, Forward, future and Options market, Forward market transactions, Forward contracts, Forward market in India, Hedging with forwards
SHORT ANSWER QUESTIONS:
Qus.1. Define futures or futures contract.
Ans. Futures/Futures Contract: A futures contract can be defined as an agreement to buy or sell a standard quantity of a specific instrument at a predetermined future date and at price agreed between the parties through open outcry on the floor of an organised futures exchange.
Futures are considered to be better when compared to forwards because of the following reasons:
- Standard volume.
- Counter party guarantee by exchange.
- Intermediate cash flows.
Qus.2. Define the term financial derivatives.
Ans. Financial Derivatives: Financial derivatives are financial instruments that are linked to a specific financial instrument or indicator or commodity and through which specific financial risks can be traded in financial markets in their own right. The financial derivatives were also known as off-balance sheet instruments because no assets or liabilities underlying the contract were put on the balance sheet as such.
In the Indian context, the Securities Contracts (Regulation) Act, 1956 defines derivatives’ to include:
- 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.
- A contract which derives its value from the prices or index of prices, of underlying securities.
Therefore, derivatives are specialized contracts to facilitate temporarily for hedging which is protection against losses resulting from unforeseen price or volatility changes. Thus, derivatives are a very important tool of risk management,
Qus.3. What are the features of derivatives?
Ans. Features of Derivatives: Derivatives can be defined as a contractor an agreement for exchange of payments, whose value is derived from the value of an underlying asset. In simple words, the price of derivative depends on the price of other assets.
Following are the main features of derivatives:
- The transactions in derivatives are separate from the transactions in the underlying securities.
- The financial derivatives are priced according to the value of the underlying assets.
- Financial derivatives are used for a wide variety of reasons such as hedging, risk management and in many cases, for speculation.
- The settlement of derivatives generally takes place through net payment of cash. It is also generally done before the maturity date.
- Financial derivatives allow for geared returns, which are generally higher than the returns made by investing in the underlying. However, it also increases the risk. For example, paying the premium is all that is required to invest in options. The potential returns can be substantial.
- The risk involved with derivative trading may be mitigated through trading or throwth contract. The offset ability of the derivatives can be achieved through the use of options other hedging activities.
Qus 4. What are the common variants of derivative contracts?
Ans. Some of the common variants of derivative contracts are as follows:
- Forward Market: A market in which foreign exchange is bought and sold for future delivery! known as forward market. It deals with transactions (sale and purchase of foreign exchange) volkich are contracted today but implemented sometimes in future. Exchange rate that prevails in a forward contract for purchase or sale of foreign exchange is called forward rate. Thus, forward rate is the ratta at which a future contract for foreign currency is made.
A forward contract is a customized contract between the buyer and the seller where settlement takes place on a specific date in future at a price agreed today. In case of a forward contract, the price which is paid/received by the parties is decided at the time of entering into contract. It is the simplest form of derivative contract mostly entered by individual in day to day life.
- Future Market: A future market or future exchange is a central financial exchange where people can trade standardized future contracts, I e, a contract to buy or sell an asset on a future date at a price specified today.
A future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Future contracts are special types of forward contracts in the sense that! the former are standardized exchange-traded contracts.
- Option Market: The option market refers to the sum total of all the buying and selling of option contracts which are conducted and may be described either on a global or a regional basis. The option trading market is closely tied to the stock market, as one of the most widely traded types of option is the stock option. Options are also available based on other financial instruments, such as futures, commodities, currencies and indices.
Options are contracts that give the right, but not the obligation to either buy or sell a specific underlying security for a specified price (called as strike/exercise price) on or before a specific date, In theory, option can be written on almost any type of underlying security. Equity (stock) is the most common, but there are also several types of non-equity options, based on securities such as bonds foreign currency. indices or commodities such as gold or oil. The person who buys an option is normally called the buyer or holder. Conversely, the seller is known as the seller or writer.
- Swap Market: Swap market is a market in which a borrower with one type of loan exchanges it! with another borrower having a different type of loan. Each borrower is looking for an advantage that the original loan did not have, e.g., that the loan is in a particular currency, has a particular interest rate, etc.
A swap is an agreement between two or more people or parties to exchange sets of cash flows over a period in future. Swaps are generally customized transactions. The swaps are innovative financing which reduces borrowing costs and to increase control over interest rate risk and fore exposure. The swap includes both spot and forward transactions in a single agreement. Swaps are at the centre of the global financial revolution. Swaps are useful in avoiding the problems of unfavorable fluctuations in fore market. The parties that agree to the swap are known as counterparties.
Qus.5. Who are the various traders in derivatives market?!
Ans. Traders in Derivatives Market: Traders in derivatives market are classified into the following! categories:
- Hedgers: These are traders who wish to eliminate price risk associated with the underlying security that is being traded. The objective is to safeguard their existing positions by reducing the risk.
- Speculators: These are pares who are adept at managing and making money out of some exogenous risks. They hake no clear interest in the underlying activity itself. They are traders with a view as well as objective of making profits.
3.Scalpers: These are person trading in the equities or options and futures market who holds a position for a very short period of time with an attempt to gain profits. They do not expect to make large profits on each trade but they generate large number of transactions throughout the trading point.
4.Arbitrageurs: These are third players who are involved in the process of simultaneous purchase securities or derivatives in one market at a lower price and sale thereof in another market at a relatively higher price.
- other traders: These include the following
(a) Individuals: These are the most important players in the market who buy or sell the contracts, They use derivatives to enhance their yield or to take out speculative positions,
(b) Banks: They include both buyers and sellers of credit risk in the market. They wish to buy protection when overexposed to a particular creditor industry whereas they will have little or posture in case of highly rated companies or fast growing companies.
(c) Financial Institutions and NBFCs: They find themselves in a similar position to the banks and are likely to be both buyers and sellers in the market.
(d) Corporate: They participate in the derivatives market to either buy or sell protection.
(e) Mutual Funds and Insurance Companies: They have an investment when they anticipate spread widening would typically be buyers of protection. Similarly, they are looking for yield enhancement and believe that spreads of a given company are expected to narrow would be
sellers of protection.
(1) Trading Members: These are the members of exchange and those who trade com their own
behalf and on behalf of clients.
Qus.6. What are the functions of derivatives market? Give its advantages and disadvantages.
Ans. Functions of Derivatives Market: Derivatives markets perform a number of economic functions:
- Price Discovery: Derivatives play a crucial role in discovering the present and future price of any commodity or financial asset. Price discovery reveals information about future cash market prices through the futures market
- Managing Risk: Financial risks are efficiently managed by the financial derivatives and help into ensure that the value-enhancing opportunities will not be ignored.
- Price Stabilization: Derivative market helps to keep a stabilizing influence on spot prices thereby reducing the short-term fluctuations.
- Efficiency in Trading: Financial derivatives allow for free trading of risk components and this leads to improving of market efficiency.
Advantages of Derivatives
The main advantages of derivatives are as follows:
- They show the view of market participants about the future course of action for the market.
- They help to transfer risk from one party to another
- They allow for speculative trade in a more controlled manner.
- They help to generate new entrepreneurial activities.
- They indirectly help in improving the liquidity in the market.
Disadvantages of Derivatives
The disadvantages of derivatives are as follows:
- They increase instability in the financial system.
- They increase the range of fluctuations.
- They create displacement effect in the financial market.
- The use of derivatives has led to overall increase in risk for the financial markets
- Derivatives lead to increased bankruptcies.
Qus.7. Write a short note on regulation of derivatives trading in India.
Ans. Regulation of Derivatives Trading in India: The regulators strive to make securities and derivatives markets fair, transparent and orderly as market integrity and efficiency as well as customer protection are important to the success of any financial market
Derivatives market are of two types:
- Financial Derivatives Markets: They are regulated and controlled by SEBI which frame rules and regulations for financial futures trading on the stock exchanges so as to protect the interest of maestros in the market. Some of the financial derivatives are controlled by RBI such as con options and futures and interest rate futures.
- Commodities Futures Markets: They are regulated by Forward Market Commission (PMC which is entrusted to regulate commodities futures trading in India.
Qus.8. What are the salient features of forward contract?
Ans. The salient features of forward contract are as follows:
- Customized Contract: Each contract is custom designed and hence, is unique in terms of
contract size, expiration date, the asset type, quality, etc.
- Bilateral Contracts: Forward contracts are bilateral contracts A bilateral
and hence, they are exposed to counterparties risk. There is a risk contract of non-performance of obligation either of the parties, so these are riskier than to futures contracts.
- Delivery Price: The specified price in a forward contract is referred to as the delivery price. The forward price for a particular forward contract at a particular time is the delivery price that would apply if the contracts were entered into at that time. It is important to differentiate between the forward price and the delivery price. Boil are equal at the time the contract is entered into.
- Synthetic Assets: In the forward contract, derivative assets can often be contracted from the combination of underlying assets, such assets are often known as synthetic assets in the forward market.
- Long and Short Position: In forward contract, one of the parties takes a long position by agreeing to buy the asset at a certain specified future date. The other party assumes a short position by agreeing to sell the same asset at the same date for the same specified price. A party with no obligation offsetting the forward contract is said to have an open position.
- Popular Contracts: Forward contracts are very popular in foreign exchange market as well as interest rate bearing instruments. Most of the large and international banks quote the forward rate! through their ‘forward desk lying within their foreign exchange trading room.
- Settlement by Delivery on Expiration Date: In the forward market, the contract has to be settled by delivery of the asset on expiration date. In case the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which may dominate and command the price that it wants as being in a monopoly situation.
- Covered Parity: In the forward contract, covered parity or cost-of-carry relations are relation between the prices of forward and underlying assets. Such relations further assist in determining the arbitrage-based forward asset prices.
Qus.9. What do you mean by forward market transactions?
Ans. Forward Market Transactions: Forward market transactions are over-the-counter transact between two or more parties where buyer and seller enter into an agreement for future delivery something of value priced today. The parties are obligated to perform on the settlement or delivery date. The earliest forward transactions occurred during the early days of civilization where crop producers entered into informal and non-standardized arrangements to buy or sell at current market price for delivery in the future.
Without an organized exchange for the execution of a transaction in the forward market and without any formal and standardized arrangement detailing provisions of the transaction (size, settlement date and actual physical delivery of the goods or services), agency-related problems, including costs arise, which one party to the transaction fail to perform. Thus, forward transactions can be risky,
Although forward transactions take place between individuals or corporations and usually major banks or financial institutions these days, the counterparty risks still raises the exposure of the banks or the financial institutions to possible non-performance risk. To alleviate the problems associated with counterparty risk, inconvenience of physical delivery and storage-related cost, an organized forward exchange was created. The transactions in the organized forward exchange came to be known as futures. 0.10. What are the advantages and disadvantages of forward contracts? Ans. Advantages of Forward Contracts: The advantages of forward contracts are as follows:
- The trader will know in advance how much money will be received or paid.
- The contract can be tailored to the user’s exact requirements with quantity to be delivered, date and price which are all flexible.
- If the price of raw materials does increase, the forward contracts offer full-hedging.
- Payment is not required until the contract is settled.
- Forward contracts can be matched for both the time period and cash size of price exposure.
MBA Introduction Derivatives Market Definition Short Model
Disadvantages of Forward Contracts
The disadvantages of forward contracts are as follows:
- Users have to bear the spread of the contract between the buying and selling price.
- Forward contract requires tying up capital. There are no intermediate cash flows before.
- The credit worthiness of the other party may be a problem.
- Deals can only be reversed by going back to the original party and offsetting the original trade.
- The user may not be able to negotiate good terms as the price may depend upon the size of the deal and how the user is rated.
- Forward contracts cannot be cancelled without the agreement of both the counterparties.
- Forward contracts are subject to default risk. There are cases in which suppliers intentionally breach the contract if they will incur a significant loss for implementing the contracts.
Qus.11. Explain hedging with forwards.
Ans. Hedging with Forwards: Hedging refers to managing risk to an extent that makes it bearable. In international trade and dealings, foreign exchange plays an important role. Fluctuations in the foreign exchange rate can have significant impact on business decisions and outcomes. Many international trade and business dealings are shelved or become unworthy due to significant exchange rate risks embedded in them. Historically, the foremost instrument used for exchange rate risk management is the forward contract. Forward contracts are customized agreements between two parties to fix the exchange rate for a future transaction. This simple arrangement would easily eliminate exchange rate
Risk, but it has some shortcomings, particularly getting a counterparty who would agree to fix the future rate for the amount and time period may not be easy. In Malaysia, many businesses are not even aware that some banks do provide forward rate arrangements as a service to their customers. By entering into a forward rate agreement with a bank, the businessman simply transfers the risk to the bank, which will now have to bear this risk. Of course, the bank in turn may have to do some kind of arrangement to manage this risk. Forward contracts are somewhat less familiar, probably because there exist no formal trading facilities, building or even regulating body.
Qus 12. What do you know about Forward Rate Agreements (FRA)?
Ans. Forward Rate Agreement: A Forward Rate Agreement or FRA is an agreement between two parties who want to protect themselves against future movements in interest rates. By entering into an FRA, the parties lock in an interest Forward rate for a stated period of time starting on a future settlement date, based on a specified notional principal amount. In simple words, a forward rate agreement is an over the-counter contract between parties that determine the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date.
The FRA determines the rates to be used along with the termination date and notional value FRAs are cash settled with the payment based on the net difference between the interest rate and the reference date in the contract. Forward Rate Agreement Payment Formula
The formula for the FRA payment takes into account five different variables. These are: FRA = the
FRA = the FRA rate
R = the reference rate
NP = the notional principal
P = the period, which is the number of days in the contract period.
Y = the number of days in the year based on the correct day-count convention for the contract.
The FRA payment amount is calculated by multiplying two terms together i.e. the settlement amount and the discount factor.
FRA payment = X 1
Qus.13. Explain the method of settlement of forward contract.
Ans. Settlement of Forward Contract: Settlement refers to the extinguishment of the obligation created under the forward contract. On the due date of the forward contract, i.e. upon the maturity, there are three possible ways of settling the obligation:
- Physical Settlement: A forward contract can be settled by the physical delivery of the underlying asset by a short investor (i.e. the seller) to the long investor (i.e. the buyer) and the payment of the agreed forward price by the buyer to the seller on the agreed settlement date.
For example, company A enters into a forward contract to buy 1 million barrels of oil at $70/barrel from company B on a future date. On that future date, company A would have to pay $70 million to company B and in exchange receive 1 million barrels of oil.
- Cash Settlement: Cash settlement does not involve actual delivery or receipt of the security. It is a method of settling forward contracts by cash rather than by physical delivery of the underlying asset. The parties settle by paying/receiving the loss/gain related to the contract in cash when the contract expires.
The cash position is the difference between the spot price of the asset on the settlement date and the agreed upon price as dictated by the forward/future contract, Cash settlement is useful and offer preferred because it eliminates much of the transaction costs that would otherwise be incurred when physically delivering a good.
- Settlement by Cancellation: Settlement by cancellation is done by entering into an offsetting contract opposite to that of the initial contract. Buyer in the initial contract can sell the assets at a new price, at any time prior to maturity or upon maturity to another party or to the original seller. Similarly, sellers in the initial contract can buy the assets from any party prior or upon the maturity seller in time prior to the initial maturity by a new price.