 | neerajsingh18 Jul 31 |
JAIIB Paper 1 (IE and IFS) Module D Unit 8 : Derivatives Market (New Syllabus) IIBF has released the New Syllabus Exam Pattern for JAIIB Exam 2023. Following the format of the current exam, JAIIB 2023 will have now four papers. The JAIIB Paper 1 (Indian Economy & Indian Financial System) includes an important topic called "Derivatives Market". Every candidate who are appearing for the JAIIB Certification Examination 2023 must understand each unit included in the syllabus. In this article, we are going to cover all the necessary details of JAIIB Paper 1 (IE and IFS) Module D (FINANCIAL PRODUCTS AND SERVICES ) Unit 8 : Derivatives Market , Aspirants must go through this article to better understand the topic, Derivatives Market and practice using our Online Mock Test Series to strengthen their knowledge of Derivatives Market. Unit 8: Derivatives Market Introduction - Derivatives are financial instruments, whose values are based on the value of an underlying asset.
- Derivatives are important tools for hedging risks as well as for speculation.
- Derivatives can be Over the Counter products, as well as exchange traded instruments.
- Types: Forwards, futures, options and swaps
What Is A Derivative? In terms of guidelines issued by RBI, A derivative is a financial instrument: - Whose value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or similar variable (called the 'underlying');
- That requires no initial net investment or little initial net investment relative to other types of contracts that have a similar response to changes in market conditions; and
- That is settled at a future date.
- A derivative security is a financial contract whose value is derived from the value of something else, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices.
- A simple commonplace example of derivative is butter, which Is derivative of milk. The price of butter depends upon price of milk, which in turn, depends upon the demand and supply of milk.
- The asset underlying a derivative may be commodity or a financial asset. For example, the price of gold or a currency, say, like US Dollars to be delivered after two months will depend, amongst other things, on the present and expected price of this commodity/currency.
Derivatives are also defined under Section 2(ac) of Securities Contract Regulation Act (SCRA), 1956. In terms of the said Act, a Derivative is: - "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".
Underlying Assets As we have seen, the value of a derivative instrument depends upon the value of an underlying asset. The underlying asset may assume many forms: - Commodities including grains, coffee, pulses, etc.;
- Precious metals like gold and silver;
- Natural resources like oil and gas;
- Foreign exchange rates or currencies;
- Bonds of different types, including medium to long-term negotiable debt securities issued by governments, corporates, etc.;
- Shares and share warrants of companies, traded on recognised stock exchanges;
- Stock Indexes;
- Short term securities such as T-bills; and
- Over-the-Counter (OTC) money market products, such as loans or deposits.
Exchange Traded and Over-The-Counter Markets Derivatives can trade on organised exchanges like the New York Stock Exchange, Chicago Board of Trade and National Stock Exchange or be traded/issued over-the-counter (OTC). Exchange-Traded Markets - Standardisation of the contracts: Terms and conditions are precisely specified by the exchange.
- This specification applies to features like the schedule of expiry dates and contract amounts.
- Participants: Market-makers (dealers) and speculators who are typically exchange members.
- The interplay between market makers and speculators creates a more liquid and more orderly market.
- The standardisation also ensures that clearing (verification of transaction and identities) and settlement (transfer of money) of derivatives contracts happens efficiently and allows for the provision of a credit guarantee by the clearinghouse.
- The clearing house can provide this guarantee through the requirement of a cash deposit called a margin.
Over-the-Counter (OTC) Markets - OTC markets provide a substitute for firms wishing to trade non-standardised products.
- Risk management activities become more complicated.
- Example of OTC derivative is the forward foreign exchange contract. It can be difficult for a dealer to find an OTC contract that is a perfect match to hedge a position, and they usually have to rely on similar transactions in which, they can lay off their risk.
- The ability to customize OTC contracts does not necessarily make the market less liquid than the standardised exchange-traded contracts.
- OTC markets have a lower level of regulation than exchange-traded markets. However, post the 2008 Global Financial Crisis, regulatory oversight has increased.
Participants In The Derivatives Market 
- Hedgers: They use derivatives markets to reduce or eliminate the risk associated with price of an asset. Majority of the participants in derivatives market belongs to this category.
- Speculators: They transact 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: Their behaviour is guided by the desire to take advantage of a discrepancy between prices of more or less the same assets or competing assets in 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.
Functions Of Derivatives - Price Discovery
- Transfer of Risk
- Hedging Price Risk
- Lower Transaction Cost
- Provide Access to Unavailable Assets and Markets
- Higher Leverage
Types Of Derivatives 
Futures A futures contract is a standardised forward contract, a legal agreement to buy or sell some asset at a predetermined price, at a specified time in the future, between parties not known to each other. The asset transacted is usually a financial instrument or commodity. Currency Futures Currency futures are exchange-traded contracts that specify the price in one currency at which, another currency can be bought or sold at a future date. Currency futures contracts are legally binding and counterparties that are still holding the contracts on the expiration date must deliver the currency amount, at the specified price, on the specified delivery date. 
Options An option is a contract which gives the buyer (holder) the right, but not the obligation, to buy or sell specified quantity of the underlying assets, at a specific (strike) price, on or before, a specified time (expiration date). 
- The underlying assets may be physical commodities, like wheat/rice/cotton/gold/ oil or financial instruments like equity stocks/stock index/bonds, etc.
- Option buyer gets the privilege to legally back out, from a contract.
Some terminologies associated with options transactions are as follows: - Underlying: The specific security/asset/index on which, an options contract is based (e.g., a foreign currency).
- Option Premium: Premium is the price paid by the buyer to the seller, to acquire the right to buy or sell the option.
- Strike Price or Exercise Price: The strike or exercise price of an option is the specified/pre-determined price of the underlying asset, at which, the same can be bought or sold, if the option buyer exercises his right to buy/sell on or before the expiration day. The buyer of the Option can choose the Strike Price he wants, according to which, the premium will change.
- Expiry date: The date on which, the option expires is known as expiry date. On the expiry date, either the option is exercised, or it expires unutilised.
- Call option: It is an option that gives the buyer of the option the right to BUY the underlying asset, at the strike price, on or before the expiry date.
- Put option: It is an option that gives the buyer of the option the right to SELL the underlying asset, at the strike price, on or before the expiry date. Open Interest: The total number of options contracts outstanding in the market at any given point of time.
- Option Holder: is the one who buys an option which can be a call or a put option. He/she enjoys the right to buy or sell the underlying asset, at a specified price, on or before specified time.
- Option seller/writer: is the one who is obligated to buy from the option holder (in case of put option) or to sell to the option holder (in case of call option), the underlying asset in case the buyer of the option decides to exercise his option.
- American Option: It is the one, which can be exercised by the buyer on or before the expiration date, e., anytime between the day of purchase of the option and the day of its expiry.
- European Option: It is the one, which can be exercised by the buyer on the expiration day only, and not any time before that.
- Call Options: A call option gives the holder (buyer) the right to BUY specified quantity of the underlying asset at the strike price, on or before expiration date. The seller or writer of the option, however, has the obligation to sell the underlying asset, if the buyer of the call option decides to exercise his option to buy.
- Put Options: A Put option gives the holder (buyer), the right to SELL specified quantity of the underlying asset, at the strike price, on or before expiry date. The seller of the put option, however, has the obligation to buy the underlying asset at the strike price, if the buyer of the option decides to exercise his option to sell.
Swaps - A swap refers to an exchange of one financial instrument for another between the parties concerned.
- This exchange takes place at a predetermined time, as specified in the contract.
- In financial markets, the two parties to swap a transaction contract, exchange cash flows.
- An interest rate swap is a customised bilateral agreement, in which, the cash flows are determined by applying a pre-arranged formula, on a notional principal,
- whereas in a currency swap, physical exchange of one currency against another takes place at pre-determined prices.
3 types of Swaps: - Currency swaps,
- Interest rate swaps and
- Credit default swaps.
Currency Swaps - A currency swap is an agreement in which, two parties exchange the principal amount of a loan and the interest in one currency for the principal and interest in another currency.
- At the inception of the swap, the equivalent principal amounts are exchanged at the spot rate.
- Companies requiring foreign currency borrowings can use their natural advantage to borrow in their home currencies and thereafter, swap the same into foreign currency.
Interest Rate Swaps - An interest rate swap (IRS) is an agreement in which, one stream of future interest payments is exchanged for another, based on a specified principal amount.
- Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa.
- IRSs can be, either floating to fixed or from fixed to floating and are used by entities to reduce their costs, as well as to protects themselves from adverse movements in interest rate.
Credit Default Swaps (CDS) - A credit default swap (CDS) is a financial derivative or contract that allows an investor to "swap" or offset his or her credit risk, with that of another investor.
- For example, if a lender is worried that a borrower is going to default on a loan, the lender could use a CDS, to offset or swap that risk.
- To swap the risk of default, the investor/lender buys a CDS from a CDS seller, who agrees to reimburse the investor in the case the borrower defaults.
- Most CDS contracts are maintained via an ongoing premium payment,
- similar to the regular premiums paid on an insurance policy. A credit default swap is emerging rapidly in India and are mainly directed to cover default risks associated with corporate bonds.
- RBI has, also, recently issued guidelines governing CDS in India.
Rbi Guidelines On Credit Default Swaps - RBI issued draft guidelines for Credit Default Swaps in February 2021. Under the said guidelines, RBI has proposed to allow retail users undertake transactions in permitted credit derivatives for hedging their underlying credit risk.
- Non-retail users shall be allowed to undertake transactions in credit derivatives for both hedging and other purposes.
- The RBI guidelines have been issued as a measure for development of a market for corporate bonds, especially for the bonds of lower rated issuers.
- According to the draft guidelines, exchanges may offer standardised single-name CDS contracts with guaranteed cash settlement.
- Retail users shall undertake transactions in exchange-traded CDS only for hedging their underlying credit risk.
User classification - Any user who is not eligible to be classified as a non-retail user will be classified as a retail user.
- Non-retail users will include insurance companies, pension funds, mutual funds, alternate investment funds, foreign portfolio investors.
- These entities will also be eligible to act as protection seller in CDS.
- Standalone primary dealers (SPDs) and non-banking finance companies (NBFCs), including housing finance companies (with minimum net owned funds of Rs 500 crores) and resident companies (with minimum net worth of Rs 500 crores), too, will be classified as non-retail users.
Eligible debt instruments - Commercial Papers,
- Certificates of Deposit and
- Non-Convertible Debentures of original maturity, up to one year,
- Rated Indian Rupee (INR) denominated corporate bonds (listed and unlisted) and
- Unrated INR bonds issued by the Special Purpose Vehicles set up by infrastructure companies.
- Shall be in dematerialised form only.
- Asset-backed securities/mortgage-backed securities and structured obligations such as credit enhanced/guaranteed bonds, convertible bonds, bonds with call/put options, etc., shall not be permitted as reference and deliverable obligations.
- Market-makers, who are entities that can buy and sell protection from/to users and other market-makers, in order to provide liquidity to the market – will include Scheduled Commercial Banks (except Small Finance Banks, Payment Banks, Local Area Banks and Regional Rural Banks) and NBFCs, including HFCs, and SPDs with minimum net owned funds of Rs 500 crores.
Restrictions - The RBI said market-makers and users shall not enter into CDS transactions if the counterparty is a related party or where the reference entity is a related party to either of the contracting parties.
- Further, marketmakers and users shall not buy/sell protection on reference entities, if there are regulatory restrictions on assuming similar exposures in the cash market or in violation of any other regulatory restriction, as may be applicable.
PDF-JAIIB Paper 1 IE & IFS Module D Unit 8- Derivatives Market (Ambitious Baba) 
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