Term Paper on Financial Derivatives

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The popular assertion that derivative securities tend to destabilize the underlying asset markets has persisted for more than three centuries. To what extent is this notion theoretically justified? To what extent has it been supported by empirical evidence? This topic has been the focus of much academic scrutiny. The purpose of this paper is to provide a comprehensive review of the theoretical and empirical literature on this issue, and more generally on the relationships between underlying and derivative markets. The debate on the effects of derivative trading is closely related to the more fundamental issue of the extent to which speculative trading in general influences market prices. Accordingly, we will begin by reviewing the theoretical literature on speculation and price stability. Much of the early literature in this area focused on the role of speculators in smoothing out seasonal price fluctuations in commodity markets. As we shall see, traditional models of this flavor generally conclude that under certain restrictive assumptions, speculative trading tends to stabilize prices. When these assumptions are violated, it is often found that speculative trading can stabilize or destabilize prices, depending on parameter values. Our study analyses the effect of the introduction of derivative markets on the underlying market in the National Stock Exchange of India. More specifically we study whether the introduction of the futures and the options on the NSE Nifty -50 index has affected the volatility and the trading volume of the underlying asset. There is not a clear hypothesis about the contribution of futures and options separately, so, we attempt to synthesize the net effect of introducing these new derivative markets. Conclusions derived from the study could serve as information for the policy makers when establishing market regulations. Additionally, characteristics associated with the Indian derivative market, youth and small size could be used to test an additional hypothesis. In particular, our hypothesis is that markets with these characteristics may exhibit the effects more strongly than larger, more mature markets.


Risk is a characteristic feature of all commodity and capital markets. Over time, variations in the prices of agricultural and non-agricultural commodities occur as a result of interaction of demand and supply forces. The last two decades have witnessed a many-fold increase in the volume of international trade and business due to the ever growing wave of globalization and liberalization sweeping across the world. As a result, financial markets have experienced rapid variations in interest and exchange rates, stock market prices thus exposing the corporate world to a state of growing financial risk. Increased financial risk causes losses to an otherwise profitable organization. This underlines the importance of risk management to hedge against uncertainty. Derivatives provide an effective solution to the problem of risk caused by uncertainty and volatility in underlying asset. Derivatives are risk management tools that help an organisation to effectively transfer risk. Derivatives are instruments which have no independent value. Their value depends upon the underlying asset. The underlying asset may be financial or non-financial. The rapidity with which corporate finance, banking and investment finance have changed in recent years has given birth to a new discipline that has come to be known as Financial Engineering. Financial engineering involves the design, the development, and the implementation of innovative financial instruments and processes, and the formulation of creative solutions to problems in finance. The last decade has witnessed the introduction of ‘derivatives’ as an innovative financial instrument in the Indian markets. Derivatives are financial instruments that derive their value from the underlying, which can be a stock index, a...
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