1.

Introduction
Derivatives have become increasingly important in finance. Futures and options are actively traded on
many exchanges throughout the world. Many different types of forward contracts, swaps, options, and
other derivatives are entered into by financial institutions, fund managers, and corporate treasurers in the
over-the counter market. Derivatives are added to bond issues, used in executive compensation plans,
embedded in capital investment opportunities, used to transfer risks in mortgages from the original
lenders to investors, and so on. The derivatives market is huge—much bigger than the stock market when
measured in terms of underlying assets. The value of the assets underlying outstanding derivatives
transactions is several times the world gross domestic product. As we shall see in this assignment,
derivatives can be used for hedging or speculation or arbitrage. They play a key role in transferring a wide
range of risks in the economy from one entity to another. A derivative can be defined as a financial
instrument whose value depends on (or derives from) the values of other, more basic, underlying
variables. Very often the variables underlying derivatives are the prices of traded assets. A stock option,
for example, is a derivative whose value is dependent on the price of a stock.
Derivatives are the most actively traded financial instruments for ensuring efficiency and depth of capital
market. Establishment of a financial derivative market improves the capital structure and profit-making
ability of commercial banks. Hedgers can easily use derivative as safeguard against the risks associated
with their assets. Derivative market can play a pivotal role to strengthen the effect of monetary policy and
absorb the foreign capital into a country as it helps bring stability in the overall financial markets.
Derivatives can be traded Over-the-counter (OTC) or on exchanges. OTC derivatives are created (and
privately negotiated) by an agreement between two individual counterparties. Most of these contracts are
held to maturity by the original counterparties, but some are altered during their life or offset before
termination. Products such as swaps, forward rate agreements, and exotic options are almost always
traded in this way.
Exchange-traded derivatives (ETD), on the other hand, are fully standardized and their contract terms are
designed by derivatives exchanges. A derivatives exchange acts as an intermediary to all transactions and
takes initial margin from both sides of the trade to act as a guarantee. This research is basically qualitative
in nature and it is based on secondary data mostly collected.
This research is basically qualitative in nature and it is based on secondary data mostly collected from
various books, journals and other publications.

2. Literature Review
Over the past three decades many different studies on financial derivatives use by non-financial firms
were published, covering different aspects of derivative markets. Some most influential early studies
describing the use of derivatives by non-financial firms were ones done by the following authors: Block
and Gallagher (1986), Dolde (1993), Judge (1995), Berkman and Bradbury (1996); Bodnar and Gebhardt
(1997), Hakkarainen et al., (1997), Bodnar et al. (1998), Alkeback and Hagelin (1999), etc. According to
Greenspan (1997) by far the most significant event in finance during the past decades has been the
extraordinary development and expansion of financial derivative. Marlowe (2000) argues that the
emergence of the derivative market products most notably forwards, futures and options can be traced
back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising
out of fluctuations in asset prices. According to Sahoo (1997) the legal framework for derivatives trading
is a critical part of overall regulatory framework of derivative markets. The purpose of regulation is to
encourage the efficiency and competition rather than impeding it. Hathaway (1998) stated that, while
there is a perceived similarity of regulatory objective, there is no single preferred model for regulation of
derivative markets. Mishkin (2006) is even more adamant that derivatives are new financial instruments
that were invented in the 1970s. He suggests that an increase in the volatility of financial markets created
a demand for hedging instruments that were used by financial institutions to manage risk. Kamara (1982)
shows that introduction of commodity futures trading generally reduced or at least did not increase cash
price volatility. Bose (2007) finds that the Indian stock markets are more volatile as compared to
developed markets and Indian Commodity Futures markets are going through many ups and downs.

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There are few researches available regarding derivatives market in context to Bangladesh. Sultana et al.
(2014) analyze the benefits, risks and opportunities of financial derivatives in Bangladesh. Rahman and
Hasan (2011) stated that, due to recent catastrophic fall capital market, rapidly declining FDI and scarcity
of investment opportunities in an equity centric economy, investors of Bangladesh is crying out for an
innovative and versatile financial product such as derivative securities for hedging and market expansion.

3. Objectives of the Study

1. To define derivative securities.
2. To introduce derivative securities in Bangladesh.
3. To focus a probable use of derivative securities in Bangladesh.

4. Methodology
This study is descriptive in nature. Qualitative analysis has been used in this study. It is mainly based on
secondary data. Secondary data were collected from Journals, Magazines and related websites. Various
books and articles related to financial derivatives were also the valuable sources. Besides these, some
discussions with the finance experts, members of Bangladesh Securities Exchange Commission (BSEC)
and experts of Stock exchanges were made which provide some important information regarding
derivatives market.

5. Theoretical Analysis
5.1 Definition of Financial Derivatives
A derivative is a contract between two or more parties whose value is based on an agreed-upon
underlying financial asset (like a security) or set of assets (like an index). Common underlying
instruments include bonds, commodities, currencies, interest rates, market indexes and stocks.
Futures contracts, forward contracts, options, swaps, and warrants are common derivatives. A futures
contract, for example, is a derivative because its value is affected by the performance of the underlying
contract.
Similarly, a stock option is a derivative because its value is "derived" from that of the underlying stock.
While a derivative's value is based on an asset, ownership of a derivative doesn't mean ownership of the
asset.
Generally belonging to the realm of advanced or technical investing, derivatives are used
for speculating and hedging purposes. Speculators seek to profit from changing prices in the underlying
asset, index or security.
For example, a trader may attempt to profit from an anticipated drop in an index's price by selling
(or going "short") the related futures contract. Derivatives used as a hedge allow the risks associated with
the underlying asset's price to be transferred between the parties involved in the contract.

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Derivatives Between Two Parties
For example, commodity derivatives are used by farmers and millers to provide a degree of "insurance."
The farmer enters the contract to lock in an acceptable price for the commodity, and the miller enters the
contract to lock in a guaranteed supply of the commodity. Although both the farmer and the miller have
reduced risk by hedging, both remain exposed to the risks that prices will change.
For example, while the farmer is assured of a specified price for the commodity, prices could rise (due to,
for instance, a shortage because of weather-related events) and the farmer will end up losing any
additional income that could have been earned. Likewise, prices for the commodity could drop, and the
miller will have to pay more for the commodity than he otherwise would have.
For example, let's assume that in April 2017 the farmer enters a futures contract with a miller to sell 5,000
bushels of wheat at $4.404 per bushel in July. At expiry date in July 2017, the market price of wheat falls
to $4.350, but the miller has to buy at the contract price of $4.404, which is much higher than the market
price of $4.350. Instead of paying $21,750 (4.350 x 5000), he'll pay $22,020 (4.404 x 5000), and the
lucky farmer recoups a higher-than-market price.
Some derivatives are traded on national securities exchanges and are regulated by the U.S. Securities and
Exchange Commission (SEC). Other derivatives are traded over-the-counter (OTC); these derivatives
represent individually negotiated agreements between parties.

How Derivatives Benefit Buyers and Sellers

Let's use the story of a fictional farm to explore the mechanics of several varieties of derivatives.
Gail, the owner of Healthy Hen Farms, is worried about the volatility of the chicken market, with all the
sporadic reports of bird flu coming out of the east. Gail wants to protect her business against another spell
of bad news. So, she meets with an investor who enters into a futures contract with her.
The investor agrees to pay $30 per bird when the birds are ready for slaughter in six months' time,
regardless of the market price. If, at that time, the price is above $30, the investor will get the benefit as
they will be able to buy the birds for less than market cost and sell them on the market at a higher price
for a gain. If the price falls below $30, Gail will get the benefit because she will be able to sell her birds
for more than the current market price, or more than what she would get for the birds in the open market.
By entering into a futures contract, Gail is protected from price changes in the market, as she has locked
in a price of $30 per bird. She may lose out if the price flies up to $50 per bird on a mad cow scare, but

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she will be protected if the price falls to $10 on news of a bird flu outbreak. By hedging with a futures
contract, Gail is able to focus on her business and limit her worry about price fluctuations.
Swapping
Now Gail has decided that it's time to take Healthy Hen Farms to the next level. She has already acquired
all the smaller farms near her and wants to open her own processing plant. She tries to get more financing,
but the lender, Lenny, rejects her.
Lenny's reason for denying financing is that Gail financed her takeovers of the other farms through a
massive variable-rate loan, and Lenny is worried that if interest rates rise, she won't be able to pay her
debts. He tells Gail that he will only lend to her if she can convert the loan to a fixed-rate loan.
Unfortunately, her other lenders refuse to change her current loan terms because they are hoping interest
rates will increase, too.
Gail gets a lucky break when she meets Sam, the owner of a chain of restaurants. Sam has a fixed-rate
loan about the same size as Gail's and he wants to convert it to a variable-rate loan because he hopes
interest rates will decline in the future.
For similar reasons, Sam's lenders won't change the terms of the loan. Gail and Sam decide to swap loans.
They work out a deal in which Gail's payments go toward Sam's loan and his payments go toward Gail's
loan. Although the names on the loans haven't changed, their contract allows them both to get the type of
loan they want.
This is a bit risky for both of them because if one of them defaults or goes bankrupt, the other will be
snapped back into his or her old loan, which may require a payment for which either Gail of Sam may be
unprepared. However, it allows them to modify their loans to meet their individual needs.

Buying Debt
Lenny, Gail's banker, ponies up the additional capital at a favorable interest rate and Gail goes away
happy. Lenny is pleased as well, because his money is out there getting a return, but he is also a little
worried that Sam or Gail may fail in their businesses.
To make matters worse, Lenny's friend Dale comes to him asking for money to start his own film
company. Lenny knows Dale has a lot of collateral and that the loan would be at a higher interest rate
because of the more volatile nature of the movie industry, so he's kicking himself for loaning all of his
capital to Gail.
Fortunately for Lenny, derivatives offer another solution. Lenny spins Gail's loan into a credit
derivative and sells it to a speculator at a discount to the true value. Although Lenny doesn't see the full
return on the loan, he gets his capital back and can issue it out again to his friend Dale.
Lenny likes this system so much that he continues to spin out his loans as credit derivatives, taking
modest returns in exchange for less risk of default and more liquidity.

Options
Years later, Healthy Hen Farms is a publicly traded corporation (HEN) and is America's largest poultry
producer. Gail and Sam are both looking forward to retirement.
Over the years, Sam bought quite a few shares of HEN. In fact, he has more than $100,000 invested in the
company. Sam is getting nervous because he is worried that another shock, perhaps another outbreak of
bird flu, might wipe out a huge chunk of his retirement money. Sam starts looking for someone to take the
risk off his shoulders. Lenny, by now a financier extraordinaire and active writer of options, agrees to
give him a hand.
Lenny outlines a deal in which Sam pays Lenny a fee for the right (but not the obligation) to sell Lenny
the HEN shares in a year's time at their current price of $25 per share. If the share prices plummet, Lenny
protects Sam from the loss of his retirement savings.
Lenny is OK because he has been collecting the fees and can handle the risk. This is called a put option,
but it can be done in reverse by someone agreeing to buy a stock in the future at a fixed price (called
a call option).

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Healthy Hen Farms remains stable until Sam and Gail have both pulled their money out for retirement.
Lenny profits from the fees and his booming trade as a financier.

The Bottom Line

This tale illustrates how derivatives can move risk (and the accompanying rewards) from the risk
averse to the risk seekers. Although Warren Buffett once called derivatives "financial weapons of mass
destruction," derivatives can be very useful tools, provided they are used properly. Like all other financial
instruments, derivatives have their own set of pros and cons, but they also hold unique potential to
enhance the functionality of the overall financial system.

5.2 The Main Function of Derivatives

Derivatives are generally used to hedge risk, but it can also be used for speculative purposes. They allow
users to meet the demand for cost-effective protection against risks associated with movements in the
prices of the underlying assets. In other words, users of derivative can hedge against fluctuations in
exchange and interest rates, equity and commodity prices, as well as credit worthiness. Specifically,
derivative transactions involve transferring those risks from entities less willing or able to manage them to
those more willing or able to do so. For example, an Asian investor who uses U.S. dollars to buy shares in
a U.S. company (traded on a U.S. exchange) would be exposed to exchange-rate risk when he sells the
shares and converts dollars back to her home currency. To hedge this risk, the investor could purchase
derivative - currency futures - to lock in a favorable exchange rate. However, hedging and speculating are
not the only motivations for trading derivative. Some firms use derivative to obtain better financing terms.
For example, banks often offer more favorable financing terms to those firms that have reduced their
market risks with hedging activities than to those without. Fund managers sometimes use derivative to
achieve specific asset allocation of their portfolios.

5.3 Major Types of Derivative

There are basically four types of derivative contracts. They are forwards, futures, options and swaps.

Forward Contracts
A relatively simple derivative is a forward contract. It is an agreement to buy or sell an asset at a certain
future time for a certain price. It can be contrasted with a spot contract, which is an agreement to buy or
sell an asset today. A forward contract is traded in the over-the-counter market—usually between two
financial institutions or between a financial institution and one of its clients. One of the parties to a
forward contract assumes a long position and agrees to buy the underlying asset on a certain specified
future date for a certain specified price. The other party assumes a short position and agrees to sell the
asset on the same date for the same price. Forward contracts on foreign exchange are very popular. Most
large banks employ both spot and forward foreign-exchange traders. Spot traders are trading a foreign
currency for almost immediate delivery. Forward traders are trading for delivery at a future time. The
example provides the quotes on the exchange rate between the British pound (GBP) and the US dollar
(USD) that might be made by a large international bank on May 24, 2010. The quote is for the number of
USD per GBP. The first row indicates that the bank is prepared to buy GBP (also known as sterling) in
the spot market (i.e., for virtually immediate delivery) at the rate of $1.4407 per GBP and sell sterling in
the spot market at $1.4411 per GBP. The second, third, and fourth rows indicate that the bank is prepared
to buy sterling in 1, 3, and 6 months at $1.4408, $1.4410, and $1.4416 per GBP, respectively, and to sell
sterling in 1, 3, and 6 months at $1.4413, $1.4415, and $1.4422 per GBP, respectively. Forward contracts
can be used to hedge foreign currency risk. Suppose that, on May 24, 2010, the treasurer of a US
corporation knows that the corporation will pay £1 million in 6 months (i.e., on November 24, 2010) and
wants to hedge against exchange rate moves. Using the quotes in Table 1.1, the treasurer can agree to buy
£1 million 6 months forward at an exchange rate of 1.4422. The corporation then has a long forward
contract on GBP. It has agreed that on November 24, 2010, it will buy £1 million from the bank for

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$1.4422 million. The bank has a short forward contract on GBP. It has agreed that on November 24,
2010, it will sell £1 million for $1.4422 million. Both sides have made a binding commitment.

Payoffs from Forward Contracts

The payoff from a long position in a forward contract on one unit of an asset is ST-K where K is the
delivery price and ST is the spot price of the asset at maturity of the contract. This is because the holder of
the contract is obligated to buy an asset worth ST for K. Similarly, the payoff from a short position in a
forward contract on one unit of an asset is K-ST. These payoffs can be positive or negative.

Futures Contracts
Like a forward contract, a futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future for a certain price. Unlike forward contracts, futures contracts are normally
traded on an exchange. To make trading possible, the exchange specifies certain standardized features of
the contract. As the two parties to the contract do not necessarily know each other, the exchange also
provides a mechanism that gives the two parties a guarantee that the contract will be honored. The largest
exchanges on which futures contracts are traded are the Chicago Board of Trade (CBOT) and the Chicago
Mercantile Exchange (CME), which have now merged to form the CME Group. On these and other
exchanges throughout the world, a very wide range of commodities and financial assets form the
underlying assets in the various contracts. The commodities include pork bellies, live cattle, sugar, wool,
lumber, copper, aluminum, gold, and tin. The financial assets include stock indices, currencies, and
Treasury bonds. Futures prices are regularly reported in the financial press. Suppose that, on September 1,
the December futures price of gold is quoted as $1,080. This is the price, exclusive of commissions, at
which traders can agree to buy or sell gold for December delivery. It is determined in the same way as
other prices (i.e., by the laws of supply and demand). If more traders want to go long than to go short, the
price goes up; if the reverse is true, then the price goes down.

Options
Options are traded both on exchanges and in the over-the-counter market. There are two types of option.
A call option gives the holder the right to buy the underlying asset by a certain date for a certain price. A
put option gives the holder the right to sell the underlying asset by a certain date for a certain price. The
party with the long position (buyer) has the ability to exercise the contract or not. The party with the short
position (seller) has the obligation to exercise the contract if asked to do so. The price in the contract is
known as the exercise price or strike price; the date in the contract is known as the expiration date or
maturity. American options can be exercised at any time up to the expiration date. European options can
be exercised only on the expiration date itself. Most of the options that are traded on exchanges are
American. In the exchange-traded equity option market, one contract is usually an agreement to buy or
sell 100 shares.

Swap Contracts
A swap is an agreement between two parties to exchange cash flows in the future. The agreement defines
the dates when the cash flows will be paid. The cash flows are calculated over a notional principal
amount, which is not usually exchanged between counterparties (Hull, 2006). Examples of swaps are
currency swaps, interest rate swaps and commodity swaps. An interest rate swap is an agreement between
two parties to exchange interest obligations or receipts in the same currency on an agreed amount of
notional principal for an agreed period of time. A currency swap is an agreement between two parties to
exchange payments or receipts in one currency for payments in another. Commodity swaps are hedging
instruments; one party (commodity user/buyer) agrees to pay a fixed price for a designated quantity of a
commodity to the counter party (commodity producer/seller), who in turn pays the first party a price
based on the prevailing market price for the same quantity (Daniel Ekerumeh,2010).

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On the other hand the derivative markets can be divided into two that for exchange traded derivative and
that for over the-counter derivative. The legal nature of these products is very different as well as the way
they are trade. Some common examples of these derivatives are the followings:

Contract Types
Underlying Exchange-traded Exchange
futures traded options OTC swap OTC forward OTC option

Option on DJIA
Back-to-back Stock option
DJIAIndex future Index future
Equity Equity swap Repurchase Warrant
Single-stock future Single-share
agreement Turbo warrant
option
Option on Interest rate cap
Eurodollar future and floor
Eurodollar future Option on Forward rate Swaption
Interest rate Interest rate swap
Euribor future Euribor future agreement Basis swap
Bond
option
Option on Bond Credit default swap Repurchase Credit default
Credit Bond future future Total return swap agreement option

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 Foreign Option on
exchange Currency future currency future Currency swap Currency forward Currency option

WTI crude oil Weather Iron ore forward

Commodity futures derivative Commodity swap contract Gold option
Source: Common derivative contract types, Wikipedia

5.4 Participators in Derivative Market

Derivatives are those financial instruments which derive their value from the value of other assets. In
other words, they have no value on their own rather their value depends on the value of the underlying
asset. For example, the value of call or put options of Microsoft stock will depend on the price movement
of Microsoft stock. There are 3 important participants in the derivatives market which include the
following-

1. Hedgers – They are those who buy or sell in derivatives market in order to reduce their risk of their
portfolio. For example, if the portfolio of hedger is long then he will protect or hedge this position by
buying put options in derivatives market. Traders, who wish to protect themselves from the risk involved
in price movements, participate in the derivatives market. They are called hedgers. This is because they
try to hedge the price of their assets by undertaking an exact opposite trade in the derivatives market.
Thus, they pass on this risk to those who are willing to bear it. They are so keen to rid themselves of the
uncertainty associated with price movements that they may even be ready to do so at a predetermined cost

2. Speculators – Speculators are those who enter into the market purely for making profit by buying or
selling the derivatives, they do not have any intention of hedging their portfolio or such thing their only
aim is to make profit based on their judgment about the stock or market. As a hedger, we passed on our
risk to someone who will willingly take on risks from us. But why someone do that? There are all kinds
of participants in the market.
Some might be averse to risk, while some people embrace them. This is because, the basic market idea is
that risk and return always go hand in hand. Higher the risk, greater is the chance of high returns. Then
again, while we believe that the market will go up, there will be people who feel that it will fall. These
differences in risk profile and market views distinguish hedgers from speculators. Speculators, unlike
hedgers, look for opportunities to take on risk in the hope of making returns

3. Arbitrageurs – Arbitrage refers to obtaining risk free profits by simultaneously buying and selling
similar instruments in different markets. Arbitrageurs enter into derivative market in order to take
advantage of any such opportunity and profit from it. Arbitrageurs: Derivative instruments are valued on
the basis of the underlying asset’s value in the spot market. However, there are times when the price of a
stock in the cash market is lower or higher than it should be, in comparison to its price in the derivatives
market.
Arbitrageurs exploit these imperfections and inefficiencies to their advantage. Arbitrage trade is a low-
risk trade, where a simultaneous purchase of securities is done in one market and a corresponding sale is
carried out in another market. These are done when the same securities are being quoted at different
prices in two markets

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Margin traders: Many speculators trade using of the payment mechanism unique to the derivative
markets. This is called margin trading. When we trade in derivative products, we are not required to pay
the total value of our position up front. Instead, you are only required to deposit only a fraction of the total
sum called margin. This is why margin trading results in a high leverage factor in derivative trades. With
a small deposit, we are able to maintain a large outstanding position. The leverage factor is fixed; there is
a limit to how much you can borrow. The speculator to buy three to five times the quantity that his capital
investment would otherwise have allowed him to buy in the cash market. For this reason, the conclusion
of a trade is called ‘settlement’ – we either pay this outstanding position or conduct an opposing trade that
would nullify this amount.

6. Role of Derivative Markets

Risk Management
As derivative prices are related to the underlying spot market goods (assets), they can be used to reduce or
increase the risk of owing the spot items. For example, buying the spot item and selling a futures contract
or call option reduces the investor’s risk. If the goods price falls, the price of the futures or options
contract will also fall. The investor can then repurchase the contract at the lower price, affecting a gain
that can at least partially offset the loss on the spot item. All investors however want/need to keep their
investments at an acceptable risk level. Derivative markets enable those wishing to reduce
their risk to transfer it to those wishing to increase it, whom we call speculators.

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Because these markets are so effective at re-allocating risk among investors, no one need to assume an
uncomfortable level of risk. Consequently, investors are willing to supply more funds to the financial
markets. This benefits the economy, because it enables more firms to raise capital and keeps the cost of
that capital as low as possible.
Many investors prefer to speculate with derivatives rather than with the underlying securities. The ease
with which speculation can be done using derivatives in turn makes it easier and less costly for hedgers.
(hedge- a transaction in which some investors seek to protect a position or anticipated position in the spot
market by using an opposite position in derivatives.)

Price Discovery
Forward and futures markets are an important source of information about prices. Futures markets in
particular are considered a primary means for determining the spot price of an asset. Futures and forwards
prices also contain information about what people expect future spot prices to be. In most cases the
futures price is more active hence, information taken from it is considered more reliable than spot market
information.
Therefore, futures and forward market are said to provide price discovery. Option markets do not directly
provide forecasts of future spot prices. They do, however provide valuable information about the
volatility and hence the risk of the underlying spot asset.

Operational Advantages
Derivative markets offer several operational advantages, such as:

1. They entail lower transaction costs. This means that commission and other trading costs lower for
traders in these markets.
2. Derivative markets, particularly the futures and exchanges have greater liquidity than the spot markets.
3. The derivative markets allow investors to sell short more easily. Securities markets impose several
restrictions designed to limit or discourage short if not applied to derivative transactions. Consequently,
many investors sell short in these markets in lieu of selling short the underlying securities.

Market efficiently
Spot markets for securities probably would be efficient even if there were no derivative markets. There
are important linkages among spot and derivative prices. The ease and low cost of transacting in these
markets facilitate the arbitrage trading and rapid price adjustments that quickly eradicate these
opportunities. Society benefits because the prices of the underlying goods more accurately reflect the
goods true economic value.
Therefore the derivative markets provide a means of managing risk, discovering prices, reducing costs,
improving liquidity, selling short and making the market more efficient.

7. Probable Ways of Using Derivative Securities in Bangladesh

7.1 Derivatives Market in Bangladesh

Derivative is the new buzz word in the financial sector of Bangladesh. Some local and international
experts are continuously telling about the importance of introducing a derivatives market to mitigate
investment risks in a developing country like Bangladesh. The BSEC also seems interested to introduce
derivatives in the country's financial market soon. They said that, at present the complete focus of
individual investors, institutions and corporation are on stock exchanges. This put a limitation for
different investors to choose investment options. If there is any future and forward market beside stock
exchange it can provide an opportunity for the investors to get away from incurring losses. The economy
of Bangladesh is emerging economy and still growing. In order to allow the economy to grow it is
essential to spread out different branches to create new investment opportunities. Stock markets and other

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derivatives market of any country is one kind of indicator which tells the strength of that country’s
economy. It also needed for Bangladesh. As the economy is raising, the country will also be looking
toward derivatives market for other investment opportunities beside the stock exchange. This will lead the
concept of establishing a derivatives market in Bangladesh. But there is still a question mark regarding
the readiness of Bangladesh's financial market to bring derivatives into play. Sophisticated instruments
like derivatives need sound institutional set-up and efficient regulatory framework. Well-organized and
full functioning market for securities and other commodities from which the value of derivatives is
derived is the fundamental requirement for introducing derivative.

7.2 Need for Derivative market in Bangladesh

• Increased volatility in capital market needs attention
• Defense against abnormal growth in capital market
• Protection in major export sector
• Protection in major import sector
• Demand for alternative source of investments

7.3 The Uses of Derivative Markets

Futures and options are standardized contracts, which can be freely traded on exchanges. These could be
employed to meet a variety of needs.

Earn Money on Shares that are Lying Idle:

So, we don’t want to sell the shares that we bought for long term but want to take advantage of price
fluctuations in the short term. We can use derivative instruments to do so. Derivatives market allows us to
conduct transactions without actually selling your shares – also called as physical settlement.

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Benefit from Arbitrage:
When we buy low in one market and sell high in the other market, it called arbitrage trading. Simply put,
we are taking advantage of differences in prices in the two markets.
Protect our Securities Against fluctuations in prices:
The derivative market offers products that allow us to hedge yourself against a fall in the price of shares
that we possess. It also offers products that protect us from a rise in the price of shares that we plan to
purchase. This is called hedging.

Transfer of Risk:
By far, the most important use of these derivatives is the transfer of market risk from risk-averse investors
to those with an appetite for risk. Risk-averse investors use derivatives to enhance safety, while risk-
loving investors like speculators conduct risky, contrarian trades to improve profits. This way, the risk is
transferred. There are a wide variety of products available and strategies that can be constructed, which
allow us to pass on our risk.
7.4 How Are Derivative Contracts Linked to Stock Prices:
Suppose we buy a Futures contract of Infosys shares at 3,000 – the stock price of the IT company
currently in the spot market. A month later, the contract is slated to expire. At this time, the stock is
trading at 3,500. This means, we make a profit of 500 per share, as we are getting the stocks at a cheaper
rate.
Had the price remained unchanged, we would have received nothing. Similarly, if the stock price fell by
Tk. 800, we would have lost Tk. 800. As we can see, the above contract depends upon the price of the
underlying asset – Infosys shares. Similarly, derivatives trading can be conducted on the indices also.
Nifty Futures is a very commonly traded derivatives contract in the stock markets. The underlying
security in the case of a Nifty Futures contract would be the 50-share Nifty index.

7.5 How to Trade in Derivative Markets:

Trading in the derivatives market is a lot similar to that in the cash segment of the stock market.
• First do the research. This is more important for the derivatives market. However, remember that
the strategies need to differ from that of the stock market. For example, we may wish to buy
stocks that are likely to rise in the future. In this case, we conduct a buy transaction. In the
derivatives market, this would need us to enter into a sell transaction. So, the strategy would
differ.
• Arrange for the requisite margin amount. Stock market rules require us to constantly maintain our
margin amount. This means, we cannot withdraw this amount from our trading account at any
point in time until the trade is settled. Also remember that the margin amount changes as the price
of the underlying stock rises or falls. So, always keep extra money in our account.
• Conduct the transaction through our trading account. We will have to first make sure that our
account allows us to trade in derivatives. If not, consult our brokerage or stock broker and get the
required services activated. Once we do this, we can place an order online or on phone with our
broker.
• Select our stocks and their contracts on the basis of the amount we have in hand, the margin
requirements, the price of the underlying shares, as well as the price of the contracts. Yes, we do
have to pay a small amount to buy the contract. Ensure all this fits our budget.
• We can wait until the contract is scheduled to expiry to settle the trade. In such a case, we can pay
the whole amount outstanding, or we can enter into an opposing trade. For example, we placed a
‘buy trade’ for Infosys futures at 3,000 a week before expiry. To exit the trade before, we can
place a ‘sell trade’ future contract. If this amount is higher than 3,000, book profits. If not, we
will make losses.

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Thus, buying stock futures and options contracts is similar to buying shares of the same underlying stock,
but without taking delivery of the same. In the case of index futures, the change in the number of index
points affects our contract, thus replicating the movement of a stock price. So, we can actually trade in
index and stock contracts in just the same way as we would trade in shares.

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7.6 The Pre-requisites to Invest:
As said earlier, trading in the derivatives market is very similar to trading in the cash segment of the stock
markets.

This has three key requisites:

Demat account: This is the account which stores your securities in electronic format. It is unique to every
investor and trader.
Trading account: This is the account through which we conduct trades. The account number can be
considered our identity in the markets. This makes the trade unique to us. It is linked to the demat
account, and thus ensures that OUR shares go to your demat account.
Margin maintenance: This pre-requisite is unique to derivatives trading. While many in the cash
segment too use margins to conduct trades, this is predominantly used in the derivatives segment.

Derivatives could be used in risk management by hedging a position to protect against the risk of an
adverse move in an asset. Hedging is the act of taking an offsetting position in a related security, which
helps to mitigate against adverse price movements.
A derivative is a financial instrument in which the price depends on the underlying asset. A derivative is a
contractual agreement between two parties that indicates which party is obligated to buy or sell
the underlying security and which party has the right to buy or sell the underlying security.
For example, assume an investor bought 1,000 shares of Tesla Motors Inc. on May 9, 2013 for $65 a
share. The investor held onto his investment for over two years and is now afraid that Tesla will be unable
to meet its earnings per share (EPS) and revenue expectations.
Tesla's stock price opened at a price of $243.93 on May 15, 2015. The investor wants to lock in at least
$165 of profits per share on his investment. To hedge his position against the risk of any adverse price
fluctuations the company may have, the investor buys 10 put option contracts on Tesla with a strike
price of $230 and an expiration date on August 7, 2015.
The put option contracts give the investor the right to sell his shares of Tesla for $230 a share. Since
one stock option contract leverages 100 shares of the underlying stock, the investor could sell 1,000 (100
* 10) shares with 10 put options.
Tesla is expected to report its earnings on August 5, 2015. If Tesla misses its earnings expectations and its
stock price falls below $230, the investor could sell 1,000 shares while locking in a profit of $165 ($230 -
$65) per share.

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7.7 Purposes and Benefits of Derivatives
Today's sophisticated international markets have helped foster the rapid growth in derivative instruments.
In the hands of knowledgeable investors, derivatives can derive profit from:
Changes in interest rates and equity markets around the world
Currency exchange rate shifts
Changes in global supply and demand for commodities such as agricultural products, precious and
industrial metals, and energy products such as oil and natural gas.
Adding some of the wide variety of derivative instruments available to a traditional portfolio of
investments can provide global diversification in financial instruments and currencies, help hedge against
inflation and deflation, and generate returns that are not correlated with more traditional investments. The
two most widely recognized benefits attributed to derivative instruments are price discovery and risk
management.

1. Price Discovery
Futures market prices depend on a continuous flow of information from around the world and require a
high degree of transparency. A broad range of factors (climatic conditions, political situations, debt
default, refugee displacement, land reclamation and environmental health, for example) impact supply
and demand of assets (commodities in particular) - and thus the current and future prices of
the underlying asset on which the derivative contract is based. This kind of information and the way
people absorb it constantly changes the price of a commodity. This process is known as price discovery.
• With some futures markets, the underlying assets can be geographically dispersed, having many
spot (or current) prices in existence. The price of the contract with the shortest time to expiration
often serves as a proxy for the underlying asset.
• Second, the price of all future contracts serves as prices that can be accepted by those who trade
the contracts in lieu of facing the risk of uncertain future prices.
• Options also aid in price discovery, not in absolute price terms, but in the way the market
participants view the volatility of the markets. This is because options are a different form of
hedging in that they protect investors against losses while allowing them to participate in the
asset's gains.

As we will see later, if investors think that the markets will be volatile, the prices of options contracts will
increase. This concept will be explained later.

2. Risk Management
Hedging has traditionally been defined as a strategy for reducing the risk in holding a market position
while speculation referred to taking a position in the way the markets will move. Today, hedging and
speculation strategies, along with derivatives, are useful tools or techniques that enable companies to
more effectively manage risk.

3. They Improve Market Efficiency for the Underlying Asset

For example, investors who want exposure to the S&P 500 can buy an S&P 500 stock index fund or
replicate the fund by buying S&P 500 futures and investing in risk-free bonds. Either of these methods
will give them exposure to the index without the expense of purchasing all the underlying assets in the
S&P500.
If the cost of implementing these two strategies is the same, investors will be neutral as to which they
choose. If there is a discrepancy between the prices, investors will sell the richer asset and buy the
cheaper one until prices reach equilibrium. In this context, derivativescreate marketefficiency.

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4. Derivatives Also Help Reduce Market Transaction Costs
Because derivatives are a form of insurance or risk management, the cost of trading in them has to be low
or investors will not find it economically sound to purchase such "insurance" for their positions
Unlike purchasing stocks from the cash market, when you purchase futures contracts you are required to
deposit only a percentage of the value of your outstanding position with the stock exchange, irrespective
of whether we buy or sell futures. This mandatory deposit, which is called margin money, covers an
initial margin and an exposure margin. These margins act as a risk containment measure for the
exchanges and serve to preserve the integrity of the market.

• We are expected to deposit the initial margin upfront. How much we have to deposit is decided
by the stock exchange.
• The exposure margin is used to control volatility and excessive speculation in the derivatives
markets. This margin is also stipulated by the exchanged and levied on the value of the contract
that we buy or sell.
• Besides the initial and exposure margins, we also have to maintain Mark-to-Market (MTM)
margins. This covers the daily difference between the cost of the contract and its closing price on
the day of purchase. Thereafter, the MTM margin covers the differences in closing price from day
to day.

7.8 Implication of Perfect Portfolio

Actually, in Bangladesh’s financial market is still in very nascent stage of development. Here, alternative
financial instruments are rare to find. There is no separate bond market. Money market is also not well-
established. Investors can’t apply any hedging strategy through risk-shifting instruments like derivative
while they are buying risky assets. Suppose, at the time of buying a stock if a purchaser simultaneously
could buy futures or options from the same marketplace to protect his investment, the perfect implication
of portfolio (comprising of risky assets and risk-free assets) could have been possible.

7.8 The possible way of protection using derivative

We have seen that the nature of volatility in DSE is very high than some other comparable. If a derivative
market can be established in this country, an investor could easily be protected himself from potential
loss. Suppose in December 10 a purchaser has bought 1000 stock of Beximco Ltd. with BDT40 each. The
investor is concerned about a possible share price decline in two months from now and wants protection.
The investor can buy February 10 put option contracts pricing of each BDT1 on Beximco Ltd. with a
strike price BDT43. This would give the investor a right to sell the stocks with the strike price. Now if the
price of stock on the maturity date is lower than the strike price the investor can exercise the contract by
selling each with BDT43.Net profit would be (43-40) × 1000=3000-(contract’s buying cost,1000×1)
=BDT2000. But if the market price on the maturity date is higher than the strike price, investor would not
exercise the contract. His loss is BDT1000(contract’s buying cost). Like options the investors can use
some others derivative instruments to protect themselves against losing their investment occurring from
the market volatility.

7.9 Risks in Derivatives Market

The danger in derivatives usage comes from the interaction of three factors. The first is leverage.
Derivatives are highly levered instruments. Leverage creates the potential for large gains but also large
losses if the market moves in the wrong direction. The second is volatility; Market volatility compounds
the effect of leverage. As volatility in the price of the underlying increases and unexpectedly large price
movements occur, the impact of leverage gets exacerbated leading to potentially larger losses on the
downside. The third is liquidity. Periods of market turmoil are often accompanied by not only higher
volatility but also liquidity drying up selectively. Almost every major derivatives-related corporate
debacle can be traced back to a combination of these factors. Besides these, another risk is that one party

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may default on the contract, which is called credit risk. Credit risk is not much of a problem for
derivatives traded on organized exchanges, since these exchanges are designed in such a way that their
contracts are almost always honored. Credit risk is much more of a problem in the OTC market, where
two parties negotiate a derivative contract specific to their needs.

8. Recommendations
• To establish a derivative market in Bangladesh, an advisory committee can be formed to conduct
a feasibility study.
• To enhance Education and Knowledge Among All Market Participants.
• To establish an Advisory Committee.
• To introduce Derivatives Products That Can be Used to Manage Risks in Natural Gas Industries,
and Other Commodity-Based Industries.
• Order Flow and Trade Execution.
• To ensure proper co-ordination between BSEC, secondary and other markets and ensuring strong.
• Build-up public awareness and deduce stakeholder’s opinion.
• To implement stringent training and licensing mechanism.
• Development of existing infrastructure and new system.
• To restructure of (BSEC) Bangladesh Security Exchange Commission is required.
• To establish a Central Counterparty (CCP).
• For an efficient derivative market, a liquid financial market is required.

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9. Conclusion
While derivatives are interesting to use, it can be like fire in the hands of a child when a novice investor
who does not understand the intricacies involved decides to make use of it. It is a very quick way to make
some quick bucks in a short time and also a quicker way to lose a lot of money within the same time
frame. Financial derivative provides risk management tools as well as alternative investment
opportunities to market participants. Exchange traded derivatives market helps investors in many different
ways in planning the finances, hedging/mitigating various risks, appropriate price discovery, arbitrage
opportunities, ease of speculations etc. There are various strategic applications, uses and benefits of the
equity derivatives market in today’s economic scenario such as providing efficiency to capital markets,
helping investors in mitigating risks, providing equitable price discovery, comforting foreign investors,
creating jobs and developing human capital, preserving value of assets during stressed market scenario
and many more ways. Although there are concerns about the explosive growth of derivatives and the risks
that they may create, it appears that these exchanges are increasing their business. However, Bangladesh
has still a long way to go for ensuring a favorable condition for introduction of derivatives. Derivative
market should be in our long-term plan and the short-term plan should include removal of existing
problems of the capital market and the commencement of liquid bond market. We are confident, adequate
legal and regulatory reform, and governance infrastructure and oversight will pave the way for successful
introduction of derivative securities in Bangladesh and provide the perfect fillip to our stagnant
investment climate.

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