Derivative Market in India


Ajit Kumar AJIT KUMARWISDOM IAS, New Delhi.

A derivative is a contract between two parties which derives its value/price from an underlying asset. Originally, underlying corpus is first created which can consist of one security or a combination of different securities. The value of the underlying asset is bound to change as the value of the underlying assets keep changing continuously. Generally stocks, bonds, currency, commodities and interest rates form the underlying asset.
As Derivatives are merely contracts between two or more parties, anything like weather data or amount of rain can be used as underlying assets. The Derivatives can be classified as Future Contracts, Forward Contracts, Options, Swaps and Credit Derivatives.

Financial Derivatives in India
At present the Indian stock markets are not having any risk hedged instruments that would allow the investors to manage and minimize the risk. In industrialized countries apart from money market and capital market securities, a variety of other securities known as „derivatives‟ have now become available for investment and trading.
The derivatives originate in mathematics and refer to a variable which has been derived from another variable. A derivative is a financial product which has been derived from another financial product or commodity. The derivatives do not have independent existence without underlying product and market. Derivatives are contracts which are written between two parties for easily. Derivatives are also known as deferred delivery or deferred payment instruments. Since financial derivatives can be created by means of a mutual agreement, the types of derivative products are limited only by imagination and so there is no definitive list of derivative products.
A derivative is a financial product which has been derived from another financial product or commodity. D.G. Gardener defined the derivatives as “A derivative is a financial product which has been derived from market for another product.”
 The securities contracts (Regulation) Act 1956 defines “derivative” as under section 2 (ac). As per this “Derivative” includes (a) “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.” (b) “a contract which derived its value from the price, or index of prices at underlying securities.” The above definition conveys that the derivatives are financial products. Derivative is derived from another financial instrument/ contract called the underlying. A derivative derives its value from underlying assets.
Accounting standard SFAS133 defines “a derivative instrument is a financial derivative or other contract which will comprise of all three of the following characteristics:
(i) It has one or more underlying asset, and one or more notional amount or payments provisions or both. Those terms determine the amount of the settlement or settlements.
(ii) It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contract that would be expected to have a similar response to changes in market factors.
(iii) Its terms require or permit net settlement. It can be readily settled net by a means outside the contract or it provides for delivery of an asset that puts the recipients in a position not substantially different from net settlement.
 From the aforementioned, derivatives refer to securities or to contracts that derive from another whose value depends on another contract or assets. As such the financial derivatives are financial instrument whose prices or values are derived from the prices of other underlying financial instruments or financial assets.
The underlying instruments may be an equity share, stock, bond, debenture, Treasury bill, foreign currency or even another derivative asset. Hence, financial derivatives are financial instruments whose prices are derived from the prices of other financial instruments. As defined above, its value is entirely derived from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, livestock or anything else.
 In other way the underlying asset may assume many forms: (i) Commodities including grain, coffee beans, orange juice; (ii) Precious metals like gold & silver; (iii) Foreign exchange rates or currencies; (iv) Bonds of different types, including medium to long term negotiable debt, securities issued by governments, companies etc; (v) Shares and share warrants of companies traded on recognized stock exchanges and stock index; (vi) Short term securities such as T-bills; (vii) Over the counter (OTC) money market products such as loans or deposits.
The Derivative Market can be classified as –
(i) Exchange Traded Derivatives Market and
(ii) Over the Counter Derivative (OTC) Market.
Exchange Traded Derivatives are those derivatives which are traded through specialized derivative exchanges whereas Over the Counter Derivatives are those which are privately traded between two parties and involves no exchange or intermediary. Swaps, Options and Forward Contracts are traded in Over the Counter Derivatives Market or OTC market. The main participants of OTC market are the Investment Banks, Commercial Banks, Govt. Sponsored Enterprises and Hedge Funds. The investment banks markets the derivatives through traders to the clients like hedge funds and the rest.
In the Exchange Traded Derivatives Market or Future Market, exchange acts as the main party and by trading of derivatives actually risk is traded between two parties. One party who purchases future contract is said to go “long” and the person who sells the future contract is said to go “short”. The holder of the “long” position owns the future contract and earns profit from it if the price of the underlying security goes up in the future. On the contrary, holder of the “short” position is in a profitable position if the price of the underlying security goes down, as he has already sold the future contract. So, when a new future contract is introduced, the total position in the contract is zero as no one is holding that for short or long.
The trading of foreign exchange traded derivatives or the future contracts has emerged as very important financial activity all over the world just like trading of equity-linked contracts or commodity contracts. The derivatives whose underlying assets are credit, energy or metal, have shown a steady growth rate over the years around the world. Interest rate is the parameter which influences the global trading of derivatives, the most.
In India, there are two major markets namely National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) along with other Exchanges of India are the market for derivatives. Here we may discuss the performance of derivatives products in Indian market.
Role of Derivatives
Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes. For example, a European investor purchasing shares of an American company off of an American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros.
Derivatives play a vital role in risk management of both financial and non-financial institutions. But, in the present world, it has become a rising concern that derivative market operations may destabilize the efficiency of financial markets. In today’s’ world the companies the financial and non-financial firms are using forward contracts, future contracts, options, swaps and other various combinations of derivatives to manage risk and to increase returns. It is true that growth of derivatives market reveal the increasing market demand for risk managing instruments in the economy. But, the major concern is that, the main components of Over the Counter (OTC) derivatives are interest rates and currency swaps. So, the economy will suffer surely if the derivative instruments are misused and if a major fault takes place in derivatives market.

Uses of Financial Derivatives
Derivatives are supposed to provide some services and these services are used by investors. Some of the uses and applications of financial derivatives can be enumerated as following -
1. Management of risk: One of the most important services provided by the derivatives is to control, avoid, shift and manage efficiently different types of risk through various strategies like hedging, arbitraging, spreading etc. Derivative assist the holders to shift or modify suitable the risk characteristics of the portfolios. These are specifically useful in highly volatile financial conditions like erratic trading, highly flexible interest rates, volatile exchange rates and monetary chaos.
 2. Price discovery: The important application of financial derivatives is the price discovery which means revealing information about future cash market prices through the future market. Derivative markets provide a mechanism by which diverse and scattered opinions of future are collected into one readily discernible number which provides a consensus of knowledgeable thinking.
 3. Liquidity and reduce transaction cost : As we see that in derivatives trading no immediate full amount of the transaction is required since most of them are based on margin trading. As a result, large number of traders, speculators, arbitrageurs operates in such markets. So, derivatives trading enhance liquidity and reduce transaction cost in the markets of underlying assets. Measurement of Market: Derivatives serve as the barometers of the future trends in price which result in the discovery of new prices both on the spot and future markets. They help in disseminating different information regarding the future markets trading of various commodities and securities to the society which enable to discover or form suitable or correct or true equilibrium price in the markets. As a result, the assets will be in an appropriate and superior allocation of resources in the society.
 4. Efficiency in trading: Financial derivatives allow for free trading of risk components and that leads to improving market efficiency. Traders can use a position in one or more financial derivatives as a substitute for a position in underlying instruments. In many instances, traders find financial derivatives to be a more attractive instrument than the underlying security. This is mainly because of the greater amount of liquidity in the market offered by derivatives as well as the lower transaction costs associated with trading a financial derivative as compared to the costs of trading the underlying instruments in cash market.
 5. Speculation and arbitrage: Derivatives can be used to acquire risk, rather than to hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset. Speculators look to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to derivative contract when the future market price is low. Individual and institutions may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset.
6. Hedging : Hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out. Hedging also occurs when an individual or institution buys an asset and sells it using a future contract. They have access to the asset for a specified amount of time, and can then sell it in the future at a specified price according to the futures contract of course; this allows them the benefit of holding the asset.
 7. Price stabilization function: Derivative market helps to keep a stabilizing influence on spot prices by reducing the short term fluctuations. In other words, derivatives reduce both peak and depths and lends to price stabilization effect in the cash market for underlying asset.
 8. Gearing of value: Special care and attention about financial derivatives provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative.
 9. Develop the complete markets : It is observed that derivative trading develop the market towards “complete markets” complete market concept refers to that situation where no particular investors be better of than others, or patterns of returns of all additional securities are spanned by the already existing securities in it, or there is no further scope of additional security.
10. Encourage competition : The derivatives trading encourage the competitive trading in the market, different risk taking preference at market operators like speculators, hedgers, traders, arbitrageurs etc. resulting in increase in trading volume in the country. They also attract young investors, professionals and other experts who will act as catalysts to the growth of financial market.
 11. Other uses : The other uses of derivatives are observed from the derivatives trading in the market that the derivatives have smoothen out price fluctuations, squeeze the price spread, integrate price structure at different points of time and remove gluts and shortage in the markets. The derivatives also assist the investors, traders and managers of large pools of funds to device such strategies so that they may make proper asset allocation increase their yields and achieve other investment goals.

Related Terms

Hedgers
 Hedgers are traders who use derivatives to reduce the risk that they face from potential movements in a market variable and they want to avoid exposure to adverse movements in the price of an asset. Majority of the participants in derivatives market belongs to this category.
 Speculators
 Speculators are traders who buy/sell the assets only to sell/buy them back profitably at a later point in time. They want to assume risk. They use derivatives to bet on the future direction of the price of an asset and take a position in order to make a quick profit. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture.
 Arbitrageurs
 Arbitrageurs are traders who simultaneously buy and sell the same (or different, but related) assets in an effort to profit from unrealistic price differentials. They attempts to make profits by locking in a riskless trading by simultaneously entering into transaction in two or more markets. They try to earn riskless profit from discrepancies between futures and spot prices and among different futures prices.
Exchange traded derivative
 Those derivative instruments that are traded via specialized derivatives exchange of other exchange. A derivatives exchange is a market where individual trade standardized contracts that have been defined by the exchange. Derivative exchange act as an intermediary to all related transactions and takes initial margin from both sides of the trade to act as a guarantee.
Forward Contract
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 simplest form of derivative contract mostly entered by individual in day to day life.
The holder of a long (short) forward contract has an agreement to buy (sell) an asset at a certain time in the future for a certain price, which is agreed upon today. The buyer (or seller) in a forward contract:
(i) Acquires a legal obligation to buy (or sell) an asset (known as the underlying asset)
(ii)  At some specific future date (the expiration date)
(iii)  At a price (the forward price) which is fixed today
Futures Contract
Futures contract is an agreement between two parties to buy or sell a specified quantity of an asset at a specified price and at a specified time and place. Future contracts are normally traded on an exchange which sets the certain standardized norms for trading in futures contracts. The features of a futures contract may be specified as follows:
 1. Futures are traded only in organized exchanges.
2. Futures contract required to have standard contract terms.
3. Futures exchange has associated with clearing house.
4. Futures trading required margin payment and daily settlement.
5. Futures positions can be closed easily.
6. Futures markets are regulated by regulatory authorities like SEBI.
7. The futures contracts are executed on expiry date.
 8. The futures prices are expressed in currency units, with a minimum price movement called a tick size.
Options Contracts
 Options are derivative contract that give the right, but not the obligation to either buy or sell a specific underlying security for a specified 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. Again we can say “An option is a particular type of a contract between two parties where one person gives the other person the right to buy or sell a specific asset at a specified price within a specified time period.” Today, options are traded on a variety of instruments like commodities, financial assets as diverse as foreign exchange, bank times deposits, treasury securities, stock, stock indexes, petroleum products, food grains, metals etc. The main characteristics of options are following:
1. Options holders do not receive any dividend or interest.
 2. Option yield only capital gains.
3. Options holder can enjoy a tax advantages.
4. Options are traded on OTC and in all recognized stock exchanges.
5. Options holders can control their rights on the underlying assets.
 6. Options create the possibility of gaining a windfall profit.
7. Options holder can enjoy a much wider risk- return combinations.
 8. Options can reduce the total portfolio transaction costs.
9. Options enable with the investors to gain a better returns with a limited amount of investment.
Swap Contract
 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 agreements between two parties to exchange assets at predetermined intervals. Swaps are generally customized transactions. The swaps are innovative financing which reduces borrowing costs, and to increase  control over interest rate risk and FOREX 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 fluctuation in FOREX market. The parties that agree to the swap are known as counter parties. The two commonly used swaps are interest rate swaps and currency swaps. Interest rate swaps which entail swapping only the interest related cash flows between the parties in the same currency. Currency swaps entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than the cash flows in the opposite direction.


Sunday, 26th Jul 2015, 11:09:05 AM

Add Your Comment:
Post Comment