M.Phil. Research Scholar
Derivatives are the financial instruments whose returns are derived from underlying assets. In other words, their performance depends on the movement of underlying assets such as commodities, indices, exchange rates, interest rates and so on. Derivatives are one of the important innovations of the financial engineering in the era of globalization.
Derivatives can be classified on the basis of the nature of contract, underlying asset or market mechanism.
a) Underlying Asset: Most derivatives are based on one of the following four types of assets:
(ii) Foreign Exchange
(ii) Equities, and
(iv) Interest bearing financial assets.
b) Nature of contract: Based on the nature of contract, derivatives can be classified into three categories:
(i) Forward rate contracts and futures
(ii) Options, and
There can be a contract which is similar in all aspects except for the underlying asset. Thus, an option contract can exist on a currency or a stock. Similarly, a futures contract can exist on a commodity or a currency.
c) Market Mechanism:
(i) OTC (Over - the - counter) products and
(ii) Exchange traded products.
A brief introduction of various derivative instruments is given below:
(i) Commodity Forwards:
A commodity forward contract is an agreement. Where in one party agrees to deliver the underlying commodity to another party at a specified price and time. The underlying commodity can be oil, a precious metal or any other commodity.
(ii) Commodity Futures:
A commodity futures contract is a tradable standardized contract, whose terms are set in advance by the commodity exchange arranging for trading on it. Commodities such as corn, soybean sugar, cotton, and coffee seeds etc. which form a part of daily consumption are traded on the future exchange.
(iii) Commodity Options:
Commodity options are financial options with the underlying asset being a specific commodity. Those investing in these products buy a right to sell or buy a commodity at a certain price. These are two basic types of commodity options: a call option and a put option. The call option gives the holder the right, but not the obligation, to buy the underlying commodity from the option writer at a specified price on or before the options expiration date. This option helps the buyer when prices escalate. The put option gives the holders the right, but not the obligation, to sell the underlying commodity to the option writer at a specified price on or before the options expiration date. This option helps the seller when price declines.
(iv) Commodity Swaps:
In a commodity swap, one set of the exchanged cash flows are dependent on the price of an underlying commodity and the other set of payments can be either fixed or determined by some other floating price or rate. Commodity swaps are used to hedge against the price of a commodity.
(v) Currency Forwards:
A currency forward is a contract to exchange a predetermined amount of one currency for another at an agreed date in the future using a rate of exchange determined at the trade date of the contract. Thus, currency forwards eliminate exchange risk.
(vi) Currency Future:
Currency future can be defined as a binding obligation to buy or sell a particular currency against another at a designated rate of exchange on a specified future date.
(vii) Currency Options:
Currency option is similar to commodity option. A currency call is similar to a call on a stock that gives the holder the right to buy a fixed amount of foreign currency at a fixed exchange rate on or before the option’s expiration date. A currency put gives gives the holder the right to sell a fixed amount of foreign currency at a fixed exchange rate on or before the option’s expiration date.
(viii) Currency Swaps:
A currency swap is a contract involving exchange of interest payments on equivalent loan in a different currency.
(ix) Index Future:
An index futures contract is basically an obligation to deliver at settlement, an amount equal to ‘x’ times the difference between the stock index value on the expiration date of the contract & the price at which the contract was originally struck. The value of ‘x’, which is referred to as the multiple, is predetermined for each stock market index.
(x) Index Options :
Index options allow investors to gain exposure to the market as a whole or to specific segments of the market with one trading decision and frequently with one transaction. In order to obtain the same level of diversification using individual stock issues or individual equity option classes , numerous decisions and transactions would be required. Employing index options can clear both the costs and complexities involved in doing so.
(xi) Interest Rate Futures :
An interest rate future contract is an agreement to buy or sell a standard quantity of specific interest bearing instruments, at a predetermined future date and at a price agreed upon between the parties.
(xii) Interest Rate Options :
An interest rate option holder gets the right to buy or sell the underlying cash instrument or the financial futures contract. The treasure may use these options to protect his position from rising interest rates or falling interest rates by buying put option or call option respectively.
(xiii) Interest Rate Swaps :
An interest rate swap can be defined as a contractual agreement between two counter parties wherein each party agrees to make a periodic payment to the other party for an agreed period of time, based upon a notional or underlying amount of principal.
Purpose of Derivatives :
Derivative instruments serve various purposes in global social and economic systems. Some of them are explained hereunder:
a) Price Discovery :
Price discovery symbolizes the process of providing equilibrium prices that reflect current and prospective demands on current and prospective supplies and making these prices visible to all, As such derivative markets not only play a significant role in terms of actual trading, but also provide guidance to the rest of the economy to optional production and consumption decisions, Forwards and future markets are significant sources of information about prices. Future markets are often considered as primary means of information for determining the spot price of the asset. High degree of correlation exists between forward/futures prices and the price which people expect to prevail for the commodity asset at the delivery date specified in the futures contract. By using the information available in the forward futures price today, market observes try to estimate the price of a given commodity asset at a certain time in future.
Thus, a future or forward price reflects a price reflects a price which a market participant can lock-in today in lieu of accepting the uncertainty of future spot price. Options market does not directly provide information about future spot price. However, they provide information about volatility and subsequently, the risk of the underlying spot asset.
Hedging attempts to reduce price risk. It can be defined as a transaction in which an investor seeks to protect a position or anticipated position in the spot market by using an opposite position in derivatives. A person who hedges is called a hedger. These are people who are exposed to risks due to the normal business operations and would like to eliminate or minimize or reduce the risk.
Hedging is done mainly for the following reasons:
- to protect a purchase against price decline.
- to protect a sale against price increase.
- to protect an anticipated purchase against a price increase
- to protect an anticipated sale against a price decline.
The result of a hedge can be judged as the ‘net effect’ of the gain or loss on the physical position plus the gain or loss on the hedging tool.
(c) Speculation :
Speculation involves assimilation of available information about a security and assigning the rise or fall of its price. A person engaged in speculation is called speculator . These people voluntarily accept what hedges wish to avoid. Based on the forecast, the speculator would like to make gains by taking long and short positions on the derivatives.
Indian Derivative Market :
In India derivatives are included within the sphere of ‘securities’ by the amendment in Securities Contract Regulation Act, (SCRA) in December 1999 and a regulatory framework was developed for governing derivatives trading. The Act specified that derivatives shall be legal and valid only if they are traded on a recognized stock exchange, thus precluding Over-the-counter derivatives. Besides, the government also withdrew in march 2000, the three decade old notification, which prohibited forwards trading in securities.
Derivatives trading commenced in India. In June 2000 with the approval of the SEBI. Subsequently, derivatives trading on the NSE started with S&P CNX Nifty index future. Futures contract on individual stocks were launched in November 2001, while trading in index options commenced in June 2001 and trading in options on individual securities began in July 2001. Similarly, trading in BSE sensex options and options on individual securities commenced in June 2001.
Trading and settlement in derivatives contracts is done in accordance with the rules, bye-laws and regulation of the respective exchanges and their clearing house corporation duly approved by the SEBI and notified in the official gazette. National Securities Clearing Corporation Limited (NSCCL) is the clearing and settlement agency for all deals executed on the National stock exchange (NSE’s) futures and options segments. It acts as legal counterparty to all deals on the F&O segment and guarantees settlement. FII’s are allowed to trade in all exchange - traded derivatives.
A brief description of the various kinds of derivatives generally traded in India is given below:
a) Commodity Forwards:
Although the commodity derivatives market has been in existence for long in India, the first organized trade took place in 1875 through the establishment of Cotton Trade Association followed by oilseeds, jute, wheat and some other commodities. Since then, contracts on various other commodities have been introduced through various local exchanges throughout the country. But the commodities market was in deep slumber post independence, when the country moved down the socialist path. The Indian Government banned cash settlement and options trading for few commodities under the Forwards Contract (Regulation) Act in 1952 and introduced minimum support prices to many agricultural products directly to protect farmers. Commodities trading further started in 1970 when the government permitted trading forwards on few commodities, but the volume was quite low. Forward contracts in India can be booked by companies, firms and any person having authentic foreign exchange exposures only to the extent and in the manner allowed by the RBI. Foreign exchange brokers are not allowed to book contacts.
With a view to improve the exchange functions, price discovery mechanism and price risk management, the regulatory role went to the forward markets commission. In 2002, the FMC decided to encourage the modern commodity exchange, that can work electronically and at the end of November 2002, the National Multi-commodity Exchange of Ahmadabad (NNCE) came out with the first electronic commodity exchange. After that in 2003, the Multi-commodity Exchange (MCX) and the National Multi-commodity Derivatives Exchange (NCDEX) started, which are promoted by ICICI, NSE and other financial institution. The fourth commodity exchange named UESIL (United Stock Exchange of India Ltd.) was started with the approval of FMC since 9th October 2009 which was promoted by. India Bulls and MM TC. Presently, futures trading is permitted in all the commodities through 26 Exchanges Associations.
b) Commodities Futures:
Commodity futures picked up with the government’s promotion of various exchanges and liberalization of the policies. In India, commodity futures are available on agriculture commodities, metallurgical commodities and so on. Under agriculture commodities, Red beans, corn, wheat, soybeans and soybean meal etc. form a part of grains, while commodities like cocoa, coffee, dried cocoon, cotton yarn and raw sugar, etc. form a part of soft commodities. Animal products like live hogs, live cattle, pork bellies, eggs and poultry products form a part of meat futures. The metallurgical category includes the genuine metals and petro products. The metals are further grouped in to precious and industrial metals. In general, the precious metals are in relative short supply and they retain their value irrespective of the condition of the economy.
C) Currency Forwards:
The volume of rupee forward has grown tremendously after 1992. When the government permitted unrestricted booking and cancellation of forward contracts for all genuine exposures, whether trade related or not. Further, in 2000, under the new regulation, Foreign exchange Management Act. 2000 (FEMA), the government issued guidelines for hedging in forward contracts. After introducing FEMA in 2000, the government has taken various steps for the development of the derivatives market. In July 2004, the government made further amendments in the conditions under which a Foreign Institutional Investor (FII) can enter into a forward contract to hedge its exposure in India. Under the new guidelines, registered FIIs alone can enter into a forward contract, and that too only if “the value of the hedge does not exceed the market value of the underlying debt or equity instruments”, Further contracts once booked shall be allowed to continue to the original maturity even if the value of the underlying portfolio shrinks.”
d) Currency Futures:
In the past few years, currency futures have witnessed significant growth in the use of different hedging techniques to address the FX exposures that companies face. The SEBI constituted the LC Gupta Committee to formulate the regulations through which trading in exchange-traded derivatives can commence in India. This step in the policy making has been supported by the NSE and commodity future began in 1995. After that a continuous growth has been seen in the derivatives markets. Now, tae NSE has Index futures, Stock futures, Interest rate options, and Rupee options.
E) Index Futures:
NSE has introduced trading in Index based futures contracts with a cash market index as the underlying asset as well as futures on the underlying stocks. NSE will define the characteristics of a futures contract such as the underlying index, market lot, and the maturity date of the contract. The contracts will be available for trading from introduction to the maturity date. Futures contracts on BSE Sensex use a multiple of 50.
F) Stock Futures:
The Securities and Exchange Board of India on November 1st, 2001, approved the scheme and risk containment measures for individual stock futures contracts and now 53 scraps are available on which derivatives trading is currently permitted. Some of the stocks include Bharat Electronics Ltd., Cipla Ltd., and Hindustan Lever Ltd.
G) Stock Options :
In India, NSE became the first exchange to launch trading in options on individual securities from July 2, 2001, Options contracts are American style and cash settled and are available on 155 securities stipulated by the securities & Exchange Board of India (SEBI). Some of the securities include dabber India Ltd, Gujarat Ambuja Cement Ltd. and Reliance Energy Ltd.
H) Interest Rate Futures:
The interest rate futures started trading in India on the NSE from June 23, 2003, The current interest rate futures products traded on the NSE are:
National 10-year Zero Coupon Bond Symbol: NSE10YZC
National 10-year Coupon Bearing Bond (6%) Symbol: NSE10Y06
National 91-day Treasury Bill Symbol: NSETB91D
Interest rate futures are the forward contracts based on benchmark interest rate traded on a stock exchange. It is a contract whose underlying security is a debt obligation. It is an agreement to buy or sell a standard quantity of a specific interest bearing instrument, at a predetermined future date at a price agreed upon between the parties. The financial settlement of all trades is guaranteed by the National Securities and Clearing Corporation Ltd. (NSCCL). Interest rate futures allow participants to take a view on movement of interest rates in the foreseeable future and accordingly enter into contracts, which would protect the underlying positions. For instance, you can sell a futures contract on T-Bills to lock-in a borrowing rate, or buy a futures contract to lock-in a lending rate. A typical example is the futures contract on 3-month sterling LIBOR traded on the London International Financial Futures Exchange (LIFFE), which is known as a short sterling futures. Unlike swaps, where two counterparties exchange streams of payments over a given period, in futures, participants enter into contracts and pay margins on a daily basis over the period of the contract and settle differences due to changes in interest rates by paying margins to the stock exchanges.
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