Derivatives are financial contracts between two or more
parties whose values are derived from the value of an underlying primary
financial instrument, commodity or index, such as interest rates, exchange
rates, commodities, bonds and equities. Derivatives include a wide assortment
of financial contracts, including forwards, futures, swaps and options. Most
derivatives are characterized by high leverage.
Since derivatives are mere contracts, just about anything
can be used as an underlying asset. There are even derivatives based on weather
data, such as the amount of rain or the number of sunny days in a particular
Derivatives are generally used to hedge risk, but can also
be used for speculative and arbitrage purposes.
Why consider Derivative Contracts?
With the present volatile market conditions and the
continuous national and international developments making it risky to have
overnight positions, clients need a way to safeguard their profits and at the
same time minimize their losses. Derivative contracts are ideal for this
Futures investors have long recognized that they have the
potential to profit from both upward and downward movement of investments.
Derivatives help to improve market efficiency because risks can be isolated and
sold to those who are willing to accept taking these risks at the least cost.
The use of derivatives breaks risk into pieces, which can be managed
independently. Thus, from the market prospective, derivatives offer the free
trading of financial risks.
Speculators can take advantage of highly leveraged exposures
in both financial and non-financial markets. That means they can buy futures
contracts by depositing just a small percentage of the overall contract price.
Their goal is to profit from changes in the price of the futures contract.
Hedgers, those who hold a specific asset or have a specific
exposure in the cash market, often take a position in the derivatives market
opposite to that in the cash market to help reduce the risk of rising or
History of Derivatives in India
In India, derivative contracts are heavily traded on both
the national exchanges, NSE and BSE. History of Derivatives in India can be
outlined as follows:
|9th June 2000
||First exchange traded Index Derivative Product –
Sensex Futures – was launched by BSE
|12th June 2000
||NSE commenced Trading in Index Futures
|1st June 2001
||BSE commenced Trading in Index Options
|4th June 2001
||NSE introduced Trading in Index Options
|2nd July 2001
||NSE commenced Trading in Options on Individual
|9th July 2001
||BSE commenced Trading in Stock Options
||NSE commenced Trading in Futures on Individual
|9th November 2002
||BSE commenced Trading in Futures on Individual
||NSE launched derivatives on Nifty Junior &
Advantages of Derivatives
The Derivatives Market is very important as it performs a
number of functions:
- The prices in an organized derivatives market reflect the perception of
market participants about the future and lead the prices of the underlying to
the perceived future level. The prices of derivatives normally converge with
the prices of the underlying at the expiration of the derivatives contract.
Thus derivatives help in discovery of future as well as current prices.
Transfer of Price Risk (Hedging function)
- This market helps to transfer risks from those who have them but may not like
them to those who have the appetite for them.
Increase in Trading Volumes
- Transfer of risk enables market participants to expand their volume of
activity. With the introduction of derivatives, the underlying market also
witness higher trading volumes because of participation by more players who
would not otherwise participate for lack of arrangement to transfer risk.
Speculative trades also shift to a more controlled environment of derivatives
Leverage – Derivatives provide a forum in which all those with an
interest in, an view on the future outlook for the price of a commodity or
financial asset can express that view by taking a market position at low
Are Derivatives made for the common man?
Although it is true that complicated mathematical models are
used for pricing some derivatives, the basic concepts and principles
underpinning derivatives and their trading are quite easy to grasp and
understand. Derivatives are now being used increasingly by market players
ranging from governments, corporate treasurers, dealers, brokers and individual
What are Forward contracts?
A forward contract is a customized contract between two
parties, where settlement takes place on a specific date in future at a price
agreed today. These contracts are not traded on any exchange.
The main features of forward contracts are
They are bilateral contracts; hence the contract size, contract price, expiry
date, asset type, asset quality etc. are decided as per mutual decision of the
two transacting parties.
Since forward contracts are not traded on any exchange, the contract price is
generally not available in public domain.
Settlement of the contract is done by delivery of the asset on expiration date.
In case, the party wishes to reverse the contract, it has to compulsorily go to
the same counter party, which being in a monopoly situation can command the
price it wants.
Since there is no central clearing agency, both the transacting parties are
exposed to counter-party risk.
What are Futures contracts?
Futures contracts are exchange-traded forward contracts. A
futures contract is an agreement between two parties to buy or sell a specified
quantity and quality of an asset at a certain time in the future at a price
agreed upon at the time of entering into the contract on the futures exchange.
The exchange sets the terms and conditions (specifications) relating to each
type of futures contract traded on that exchange. Some futures contracts may
call for physical delivery of the asset, while others are settled in cash. The
futures markets are characterized by the ability to use very high leverage
relative to stock markets.
Differences between Forwards and Futures
The points of difference between forward and futures
contracts are listed below:
|Nature of Contract
||Customised contract between 2 parties, not
traded on any exchange.
||Standardised contract between 2 parties traded
on an exchange.
||Counter-party risk involved as payment and
delivery of asset by respective parties not guaranteed.
||Counter-party risk reduced to almost nil as
credit risk is transferred to exchange / clearing agency.
||Illiquid. Contract can be reversed only by
negotiating with the counter-party.
||Highly Liquid as contract can be reversed by
squaring up with any other party trading on the same exchange.
||No margin involved
||Initial Margin as well as Mark to Market Margin
||Used for physical delivery and hedging.
||Used for speculation and hedging.
||Not transparent, as deals are private in nature.
||Transparent, as Exchange reports the
transactions on a daily basis.
|Mark To Market
||Contracts are not marked to market
||Contracts are marked to market on a daily basis.
Gains or losses made by the party are reflected by crediting or debiting the
accounts of the parties respectively by the exchange
How are Derivative Contracts settled currently?
Currently, settlements of all Derivatives trades are in
cash. There is Daily as well as Final Settlement. As long as the position is
open, the same will be marked to market at the Daily Settlement Price, the
difference will be credited or debited accordingly and the position shall be
brought forward to the next day at the daily settlement price. Any position
which remains open at the end of the final settlement day (i.e., last Thursday)
shall be closed out by the exchange at the Final Settlement Price which will be
the closing spot value of the underlying.
There are two types of margins collected on the open
position, viz., Initial Margin which is collected upfront and Mark to Market
Margin to be paid on T+1 day. As per SEBI Guidelines it is mandatory for
clients to give margin, failing which the outstanding positions may be closed
Should the entire investible funds be used for leveraging?
Never! Leverage is like a double-edged sword. The leverage
available using futures contract appears to be a great opportunity. The use can
benefit immensely in terms of the return on the capital employed if used
properly. Leverage can hurt its user equally if not used judiciously. The
amount to be used for leveraged trades should form a part of the risk capital.
One should always try to look for a balanced and well diversified portfolio for
efficient risk management.
Risks of Trading in Futures & Options
Before you step into the world of Derivative trading, it is
essential to take note of the risks involved. Since futures trading can be
highly unpredictable with dramatic market swings, it is not suitable for all
investors. You may lose your entire investment and, in some cases, even more
than you invested. It is therefore, imperative to have a good knowledge of the
field to make thoughtful and wise investment decisions and not act on impulse
or emotions. The following must be taken into account before you start trading
What is an Option?
An option is a financial derivative which represents a
contract sold by one party (option writer) to another party (option holder).
The contract offers the buyer the right, but not the obligation, to buy (call)
or sell (put) a security or other financial asset at an agreed-upon price (the
strike price) during a certain period of time or on a specific date (exercise
Options are extremely versatile securities that can be used
in many different ways. Traders use options to speculate while hedgers use
options to reduce the risk of holding an asset.