Introduction
The term Derivative indicates the value which is entirely derived from the value of the asset such as securities, commodities, bullion, currency, live stock or anything else.
Financial history of Derivatives
Derivatives initially had its reference to the bank transaction when banks created deposits out of primary deposits. The primary deposit is received by banks and the same is lent on book credit. The bank does not give cash to the borrower but provides him with a cheque book and allows him to draw for payment. When these cheques are presented in the bank, they create deposits and they were referred to as the derivatives. In a similar fashion, the stocks are traded in exchanges either as spot, that is delivery on payment or on forward market that is delivery on future payment. This may or may not happen but the purpose is to prevent any fall in price of stocks which is insurance against the risk of volatility in prices. The derivatives market consists of forward contract, futures contract, options trading and swaps markets.
History of Derivatives
With the opening of the economy to multinationals and the adoption of the liberalized economic policies, the economy is driven more towards the free market economy. The complex nature of financial structuring involves the utilization of multi currency transactions. It exposes the clients, particularly corporate clients to various risks such as exchange rate risk, interest rate risk, economic risk and political risk which multiplied with the integration of the financial markets. For instance risks due to fluctuations in the exchange rates.
In the present state of the economy, there is an imperative need of the corporate clients to protect their operating profits by shifting some of the uncontrollable financial risks to those who are able to bear and manage them. Thus, risk management becomes a must for survival since there is a high volatility in the present financial markets.
In this context, derivatives occupy an important place as risk reducing machinery. The financial service companies can play a very dynamic role in dealing with such risks. They can ensure that the above risks are hedged by using derivatives like forwards, future, options, swaps etc. Derivatives, thus, enable the clients to transfer their financial risks to the financial service companies. This really protects the clients from unforeseen risks and helps them to get their due operating profits or to keep the project well within the budget costs.
Structure of Derivative Markets in
Derivative trading in
Derivatives in Indian Capital Market
In November 1996, L.C.Gupta Committee was set up and in 1998 the recommendations of L.C.Gupta Committee was accepted by the Government. Subsequently in February 1999, Securities Contract (Amendment) Act was passed and definition of derivatives was inserted in SCRA. In June 2000, the actual trading in Index Futures started on Bombay Stock Exchange (BSE) and National Stock Exchange (NSE).
SEBI has also framed suggestive bye-law for Derivative Exchanges/Segments and their Clearing Corporation/House which lays down the provisions for trading and settlement of derivative contracts. The Rules, Bye-laws & Regulations of the Derivative Segment of the Exchanges and their Clearing Corporation/House have to be framed in line with the suggestive bye-laws.
Meaning of Derivatives
In a broad sense, many commonly used instruments can be called derivatives since they derive their value from an underlying asset. For instance, equity shares itself is a derivative, since, it derive its value from the firms underlying assets. Similarly, one takes insurance against his house. Again, if one signs a contract with a building contractor stipulating a condition, if the cost of materials goes up by 15% the contract price will also go up by 10%. This is also a kind of derivative contract. Thus, derivatives cover a lot of common transactions.
In a strict sense, derivatives are based upon all those major financial instruments, which are explicitly traded like equity, debt instruments and commodity based contracts. Thus here derivatives means only financial derivatives namely forward, futures, options, swaps etc. The peculiar features of these instruments are that
1. They can be designed in such a way so as to cater the varied requirements of the users either by simply using any one of the above instruments or by using a combination of two or more such instruments.
2. They can be designed and traded on the basis of expectations regarding the future price movements of underlying assets.
3. They are all off balance sheet instruments and
4. They are used as device for reducing the risks of fluctuations in asset values.
Definition of Derivative:
Derivatives involve payment/receipt of income generated by the underlying asset on a notional principal.
Economic functions of a derivatives market:
The derivative market performs a number of economic functions such as
1. It helps in transferring risk from risk averse people to risk oriented people.
2. It helps in the discovery of future as well as current prices.
3. It catalyzes entrepreneurial activity.
4. It increases the volume traded in markets because of increasing participation of risk averse people
5. It increases savings and investment in the long run.
FUTURES;-
A future contract is very similar to a forward contract in all respects excepting the fact that it is completely a standardized one. Hence, it is rightly said that a futures contract is nothing but a standardized forward contract. It is legally enforceable and it is always traded on an organized exchange.
Clark has defined future trading “as a special type of futures contract bought and sold under the rules of organized exchanges” the term future trading includes both speculative transactions where futures are bought and sold with the objective of making profits from the price changes and also the hedging or protective transactions where futures are bought and sold with a view to avoiding unforeseen losses resulting from price fluctuations.
FEATURES OF FUTUES;-
I) highly standardized: Futures are standardized and legally enforceable. Hence, they are traded only in future exchanges. It is also difficult to modify the agreement according to the needs of the contracting parties.
II) Down payment: The contracting parties need not pay any down payment at the time of agreement. However, they deposit a certain percentage of the contract price with the exchange and it is called initial margin. This gives a guarantee that the contract will be honored.
III) Settlements: Though future contracts can be held till maturity, they are not so in actual practice. Futures instruments are marked to the market and the exchange records profit and loss on them on daily basis. That is once a futures contract is entered into, profits or losses to both the parties are calculated on daily basis. The difference between the futures depending upon the prevailing spot prices. The spot price is nothing but the market price prevailing then.
IV) Hedging of price risks: The main feature of a futures contract is to hedge against price fluctuations. The buyers of a futures contract hope to protect themselves from future spot price increases and the sellers from future spot price decreases.
V) Linearity: As stated earlier, futures contract is nothing but a standardized forward contract. Therefore, it is also possesses the property of linearity.
V1) Secondary market: Futures are dealt in organized exchanges, and as such, they have secondary market too.
TYPES OF FUTURES
1) Commodity futures:
A commodity future is a futures contract is commodities like agricultural products, metals and minerals etc. in organized commodity future markets, contracts are standardized with standard quantities. Of course, this standard
from commodity to commodity. They also have fixed delivery dates in each month or a few months in a year. In
Some of the well established commodity exchanges are a follows:
1. London Metal Exchange (LME) to deal in gold.
2. Chicago Board Of Trade (CBT) to deal in soybean oil.
3. New York Cotton Exchange (CTN) to deal in cotton.
4. Commodity Exchange,
5. International Petroleum Exchange of London ( IPE) to deal in crude oil.
2. Financial futures:
Financial futures refer to a futures contract in foreign exchange or financial instruments like Treasury bill, commercial paper, stock market index or interest rates. It is an area where financial service companies can play a very dynamic role. Financial futures are very popular in western countries as hedging instruments to protect against exchange rate/ interest rate fluctuations and for ensuring interest rates on loans.
Just like forward rate currency contracts and forward rate contracts on interest rates, we have futures contracts on currency and interest rates. But, the primary objective of futures markets is to enable individuals and companies to hedge against price fluctuations.
FORWARDS Vs FUTURES CONTRACT
For all practical purposes, when a forward contract is standardized and dealt in an some and the same. however, they differ from each other in the following respects.
1. It is tailor made contract in the sense that the terms of the contract like quantity, price, period, date, delivery, conditions etc. can be negotiated between the parties according to their convenience. On the other hand, a future contract is a highly standardized one where all the terms of the contract are standardized and they can not be altered to the requirements of the parties to the contract.
2. EXISTENCE OF SECONDARY MARKET: Since forward contract is a customized contract, it is not a standard one.so, it cannot be traded on an organized exchange. With a result, there is no secondary market for a forward contract. but, futures contract can be traded on organized exchanges. Hence it has a secondary market.
3.SETTLEMENT: A forward contract is always settled only on the date of maturity. but, a futures contract is always settled daily, irrespective of maturity date,in the sense that,it is’marked to market’on a daily basis.
4. MODUS OPERANDI: Generally, parties enter into a forward agreement with the help of some financial intermediary like a bank. but, it is not so in the case of a future contract.it is mainly facilitated through organized exchanges and the question of a third party does not rise.
5.DOWN PAYMENT: In the case of a forward contract, the contracting parties need not pay any down payment at the time of agreement. however, in case of a future contract, the contracting parties have to deposit a certain percentage of the contract price as ‘Margin money’ with the exchange .it acts as a collateral to support the contract.
6.DELIVERY TO THE ASSET: The delivery of the asset in question is essential on the data of maturity of the contract in the case of a forward contract whereas a futures contract does not end with the delivery of the asset. the parties merely exchange the difference between the future and spot prices on the date of maturity.
ADVANTAGES:
One can derive the following advantages from a forward as well as future contract:
1. PROTECTION AGAINST PRICE FLUCTUATIONS:
Parties to these contracts can protect themselves against the risk of adverse fluctuations in the price of assets in question. for instance, the buyer a forward rate currency contract can avoid the risk of a possible adverse hike in exchange rate in future.similarly,the buyer of a commodity future contract can avoid the risk of a possible price escalation in future. thus risks can overcome.
2. AVOIDANCE OF CARRYING COSTS: the buyer of this contract can avoid paying carrying costs on the asset bought in advance since he need not take delivery of the asset in advance of the time it is required.
3. PROPER PLANING FOR BUYING/SELLING: These contracts enable the parties to buy or sell assets at the time when they are most requires and thus they prevent the need to purchase or sell assets in advance of future requirement. thus ,they facilitate proper planning for buying and selling.
4.PROPER PORTFOLIO MANAGEMENT: portfolio managers, investors or even speculators can use these contracts to hedge against future declines in portfolios or against adverse future fluctuations in prices. thus, they act as boon to portfolio managers in portfolio management.
5. PROPER CASH MANAGEMENT: these contracts avoid the payment of the purchase price immediately. in the absence of these contracts, liquid cash must have been paid at the time of the contract itself. now, the purchaser can make use of this fund to earn further income till the maturity of the contract.thus, the efficient cash management is made possible with help of these contracts.
6. PURACHASES AND SALES IN BULK: these contracts facilitate bulk purchases and sales of assets at short notice in advance of delivery and even in advance of production.
7.HIGHLY FLEXIBLE: these contracts are flexible and if the parties to the contract prefer to close out their positions by exchanging the net difference between the positions. thwy need not take the take the trouble of exchanging the assets physically
8.BOON TO FINANCIAL INTERMEDIARIES :these contracts give a very good scope for the financial companies to play a dynamic role.they can act as intermediaries between the parties.they can diversify their activities by innovating new instruments in this field and taking up new lines of financial activities in the best interest of their customers
OPTION
In the volatile environment, risk of heavy fluctuation in the prices of assets is very heavy.Option is yet another tool to manage such risk.
As the very name implies, an option contract gives the buyer an option to buy or sell an underlying asset(stock, bond, currency etc..)at a predetermined price on or before a specified date in future. The price so predetermined is called the ‘strike price’ or ‘exercise price’
Writer
In an option contract, seller is usually referd to as a “writer” since he is said to write the contract. It is similar to the seller who is said to be in ‘short position’ in a forward contract. However, in a put option, the writer is in a different position. He is obliged to buy shares. In an option contract, the buyer has to pay a certain amount at the time of writing the contract for enjoying the right to buy or sell.
Types of Option
Option may fall under any of the following category;
i. Call option
ii. Put option
iii. Double option
Call option:
A call option is one which gives the option holder the right to buy a underlying asset (commodities, foreign exchange, stocks, shares etc.,) at a predetermined price called “Exercise price” or “strike price” on or before a specified date in future. In such a case, the writer of a call option is under exercises his option to buy. Thus, the obligation to sell arises only when the option is exercised.
Put option:
A put option is one which gives the option holder the right to sell an underlying asset at a predetermined price on or before a specified date in future.It means that the writer of a put option is under an obligation to buy the asset at the exercise prie provided the option holder exercises his option to sell.
Double option:
A Double option is one which gives the option holder both the rights-either to buy or to sell an underlying asset at a predetermined price on or before a specified date in future.
Option Premium:
In an option contract, the option writer agrees to buy or sell an underlying asset at a future date for an agreed price from\to the option buyer\seller at his option. The consideration for this contract is a sum of money called ‘premium’.
Option Market:
Option market refers to the market where option contracts are brought and sold. Once an opyion contract is written, it can be bought or sold on the option market.
Benefits:
Option trading is beneficial to the parties. For instance, index based options help the investment managers to insure the whole portfolio against fall in prices rather than hedging each and every security individually.
Again, option writing is a source of additional income for the portfolio managers with a large portfolio of securities. Infact, large portfolio managers can guess the future movement of stock prices accurately and enter into option trading. Generally, the option writers are the most sophisticated participants in the option market and the option premiums are simply an additional source of income.
Option trading is also flexible and simple. For instance, option transactions are index based and so all calculations are made on the change in index value. The value at which the index points are contracted forms the basis for the calculation of profit or loss, fixing of option price etc.
Importance of Derivatives
Thus derivatives are becoming increasingly important in world markets as a tool for risk management. Derivative instruments can be used to minimize risk. Derivatives are used to separate the risks and transfer them to parties willing to bear these risks. The kind of hedging that can be obtained by using derivatives is cheaper and more convenient than what could be obtained by using cash instruments. It is so because, when we use derivatives for hedging, actual delivery of the underlying asset is not at all essential for settlement purposes. The profit on loss on derivative deal alone is adjusted in the derivative market.
Moreover, derivatives do not create any new risk. They simply manipulate risks and transfer them to those who are willing to bear these risks. Hedging risk through derivatives is not similar to speculation. The gain or loss on a derivative deal is likely to be offset by an equivalent loss or gain in the values of underlying assets, ‘Offsetting of risks’ in an important property of hedging transactions. But, in speculation one deliberately takes up a risk openly. When companies know well that they have to face risk in possessing assets, it is better to transfer these risks to those who ready to bear them.
All derivative instruments are very simple to operate. Treasury managers and portfolio managers can hedge all risks without going through the tedious process of hedging each day and amount/share separately.
Till recently, it may not have been possible for companies to hedge their long term risk, say 10-15 year risk. But with the rapid development of the derivative markets, now, it is possible to cover such risks through derivative instrument like swap. Thus, the availability of advanced derivatives market enables companies to concentrate on those management decisions other than funding decisions.
Further, all derivative products are low cost products. Companies can hedge a substantial portion of their balance sheet exposure, with a low margin requirement. Derivatives also offer high liquidity. Just as derivatives can be contracted easily, it is also possible for companies to get out of position in case that market reacts otherwise. This also does not involve much cost.
Derivatives in
In
In the forex market, there are brighter chances of introducing derivatives on a large scale. Infact, the necessary ground work for the introduction of derivatives in forex market was prepared by a high level expert committee appointed by the RBI. However there should be proper legislation for the effective implementation of derivative contracts. The utility of derivative through hedging can be derived, only when, there is transparency with honest dealings. The players in the derivative market should have a sound financial base for dealing in derivative transactions.
Now, derivatives have been introduced in the Indian Market in the form of index options and index futures. Index options and index futures are basically derivate tools based on a stock index. They are really the risk management tools. Since derivatives are permitted legally, one can use them to insulate his equity portfolio against the vagaries of the market.
Every investor in the financial area is affected by index fluctuations. Hence, risk management using index derivatives is of far more importance than risk management using individual security options. Moreover, Portfolio risk is dominated by the market risk, regardless of the composition of the portfolio. Hence, investors would be more interested in using index based derivative products rather than security based derivative products.
There are no derivatives based on interest rates in
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