Derivatives are financial instruments that have no intrinsic value, but derive their value from something else. They hedge the risk of owning things that are subject to unexpected price fluctuations, e.g. foreign currencies, crude oil, stocks and government bonds.
The term "derivative" indicates that it has no independent value, i.e. its value is entirely "derived" from the value of the cash asset. A derivative contract or product, or simply "derivative", is to be sharply distinguished from the underlying cash asset, i.e. the asset bought/sold in the cash market on normal delivery terms.
The price of the cash instrument is referred to as the "underlying" price. Examples of cash instruments include actual shares in a company, physical stocks of commodities, foreign exchange, etc.
Examples of Derivatives
Forward contract is an agreement entered between two parties to buy or sell an asset at a future date for an agreed price. Forward contract is not traded on an exchange.
For example, a foreign exchange forward contract requires party A to buy (and party B to sell) 1 million euros for U.S. dollars at $1.0865 per euro say, a year from now.
Main features of forward contracts
They are bilateral contracts and hence exposed to counter-party risk.
Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.
Main features of forward contracts…
The contract price is generally not available in public domain.
The contract has to be settled 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.
Futures contracts are like forwards, except that they are highly standardized.
A futures contract is an agreement between two parties to buy or sell a specified quantity and quality of asset at a certain time in future at a certain price agreed at the time of entering into the contract on the futures exchange .
Futures contracts are standardized tradable contracts.
They are standardized in terms of size, expiration date and all other features.
They are traded on specially designed exchanges in an environment of stringent financial safeguards.
They are liquid and transparent. Their market prices and trading volumes are regularly reported.
The futures trading system has effective safeguards against defaults in the form of Clearing Corporation guarantees for trades and the daily cash adjustment (mark-to-market) to the accounts of trading members based on daily price change.
An Option is the right but not the obligation of the holder, to buy or sell underlying asset by a certain date at a certain price.
There are two types Options:
A call option is a contract that gives the owner the right, but not obligation to buy the underlying asset by a specified date at a specified price.
A put option is a contract that gives the owner the right, but not obligation to sell the underlying asset by a specified date at a specified price.
A call option will give the investor the right to buy, say, crude oil at $58 a barrel over a 3 months period.
If the price rise above the strike price of $58 before the option expires (i.e., before the 3 months are over), then the investor can exercise the option and capture a profit equal to the market price less $58.
CALL OPTION example
Say for example the price of oil rises to $60. The investor will exercise the option by buying oil at US$58 and then sells it in the open market at $60 thus pocketing the $2 profit.
CALL OPTION example
If, on the other hand, the price never rises above $58 or even falls below that level, then the option expires worthless or "out of the money" and the investor loses the money (known as the option premium) he paid for the option.
A put option is similar.
Take the example of coffee. A put option would provide an investor the right to sell coffee at a strike or exercise price of $0.65 per pound;
if the price were to fall to say $0.60, then the investor would be able to exercise the put option (i.e., sell the coffee at $0.65 while buying from the open market at US$0.60) and gain $0.05 for every pound of coffee covered by the options contract.
Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula.
The two commonly used swaps are :
1) Interest rate swap: These entail swapping only the interest related cash flows between the parties in the same currency. This involves the exchange of fixed-rate and floating-rate interest payments for a fixed par value
2)Currency swap : These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. Currency swap is the exchange of interest payments in different currencies
Worldwide derivatives market
The derivatives market is mostly made up of derivatives based on:
Interest rates: ( ~65% of the market).
Currencies: (~25%). Options and swaps on foreign exchange.
Equity: (~5-10%). Index futures, Index swaps, etc.
Uses of derivatives:
They are useful in reallocating risk either across time or among individuals with different risk-bearing preferences.
Uses of derivatives…
One kind of passing-on of risk is mutual insurance between two parties who face the opposite kind of risk. For example, in the context of currency fluctuations, exporters face losses if the rupee appreciates and importers face losses if the rupee depreciates. By forward contracting in the dollar-rupee forward market, they supply insurance to each other and reduce risk.
How derivatives markets work
Derivatives are traded in two kinds of markets: in exchanges and in over-the-counter (OTC) markets.
Traditionally exchanges have used the open-outcry system, but increasingly they are switching to electronic trading
Contracts are standard there is virtually no credit risk
A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers
Contracts can be non-standard and there is some small amount of credit risk
The participants in a derivatives market
Hedgers use futures or options markets to reduce or eliminate the risk associated with price of an asset.
Speculators use futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture.
Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.
Development of Derivatives in India:
Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2000.
SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts.
To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE–30(Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities.
Beginning of Exchange traded derivatives in India
June 2000 – Equity Index futures
June 2001 – Equity Index options
July 2001 – Stock Options
November 2001 – Stock futures
June 2003 – Interest rate futures
FUTURES AND OPTIONS TRADING IN INDIA
Products on NSE
Index futures and options on 6 indices:
S&P CNX Nifty
S&P Nifty Junior
Nifty Midcap 50
Futures and Options on individual securities (189 securities)
Interest Rate Derivatives
Futures and Options on index
S&P CNX Nifty is a well diversified 50 stock index.
CNX Nifty Junior is an index based on 50 stocks.
CNX 100 is an index based on 100 stocks.
CNX Bank Index is an index comprised of the 12 most liquid and large capitalized Indian Banking stocks.
CNX IT Index is an index based on 20 stocks of the IT sector.
Futures and Options on Individual Securities
The futures and options contracts are available on 189 securities stipulated by the Securities & Exchange Board of India (SEBI).
As per SEBI guidelines the stock shall be chosen from amongst the top 500 stocks in terms of average daily market capitalization and average daily traded value in the previous six months on a rolling basis.
3 month trading cycle - the near month (one), the next month (two) and the far month (three)
Expiry day- Last Thursday of the expiry month. If the last Thursday is a trading holiday, then the expiry day is the previous trading day.
On expiry of the near month contract, new contracts are introduced on the trading day following the expiry of the near month contract. The new contracts are introduced for three month duration.
The options contracts on index are European style and cash settled. Option contracts on individual securities are American style and cash settled.