2. Derivative
■ Derivative means an financial instrument which derives it value from the
underlying asset
■ What is underlying asset? It can be
Share (TCS, Nykaa, Zomato, Paytm)
Commodity (Gold, Silver, Crude oil, Rubber, Copper, Zinc)
Others (Currency, Interest rates)
3. Regulation & trading framework for derivatives
Dr. L.C Gupta Committee constituted by SEBI had laid down the regulatory framework for
derivative trading in India.
Eligibility conditions have been framed to ensure that Derivative Exchange/Segment &
Clearing Corporation/House provide a transparent trading environment, safety & integrity
and provide facilities for redressal of investor grievances
With the amendment in the definition of 'securities' under SC(R)A (to include derivative
contracts in the definition of securities), derivatives trading takes place under the provisions
of the Securities Contracts (Regulation) Act, 1956 and the Securities and Exchange Board of
India Act, 1992.
Regulatory powers were delegated to SEBI. It has allowed BSE & NSE to offer derivatives
where they have started in June,2000
4. When did it started
Stock
BSE,NSE - in June, 2000
Currency
NSE - Aug,2008
BSE - Oct,2008
Commodity
Brought under SEBI from 2015, Earlier it was under FMC
SEBI regulates Stock & Commodity derivatives
RBI regulates Interest Swap, Forex Derivatives
5. Interest Rate Derivatives
An interest rate derivative is a financial instrument with a value that is linked to the movements
of an interest rate or rates. These may include futures, options, or swaps contracts. Interest rate
derivatives are often used as hedges by institutional investors, banks, companies, and
individuals to protect themselves against changes in market interest rates, but they can also be
used to increase or refine the holder's risk profile or to speculate on rate moves
Interest rate – Fixed to floating
Caps & floors - A company with a floating rate loan that does not want to swap to a fixed rate
but does want some protection can buy an interest rate cap. The cap is set at the top rate that the
borrower wishes to pay; if the market moves above that level, the owner of the cap receives
periodic payments based on the difference between the cap and the market rate. The premium,
which is the cost of the cap, is based on how high the protection level is above the then-current
market; the interest rate futures curve; and the maturity of the cap; longer periods cost more, as
there is a higher chance that it will be in the money.
6. ■ Contract Size - Contract size refers to the
Deliverable quantity of a stock, commodity, or other financial instruments
Underlie futures or options contract.
It is a standardized amount that tells buyers and sellers exact quantities that are being bought
or sold, based on the terms of the contract. Contract sizes are often standardized by
exchanges. Size of the contract varies depending on the commodity or instrument
■ Lot Size - In the stock market, lot size refers to the number of shares you buy in one
transaction. In options trading, lot size represents the total number of contracts contained in
one derivative security.
Eg.- Zomato priced in range of 72 to 76 qith lot size of 195 shares which means investor can
buy shares only in multiples of 195 like 195, 390, 585, 780…
7. ■ Tick Size - Tick size refers to the minimum price fluctuation in the value of a contract.
The tick size is presently "0.05" or 5 paisa. In Rupee terms, this translates to a minimum
price fluctuation of Rs. 0.75 for a single transaction of S & P BSE SENSEX Futures
Contract (Tick size X Contract Multiplier = 0.05 X Rs. 15)
■ Multipliers - This means that the Rupee notional value of a Sensex futures contract
would be XX times the contracted value
Lets say, Multiplier of Sensex is 15
Contracted Price of Futures Notional Value in Rs.
(Based on Market Lot of 15 )
17,800 2,67,000 (17,800*15)
17,850 2,67,750 (17,850*15)
17,900 2,67,800 (17,900*15)
8. ■ Hedging risk exposure - Since the value of the derivatives is linked to the value of the
underlying asset, the contracts are primarily used for hedging risks. For example, an investor
may purchase a derivative contract whose value moves in the opposite direction to the value of
an asset the investor owns. In this way, profits in the derivative contract may offset losses in the
underlying asset.
■ Underlying asset price determination - Derivatives are frequently used to determine the price
of the underlying asset. For example, the spot prices of the futures can serve as an
approximation of a commodity price.
■ Access to unavailable assets or markets - Derivatives can help organizations get access to
otherwise unavailable assets or markets. By employing interest rate swaps, a company may
obtain a more favorable interest rate relative to interest rates available from direct borrowing
Derivatives - Advantages
9. Derivatives - Disadvantages
Despite the benefits that derivatives bring to the financial markets, the financial instruments come with some
significant drawbacks. The drawbacks resulted in disastrous consequences during the Global Financial Crisis
of 2007-2008. The rapid devaluation of mortgage-backed securities and credit-default swaps led to the
collapse of financial institutions and securities around the world
■ High risk - The high volatility of derivatives exposes them to potentially huge losses. The sophisticated
design of the contracts makes the valuation extremely complicated or even impossible. Thus, they bear a
high inherent risk.
■ Speculative features - Derivatives are widely regarded as a tool of speculation. Due to the extremely
risky nature of derivatives and their unpredictable behavior, unreasonable speculation may lead to huge
losses.
■ Counter-party risk - Although derivatives traded on the exchanges generally go through a thorough
due diligence process, some of the contracts traded over-the-counter do not include a benchmark for due
diligence. Thus, there is a possibility of counter-party default.