What are Derivatives?

The term "Derivative" indicates that it has no independent value, i.e. its value is entirely "derived" from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, live stock or anything else. In other words, Derivative means a forward, future, option or any other hybrid contract of pre determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities.

The Securities Contracts (Regulation) Act 1956 defines derivative as under:

"derivative" includes -

1. a security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security;

2. a contract which derives its value from the prices, or index of prices of underlying securities;

The above definition conveys

1. That derivatives are financial products

2. Derivative is derived from another financial instrument/contract called the underlying. In the case of Nifty futures, Nifty index is the underlying.

3. A derivative derives its value from the underlying assets

Derivatives are used -

1. By Hedgers for protecting (risk-covering) against adverse movement. Hedging is a mechanism to reduce price risk inherent in open positions. Derivatives are widely used for hedging. A Hedge can help lock in existing profits. Its purpose is to reduce the volatility of a portfolio, by reducing the risk.

2. Speculators to make quick fortune by anticipating/forecasting future market movements. Hedgers wish to eliminate or reduce the price risk to which they are already exposed. Speculators, on the other hand are those class of investors who willingly take price risks to profit from price changes in the underlying. While the need to provide hedging avenues by means of derivative instruments is laudable, it calls for the existence of speculative traders to play the role of counter-party to the hedgers. It is for this reason that the role of speculators gains prominence in a derivatives market.

3. Arbitrageurs to earn risk-free profits by exploiting market imperfections. Arbitrageurs profit from price differential existing in two markets by simultaneously operating in the two different markets.

BSE Website has summarised the following benefits justifying derivatives trading-

"There are several risks inherent in financial transactions. Derivatives allow you to manage these risks more efficiently by unbundling the risks and allowing either hedging or taking only one (or more if desired) risk at a time. For instance, if we buy a share of TISCO from our broker, we take following risks.

1. "Price risk that TISCO may go up or down due to company specific reasons (unsystematic risk).

2. "Price risk that TISCO may go up or down due to reasons affecting the sentiments of the whole market (systematic risk).

3. "Liquidity risk, if our position is very large, that we may not be able to cover our position at the prevailing price (called impact cost).

4. "Counterparty (credit) risk on the broker in case he takes money from us but before giving delivery of shares goes bankrupt.

5. "Counterparty (credit) risk on the exchange - in case of default of the broker, we may get partial or full compensation from the exchange.

6. "Cash out-flow risk that we may not able to arrange the full settlement value at the time of delivery, resulting in default, auction and subsequent losses.

7. "Operating risks like errors, omissions, loss of important documents, frauds, forgeries, delays in settlement, loss of dividends & other corporate actions etc."

"Once we are long on TISCO we can hedge the systematic risk by going short on index futures. On the other hand, if we do not want to take unsystematic risk on any one share, but wish to take only systematic risk - we can go long on index futures, without buying any individual share. The credit risk, cash outflow risk and operating risks are much easier to manage in this case."

[Long Position:- which commits the buyer to purchase an item at the contracted price on maturity. Short Position:- which commits the seller to deliver an item at the contracted price on maturity.]

Badla is a mechanism to avoid the discipline of a spot market; to do trades on the spot market but not actually do settlement. The "carryforward" activities are mixed together with the spot market. SEBI has since disallowed badla system as stated in the article on the subject. For more information refer the detailed article on the subject.

the derivatives can be classified as

• Forwards (Currencies, Stocks, Swaps etc),

  Forward contract is different from a spot transaction, where payment of price and delivery of commodity concurrently take place immediately the transaction is settled. In a forward contract the sale/purchase transaction of an asset is settled including the price payable, not for delivery/settlement at spot, but at a specified future date. India has a strong dollar-rupee forward market with contracts being traded for one, two, .. six month expiration. Daily trading volume on this forward market is around $500 million a day. Indian users of hedging services are also allowed to buy derivatives involving other currencies on foreign markets.

• Futures (Currencies, Stocks, Indexes, Commodities etc)

  A futures contract has been defined as "a standardized, exchange-traded agreement specifying a quantity and price of a particular type of commodity (soybeans, gold, oil, etc.) to be purchased or sold at a pre-determined date in the future. On contract date, delivery and physical possession take place unless the contract has been closed out. Futures are also available on various financial products and indexes today.

  A futures contract is thus a forward contract, which trades on an exchange. S&P CNX Nifty futures are traded on National Stock Exchange. This provides them transparency, liquidity, anonymity of trades, and also eliminates the counter party risks due to the guarantee provided by National Securities Clearing Corporation Limited.

• Options (Currencies, Stocks, Indexes etc).

  Options are the standardized financial contracts that allows the buyer (holder) of the options, i.e. the right at the cost of option premium, not the obligation, to buy (call options) or sell (put options) a specified asset at a set price on or before a specified date through exchanges under stringent financial security against default.

A cash market transaction in which a seller agrees to deliver a specific cash commodity to a buyer at some point in the future. Unlike futures contracts (which occur through a clearing firm), forward contracts are privately negotiated and are not standardized. Further, the two parties must bear each other's credit risk, which is not the case with a futures contract. Also, since the contracts are not exchange traded, there is no marking to market requirement, which allows a buyer to avoid almost all capital outflow initially (though some counterparties might set collateral requirements). Given the lack of standardization in these contracts, there is very little scope for a secondary market in forwards. The price is specified in a forward contract for a specific commodity. The forward price makes the forward contract have no value when the contract is written. However, if the value of the underlying commodity changes, the value of the forward contract becomes positive or negative, depending on the position held. Forwards are priced in a manner similar to futures. Like in the case of a futures contract, the first step in pricing a forward is to add the spot price to the cost of carry (interest forgone, convenience yield, storage costs and interest/dividend received on the underlying). Unlike a futures contract though, the price may also include a premium for counterparty credit risk, and the fact that there is not daily marking to market process to minimize default risk. If there is no allowance for these credit risks, then the forward price will equal the futures price.

The main features of forward contracts are

• 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.

• 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.