Derivatives Trading in Financial Markets

Derivatives were not traded in the financial markets of the world up to the period about three decades back, though Stock Exchanges trading in securities in the cash market came to be in vogue more than a century ago. In India the first Stock Exchange, BSE was established in 1875. But BSE commenced trading in derivatives only from 2001. Even in the international financial/securities market the advent of derivatives as trading products was a concurrent-effect with the process of globalisation and integration of the national economies of the developed countries beginning from the Seventies of the last Century. As volumes traded increased and as competition turned intense, trade & business became more complex in the new environment. The new opportunities were matched by fresh challenges and unpredictable volatility of the trading environment. Corporates for the first time sensed the formidable risks inherent in business transactions and the unpredictability of the markets to which they are exposed. Facing multiple risks the business organisations, were induced to search for new remedies, i.e. risk containment devices/instruments. Derivatives came to be the natural remedy in this context. To quote an international professional authority:

"As capital markets become increasingly integrated, shocks transmit easily from one market to another. The proliferation of new instruments with complex features has led to enhanced investment opportunities. One such instrument which has become darling of corporates, banks, institutions alike is 'Derivatives'. To have a touch of the tree top's view, Derivatives transaction is defined as a bilateral contract whose value is derived, from the value of an underlying asset, or reference rate, or index. Derivative transactions have evolved in the past twenty years to cover a broad range of products which include instruments like 'forwards', 'futures', 'options', 'swaps' covering a broad spectrum of underlying assets including exchange rates, interest rates, commodities, and equities."
[Extract from newsletter from the Association of Chartered Treasury Managers, December 15-28,2000, promoted by the Transworld University, USA]

Though recent in origin derivatives instruments issued over the years have grown by leaps and bounds and the total amount issued globally is estimated to approach $80 trillion by the advent of the new millenium. Derivative positions have grown at a compounding rate of 20% since 1990. In India though derivatives were introduced very recently in 2001, the trading turnover has already surpassed that of the equity segment. In NSE alone as per a report on its website the total turnover of the derivatives segment for the month of May 2003 stood at Rs. 53424 crores. During the month of May 2003, the percentage of derivatives segment as a percentage of the cash segment was 97.68%. However in the earlier two months the turnover of Derivatives was higher than that of the cash segment.

"The pace of innovation in derivatives markets increased remarkably in the 1970s.

• The first major innovation occurred in February 1972, when the Chicago Mercantile Exchange CME began trading futures on currencies in its International Monetary Market (IMM) division. This marked the first time a futures contract was written on anything other than a physical commodity.

• The second was in April 1973, when the CBT formed the Chicago Board Options Exchange (CBOE) to trade options on common stocks. This marked the first time an option was traded on an exchange.

• The third major innovation occurred in October 1975, when the CBT introduced the first futures contract on an interest rate instrument - Government National Mortgage Association futures.

• In January 1976, the CME launched Treasury bill futures and, in August 1977, the CBT launched Treasury bond futures.

• The 1980s brought yet another round of important innovations. The first was the use of cash settlement. In December 1981, the IMM launched the first cash settlement contracts, the 3-month Eurodollar futures. At expiration, the Eurodollar futures is settled in cash based on the interest rate prevailing for a three-month Eurodollar time deposit .

• Cash settlement made feasible the introduction of derivatives on stock index futures, the second major innovation of the 1980s. In February 1982, the Kansas City Board of Trade (KCBT) listed futures on the Value Line Composite stock index, and, in April 1982, the CME listed futures on the S&P 500. These contract introductions marked the first time that futures contracts were written on stock indexes.

• The third major innovation of the 1980s was the introduction of exchange-traded option contracts written on "underlyings" other than individual common stocks. The CBOE and AMEX listed interest rate options in October 1982 and the Philadelphia Stock Exchange (PHLX) listed currency options in December 1982 as also options and gold futures.

• In January 1983, the CME and the New York Futures Exchange (NYFE) began to list options directly on stock index futures, and, in March 1983, the CBOE began to list options on stock indexes.

These two decades of innovation have transformed the nature of derivatives trading activity on exchanges. While derivatives exchanges were originally developed to help market participants manage the price risk of physical commodities, today's trading activity is focused on hedging the financial risks associated with unanticipated price movements in stocks, bonds, and currencies.

The 1980s also saw the re-emergence of OTC derivatives trading. As derivatives on financial assets became increasingly popular, investment banks began to think of new ways to tailor contracts to meet customer needs. Some innovations were minor changes in the standard terms of exchange-traded derivatives contracts on financial instruments (e.g., modifications to the expiration date and/or the contract denomination).

1. In 1980, for example, the first OTC Treasury bond option was traded. Other contracts were new and seemingly different. They fall under the generic heading of "swaps". A swap contract is a contract to "swap" a series of periodic future cash flows, where the terms of the swap are usually set such that the up-front payment is zero.

2. The first interest rate swap was in 1981, when the Student Loan Marketing Association (i.e., "Sallie Mae") swapped interest payments on intermediate-term fixed rate debt for floating-rate payments indexed to the three-month Treasury bill rate. The cash flows of the two legs of a swap can be linked to virtually any asset or index.

3. A basis rate swap, for example, is an exchange of floating rate payments where the two floating rates are linked to, say, a three-month Treasury bill rate and a three-month Eurodollar time deposit rate.

4. A currency swap is an exchange of interest payments (either fixed or floating) in one currency for payments (either fixed or floating) in another.

5. An equity swap involves the exchange of an interest rate payment and a payment based on the performance of a stock index.

6. an equity basis swap involves an exchange of payments on two different indexes. Swap agreements may appear different from standard forward and option contracts, but they are not. Every swap can be decomposed into a portfolio of forwards and options. The benefit a swap provides is that several transactions are bundled into a single product."
   [Source: From Article titled Derivatives published by Robert E. Whaley, Faculty, Fuqua School of Business, Duke University, USA]

1. Futures /Forward

2. Options

3. Warrants

4. Swaps

Derivatives have come and to stay everywhere with a hoard of new words and jargons. Global turnover upto 1994 given below. It is now necessary for us to learn in detail what derivatives are and what are their features & characteristics. For this purpose let us go to the next page and further.