OVERVIEW recent years, the market for financial derivatives

OVERVIEW ON DERIVATIVES
MARKET

 

INTRODUCTION

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In industrialized countries apart from money market
and capital market securities, a variety of other securities known as
“derivatives” have now become available for investment and trading. The
derivatives originate in mathematics and refer to a variable which has been
derived from another variable. A derivative is a financial product which has
been derived from another financial product or commodity.

           

DERIVATIVES

            Derivatives
are financial instruments that are mainly used to protect against or to manage
risks, and very often also for investment purposes, providing various
advantages compared to securities. Derivatives come in many varieties and can
be differentiated by how they are traded, what they refer to, and the product
type.

 

A derivative is an instrument whose
value is derived from the value of one or more underlying assets such as
commodities, precious metals, currency, bonds, stocks, etc. A derivative
instrument by itself does not constitute ownership. It is, instead, a promise
to convey ownership. All derivatives are based on some “cash” products. The
underlying basis of a derivative instrument may be any product including

Commodities like grain, coffee
beans, orange juice, etc.
Precious metals like gold and
silver
Foreign exchange rate
Bonds of different types, including
medium and long-term negotiable debt securities issued by governments,
companies, etc.
Short-term debt securities such as
T-bills

 

EMERGENCE
OF FINANCIAL DERIVATIVES

Derivative products initially emerged as
hedging devices against fluctuations in common prices. Financial derivatives
came into limelight in the post-1970s due to growing instability in the
financial markets. However, since their emergence, financial derivatives
products have become very popular and in 1990’s, overtaking the commodity
derivatives they accounted for about two-thirds of total transaction in
derivative market. In recent years, the market for financial derivatives has
grown tremendously in terms of variety of instruments available, their
complexity and also in terms of turnover.

 

In the class of equity derivatives
world, futures and options on stock indices have gained more popularity than on
individual stocks, especially among institutional investors, who are the major
users of index-linked derivatives. The lower cost associated with index
derivatives than derivative products based on individual securities is another
reason for their growing use.

 

HISTORY OF DERIVATIVE
MARKET IN INDIA

Derivatives markets in
India have been in existence in one form or the other for a long time. In the
area of commodities, the Bombay Cotton Trade Association started futures
trading way back in 1875. In 1952, the Government of India banned cash
settlement and options trading. Derivatives trading shifted to informal
forwards markets. In recent years, government policy has shifted in favour of
an increased role of market-based pricing and less suspicious derivatives
trading.

 

The first step towards
introduction of financial derivatives trading in India was the promulgation of
the Securities Laws (Amendment) Ordinance, 1995. It provided for withdrawal of
prohibition on options in securities. The last decade 2000, saw lifting of ban
on futures trading in many commodities. Around the same period, national
electronic commodity exchanges were also set up. Derivatives trading commenced
in India in June 2000 after SEBI granted the final approval to this effect in
May 2001 on the recommendation of L. C Gupta committee. Securities and Exchange
Board of India (SEBI) permitted the derivative segments of two stock exchanges,
NSE3 and BSE4, and their clearing house/corporation to commence trading and
settlement in approved derivatives contracts.

 

Initially, SEBI
approved trading in index futures contracts based on various stock market
indices such 3 The National Stock Exchange (NSE), located in Bombay is the
first screen based automated stock exchange. It was set up in 1993 to encourage
stock exchange reform through system modernization and competition. It opened
for trading in mid1994 and today accounts for 99% market shares of derivatives
trading in India. Bombay Stock Exchange (BSE), which is Asia’s Oldest Broking
House, was established in 1875 in Mumbai. It is also called as Dalal Street.
The BSE Index, called the Sensex, is calculated by Free Float Method by
including scrips of top 30 companies selected on the market capitalization
criterion.

 

The trading in BSE
Sensex options commenced on June 4, 2001 and the trading in options on
individual securities commenced in July 2001. Futures contracts on individual
stocks were launched in November 2001. The derivatives trading on NSE commenced
with S&P CNX Nifty Index futures on June 12, 2000. The trading in index
options commenced on June 4, 2001 and trading in options on individual
securities commenced on July 2, 2001. Single stock futures were launched on
November 9, 2001. The index futures and options contract on NSE are based on
S&P CNX. In June 2003, NSE introduced Interest Rate Futures which were
subsequently banned due to pricing issue.

 

SIGNIFICANCE OF DERIVATIVE MARKET

The derivatives market performs a number of economic functions;
they are

Price Discovery: Prices
in an organized derivatives market reflect the perception of market
participants about the future and lead the prices of underlying to the
perceived future level. Thus derivatives help in discovery of future as
well as current prices.
Risk Transfer: Due
to the inherent link of derivatives market with the underlying cash
market, witnesses higher trading volumes because of participations by more
players who would not have otherwise participated for lack of an
arrangement to transfer risk.
Controlled Speculative
Trading: Speculative trades shift to a more
controlled environment due to the existence of derivatives market. In the
absence of an organized derivatives market, speculators trade in the
underlying cash markets and margining, monitoring and surveillance of the
activities of various participants become extremely difficult in
derivative markets.
Financial Architecture: The
derivative has a history of attracting many bright, creative,
well-educated people with an entrepreneurial attitude. They often energize
others to create new business, new products and new employment
opportunities, the benefit of which is immense.
Enhancing Volume of Activity: Derivatives
market help to increase savings and investment in the long run and
transfer of risk enables the market participants to expand their volume of
activity.

 

CLASSIFICATION OF DERIVATIVES

There are two groups of derivative
contracts, which are distinguished by the way they are traded in the market.

1.     
Over-the-counter
derivatives

2.     
Exchange-traded
derivatives

 

Over-the-counter (OTC) derivatives are
contracts that are traded (and privately negotiated) directly between two
parties, without going through an exchange or other intermediary. Products such
as swaps, forward rate agreements, exotic options and other exotic derivatives
are almost traded in this way. The OTC derivative market is the largest market
for derivatives, and is mostly unregulated with respect to disclosure of
information between the parties.

 

Exchange-traded
derivative contracts (ETD) are those derivatives instruments that are traded
via specialized derivatives exchanges or other exchanges. A derivatives exchange
is a market where individual trade standardized contracts that have been
defined by the exchange. It acts as an intermediary to all related
transactions, and takes initial margin from both sides of the trade to act as a
guarantee.

 

The most commonly used derivatives contracts are

1.     
Forward

2.     
Future

3.     
Option

4.     
Swap.

 

 Forward Contracts:

A forward contract is an agreement
between two parties to buy and sell a commodity or financial asset at certain
future time for a certain price. A forward contract is traded in the
over-the-counter market usually between two financial institutions or between a
financial institution and one of its clients. One of the parties to a forward
contract assumes a long position and agrees to buy the underlying asset on a
certain specified future date for a certain specified price. The other party
assumes a short position and agrees to sell the asset on the same date for the
same price.

 

Futures Contracts:

A futures contract is an agreement
between two parties to buy or sell an asset at a certain time in the future for
a certain price. Futures contracts are normally traded on an exchange. As the
two parties to the contract do not necessarily know each other, the exchange
provides a mechanism that gives the two parties a guarantee that the contract
will be honoured. The largest exchanges on which futures contracts are traded
are the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange
(CME). On these and other exchanges throughout the world, a very wide range of
commodities and financial assets form the underlying assets in the various
contracts. The commodity includes even pork bellies, live cattle, sugar, wool,
lumber, copper, aluminium, gold, and tin. The financial assets include stock
indices, currencies, and treasury bonds.

 

The contract is referred to by its
delivery month, and the exchange specifies the period during the month when
delivery must be made. For commodities, the delivery period is often the entire
month. The holder of the short position has the right to choose the time during
the delivery period when it will make delivery. The exchange specifies the
amount of the asset to be delivered for one contract and how the futures price
is to be quoted. In the case of a commodity, the exchange also specifies the
product quality and the delivery location.

 

Options Contracts

Options are traded both on exchanges and
in the over-the-counter market. There are two basic types of options.

 

A call
option gives the holder the right to buy the underlying asset by a certain
date for a certain price.

 

A put
option gives the holder the right to sell the underlying asset by a certain
date for a certain price.

 

The price in the contract is known as
the exercise price or strike price; the date in the contract is known as the
expiration date or maturity date.
The price paid by the buyer to the seller to acquire the right to buy or sell
is known as the Premium. The one who is obligated to buy the underlying asset
in case of the buyer of the option decides to exercise his option is known as
the option seller/ writer. The one who buys an option which can be a call or a
put option is known as the option holder.

 

When the option’s strike price is equal to the
underlying asset price, the option is said to be ‘at-the-money’. A call option
is said to be ‘in-the-money’ when the strike price of the option is less than
the underlying asset price. A call option is said to be ‘out-the-money’ when
the strike price is greater than the underlying asset price.

 

Swap contracts

            Swap
refers to an exchange of one financial instrument for another between the
parties concerned. This exchange takes place at a predetermined time, as
specified in the contract.

The two commonly used swaps are interest rate swaps and currency swaps.

Interest
rate swaps: These involve swapping only the interest
related cash flows between the parties in the same currency.
Currency
swaps: 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.

 

PLAYERS IN DERIVATIVE MARKETS

Three broad categories of traders can be
identified among the players in the market:             

Hedgers
Speculators
Arbitrageurs

Hedgers use futures, forwards, and options to reduce
the risk that they face from potential future movements in a market variable.
Speculators use them to bet on the future direction of a market variable.
Arbitrageurs take offsetting positions in two or more instruments to lock in a
profit.

 

Hedgers

 Hedgers
are the traders who wish to eliminate the risk associated with the price of an
asset and they may take a long position or short position on a commodity to
lock in existing profits. The main purpose is to reduce the volatility of a
portfolio, by reducing the risk. An option contract involves an initial cost.
In the event of call is not exercised, the premium paid for it becomes a net
loss while if it is exercised, the profit resulting from the call exercise
compensates the cost.

 

Speculators

Speculators are those who are willing to
take such risk. These are the people who take positions in the market and
assume risks, to gain profit from fluctuations in prices. In fact, the
speculators consume information, make forecasts about the prices and put their money
in these forecasts. By taking positions, they are betting that a price would go
up or they are betting that it would go down. Depending on their perceptions,
they may take long or short positions on futures or options or may hold spread
positions.

Speculators in the derivatives market may be categorized as

Scalpers – Scalpers attempt to make
profit from small changes in the contract price.

Day traders – Day traders speculate
on the price movements during single trading day, thus open and close positions
many times a day but do not carry any position at the end of the day.

Position traders – Position
traders attempt to gain from price fluctuations by keeping their positions open
for longer durations – may be for a few days, weeks or even months.

 

Arbitrageurs

Arbitrageurs attempt to earn risk-free
profits by exploiting market imperfections. An arbitrageur profits by trading a
given commodity or other items that sell for different prices in different
markets. Thus, arbitrage involves making riskless profit by simultaneously
entering into transactions in two or more markets. If a certain share is quoted
at a lower rate on the NSE and at a higher rate on the BSE, an arbitrageur
would make profit by buying the share at NSE and simultaneously selling it at
BSE. This type of arbitrage is “arbitrage over space”.

 

INDEX BASED DERIVATIVES

            As
price volatility in individual stocks is very high, futures based on individual
stocks are not very common. In India, L.C. Gupta committee has not mentioned
futures on individual stocks as a possible derivative contract. The index based
derivatives is very popular.

            The value of an index is derived
from the value it underlying. For example, the value of the BSE 30 Sensex, is
derived from the value of the 30 shares on which the index is based. These are
the shares of large well-established sound companies.

           

According to the Committee on Derivatives set up the
securities and Exchange Board of India (SEBI) under the chairmanship of L.C.
Gupta, stock index futures are internationally the most popular form of equity
derivatives for the following reasons:

1.      They
provide portfolio hedging facility.

2.      There
is less risk in manipulation of stock index as compared to individual stock
prices.

3.      Their
greater popularity makes them more liquid.

4.      Stock
index is generally less volatile than individual stock prices.

Both
the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) have
launched index futures in June 2000.

 

CONCLUSION

Financial derivatives
have earned a well deserved extremely significant place among all the financial
instruments (products), due to innovation and revolutionized the landscape.
Derivatives are tool for managing risk. Derivatives provide an opportunity to
transfer risk from one to another. Launch of equity derivatives in Indian
market has been extremely encouraging and successful. The growth of derivatives
in the recent years has surpassed the growth of its counterpart globally.

 

REFERENCE

Books:

Francis
Cherunilam, “BUSINESS ENVIRONMENT”, 17th Edition – February 2006.
E. Gordon, “FINANCIAL
MARKET AND SERVICES”, 10th Edition – May 2016.
Rangarajan
K. Sundaram, “DERIVATIVES IN FINANCIAL MARKET DEVELOPMENT”, February 2013.

Journals:

 

Dr. P. V.
Raveendra, “A STUDY OF DERIVATIVES
MARKET IN INDIA AND ITS CURRENT POSITION IN GLOBAL FINANCIAL DERIVATIVES
MARKET”.

Website:

WWW.NCDEX.COM

 

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