Financial Instruments Derivatives

Derivatives are financial instruments, the prices of which are dependent on one or more than one underlying assets. In simple terms, these are a contract between the two parties in general. The value of a derivative is ascertained on the basis of fluctuations in its underlying asset. For example, we can have derivatives on stocks; bonds; indexes; currency; interest rates and commodities. These are highly leveraged instruments, where one does not needs to pay the full money of transactions upfront.

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History in India

SEBI gave permission of trading in derivatives in June, 2000. Since, then, the market has evolved manifold both in terms of value and volume across the different types of it. The market started with trading in futures at both NSE and BSE. Currently, there are both futures and options.

Why do people trade in Derivatives?

• Hedging: Public is unaware about the future. So, in order to safeguard themselves from the uncertainty of prices of the underlying in future, they try to hedge the risk by entering into a derivative contract.
• Speculation: there is also a large crowd, which trades in derivatives just for the sake of speculating. This is more of a kind of gamble which people make, predicting what would be the price of the asset in future.
• Arbitrage: these are people who make profits out of mispricing existing in different places. By this, it means that they take the opportunity to cough up riskless profit out of trading in different markets by buying in the cheap market and selling at a higher price in the expensive one.

Derivatives vis-à-vis Assets

• To trade in derivatives, one needs a small proportion of the capital as a margin money, while if you directly buy in the spot market, then you would be required to pay up in full for the asset.
• Due to the leverage aspect of the derivatives, it becomes extremely important to trade cautiously, because of the risk of bankruptcies in case of non-payment of losses.

Types of Derivatives

Although the complexity of a derivative instrument is huge; but, to simplify it, we can categorize it under 4 broad heads:

Forwards – These are contracts in which the buyer agrees to buy the financial or physical asset, and the seller agrees to sell/deliver the asset at an agreed upon price on a specified future date. However, these are customized contract, and each party to this contract is exposed to default risk, the risk of non-performance by either of the party. Generally, there is hardly, any money changing hands at the initiation of the contract. There are various types of it – Currency; Interest Rates; Bonds; Commodities etc.

Futures – These are standard deliverable contracts between the two parties, in which, party agreeing to buy(long position) and the party agreeing to sell(short position), both are under obligation to perform their respective contract for a certain price on a specified future date. These are exchange-traded derivatives, in which, there is a clearing house that takes care of the default risk, and hence, does not makes any party to suffer that risk. Instead, it follows a Marked to Market mechanism, wherein, parties to the contract are told to pay up for the losses and withdraw for the gains, if any, on a day to day basis. Hence, the chance of default risk to both the parties is minimized significantly. The government having legal jurisdiction regulates the futures market.

Options – there are two types of options, one is a call option, and other is a put option. An option to buy an asset at a particular price is termed as a call option. Here, the option seller is obliged to sell the asset at the agreed upon price if the buyer exercises/executes his/her option. An option to sell an asset at a particular price is termed as a put option. The seller of the option has an obligation to buy the asset at the agreed upon price, if the put option buyer exercises the option with him.

Swaps – A swap is considered equal to a series of forward contracts. If we take up the case of a plain vanilla swap, one party agrees to pay the short-term (floating) rate of interest on some principal amount, and the counter-party agrees to pay a certain (fixed) rate of interest in return.

This article has been authored by Kushal Gupta from LBSIM

References:

• http://www.investopedia.com/terms/d/derivative.asp
• http://www.sharegyan.com/nse/types-of-derivatives/
• http://www.bseindia.com/markets/Derivatives/DeriReports/FAQsBasicsofDerivatives.aspx