A derivative is a contract between two parties, which derives its value from an underlying asset. It gives certain rights and obligations to both the parties and has either linear or skewed payoffs. Underlying assets include shares, bonds, foreign exchange, gold, silver, energy resources etc. Derivatives can either be traded over-the-counter or on an exchange. Derivatives, in the modern era, are used for hedging the risk, to create an ability to derive value from contingent events, to provide leverage, and to speculate to earn profits. Futures, Forwards, Options, and Swaps are some of the common forms of derivatives.
Types of underlying asset-
Financial assets such as equities, debts, bonds, currencies and indices.
Agricultural produce such as grains, coffee, pulses and cotton.
Metals such as gold, silver, copper and aluminum.
Energy sources such as crude oil, natural gas, electricity and coal.
History of derivatives market–
Derivatives market in India has a history dating back in 1875. The Bombay Cotton Trading Association started future trading in this year. History suggests that by 1900 India became one of the world’s largest futures trading industry. However after independence, in 1952, the government of India officially put a ban on cash settlement and options trading. This ban on commodities future trading was uplift in the year 2000. The creation of National Electronics Commodity Exchange made it possible. In 1993, the National stocks Exchange, an electronics based trading exchange came into existence. The Bombay stock exchange was already fully functional for over 100 years then. Over the BSE, forward trading was there in the form of Badla trading, but formally derivatives trading kicked started in its present form after 2001 only. The NSE started trading in CNX Nifty index futures on June 12, 2000, based on CNX Nifty 50 index.
Types of players-
Hedgers- Hedgers are traders who use derivatives to reduce the risk that they face from potential movements in a market variable and they want to avoid exposure to adverse movements in the price of an asset. Majority of the participants in derivatives market belongs to this category.
Speculators- Speculators are traders who buy/sell the assets only to sell/buy them back profitably at a later point in time. They want to assume risk. They use derivatives to bet on the future direction of the price of an asset and take a position in order to make a quick profit. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture.
Arbitrageurs- Arbitrageurs are traders who simultaneously buy and sell the same (or different, but related) assets in an effort to profit from unrealistic price differentials. They attempts to make profits by locking in a riskless trading by simultaneously entering into transaction in two or more markets.
Type of derivatives-
Forward contract –
A Forwards contract is known to be a contract between two parties (individuals or entities) for buying or selling any asset (at a specific decided amount) at one specific time in the future. In the case of Forwards Derivative, there are two positions people take, one is going long and other is going short.
For instance, out of the two parties, the one which decides to buy in the future undertakes a long position, whereas the one which decides to sell in the future undertakes a short position.
Suppose we need to buy some gold ornaments, say from a local jewelry manufacturer Gold Inc. Further, assume we need these gold ornaments some 3 months later in the month of February. We agree to buy the gold ornaments at Rs 48500 per 10 gram on 8 FEB, 2022. The current price, however, is INR 4800 per gram.
This will be the forward rate or the delivery price three months from now on the delivery date from the Gold Inc.
This illustrates a forward contract. Please note that, during the agreement there is no money transaction between we and Gold Inc. Thus during the time of the creation of the forward contract no monetary transaction takes place. The profit or loss to the Gold Inc. depends rather, on the spot price on the delivery date.
Now assume that the spot price on delivery day becomes INR 480700 per 10 gram. In this situation, Gold Inc will lose INR 200 per 10 gram and we will benefit the same on your forward contract.
Thus, the difference between the spot and forward prices on the delivery day is the profit/loss to the buyer/seller.
Along with some exception to forward contracts, there are future contracts. What makes future differ forward contracts is that we trade future on stock exchanges while forward on the OTC market. OTC or the over the counter market is a marketplace for typically forward contracts.
Another distinction relates to the settlement of the contracts. While futures, in general, settle daily whereas, forwards settle on expiration. The daily settlement is technically known as marked-to-market.
Futures are generally used to hedge the risk of price fluctuations by fixing the price in advance. Speculators also use futures to make a profit through analyzing and forecasting the future price movements.
Futures of Basmati Rice are being traded on a commodities exchange and each contract is for 100 kgs. Nita wants to buy 5,000 kgs of Basmati Rice during the last week of the month. While, Jay seeks to sell 5,000 kgs of Basmati Rice during the last week of the month. The futures contract is suitable for the both parties, as a trade could be executed between the two parties for 50 contracts on the exchange. The disadvantage of the futures is that the contracts are not customized as in forwards. For example, if both the parties in the above example wanted to trade 4000 kgs then the futures contract would not have served their purpose.
An option is a financial derivative that specifies a contract between two parties that gives the buyer (of the option) the right but not the obligation to buy/sell an underlying asset at a pre-decided price (strike price) on or before a specified date, while the seller (of the option) is obligated to fulfil the transaction. Option buyers are referred to as holders, while option sellers are called writers.
In options, either of the two rights is given to the holder of the option: Right to buy the underlying asset (known as Call option) or Right to sell the underlying asset (i.e. Put option) at the strike price. As the holder has a right, he has to pay an upfront amount to the seller called premium.
Based on when the options can be traded until expiration, options can be of two types: American Options and European Options.
Swaps are agreements to exchange one financial contract for another on the specified future date, as specified in the contract. Swaps are traded over the counter. Swaps can be used for hedging which includes interest rate risk and currency risk. Some of the common types of swap contracts are:
Interest rate swaps – It is a type of swap agreement in which two parties agree to exchange interest rate cash flows, based on a specified notional amount.
Commodity swaps – In a commodity swap, there is an exchange of floating price based on an underlying commodity for a fixed price over a specified period of time. No commodities are exchanged during a swap trade, instead, cash is exchanged.
Currency swaps – In a currency swap, there is an exchange of the principal and the fixed interest rate on debt denominated in different currencies.
Credit default swaps – A credit default swap is a type of swap in which the lender of a loan is given a guarantee against the non-payment of the loan.