INVESTMENT MANAGEMENT

MODULE III – DERIVATIVES

DERIVATIVES – MEANING
Derivatives are securities or financial contracts whose value is dependent on or derived from an underlying
asset. For example, an oil futures contract is a type of derivative whose value is based on the market price of oil.
Derivatives have become increasingly popular in recent decades. There is a vast quantity of derivative contracts
tailored to meet the needs of a diverse range of counterparties. Since the value of the assets which control the
derivative value fluctuates occasionally, the derivatives do not have a fixed value.
The basic guiding principle of derivative trading is that the buyer successfully predicts market changes to earn
profits from their contracts. When the price of the asset on which the derivative depends falls, you will meet with a
loss, whereas a surge in price, results in a profit. Therefore, trading in derivatives is about being able to predict the rise
and fall of the asset and timing your exit and entry into the market subsequently.
Most derivatives are traded over-the-counter (OTC). However, some of the contracts, including options and
futures, are traded on specialized exchanges. The biggest derivative exchanges include the CME Group (Chicago
Mercantile Exchange and Chicago Board of Trade), the Korea Exchange, and Eurex.

DERIVATIVES MARKET
Derivatives can either be exchange-traded or traded over the counter (OTC). Exchange refers to the formally
established stock exchange wherein securities are traded and have a defined set of rules for the participants. Whereas
OTC is a dealer-oriented market of securities, which is an unorganized market where trading happens by way of
phone, emails, etc. Derivatives traded on the exchange are standardized and regulated. On the other hand, OTC
derivative constitutes a greater proportion of derivatives contracts, but it carries higher counterpart risk and is
unregulated. These financial instruments help in making a profit by simply betting on the future value of the
underlying asset. Hence the name derivative as they derive the value from the underlying asset.

HISTORY OF THE MARKET

Derivatives are not new financial instruments. For example, the emergence of the first futures contracts can be
traced back to the second millennium BC in Mesopotamia. However, the financial instrument was not widely used
until the 1970s. The introduction of new valuation techniques sparked the rapid development of the derivatives market.
Nowadays, we cannot imagine modern finance without derivatives.

PARTICIPANTS OF THE DERIVATIVES MARKET

1. Hedgers:
Risk-averse brokers and traders who wish to play it safe in the stock market. Rather than invest in tricky
stocks which may give them either a huge profit or a huge loss, hedgers invest their money in derivative markets, in a
bid to protect their portfolio. By assuming an opposite position concerning the derivatives market, they can protect
themselves against market risk and price fluctuations.
2. Speculators:
They are the primary risk-takers of any derivative market as they don’t mind taking risks to earn large profits.
Therefore, they have a frame of mind that is the polar opposite to the one possessed by hedgers, who wish to play safe
always.
3. Margin Traders:
Margin is the bare minimum that an investor needs to pay the broker to take part in derivatives trading. This
margin is a form of representing market fluctuations as it reflects the loss or gain made on that day.
4. Arbitrageurs:
They make use of market imperfections to make money by buying low-priced stocks and then selling them at
higher prices in a different market. However, this becomes possible only if the commodity in question is priced
differently in different markets.

FEATURES OF TRADING IN THE DERIVATIVES MARKET

1. Investors should take care to study the derivatives market before trading as their rules. And regulations are quite
different from that of the stock market.
2. Before you begin trading, individuals must deposit a margin amount, which once paid, cannot be withdrawn until after
the trade is settled. Furthermore, if it ever falls below the required amount, the individual must replenish or reload it

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 before continuing to trade.
3. To trade on the derivatives market, the trader must possess an active trading account with a permit for derivative
trading.
4. To buy stocks, traders must look at factors such as cash available, margins, contract price and price of shares.
5. As transactions occur in the future, within the market, it is easier to short sell
6. The market has low transaction costs as the market is heavily standardised owing to low risk
7. The most important underlying assets which determine the cost of a derivative are stock prices, exchange rates and
interest rates
8. In some cases, derivatives can also be used to determine prices of the underlying assets
9. They also help in improving the efficiency of financial markets by allowing better accessibility and visibility
10. However, the high volatility of the derivative market results in huge losses if uncalculated steps are taken. And hence,
investors must be very careful while investing in derivatives.

CRITICISMS OF THE DERIVATIVES MARKET

1. Risk
The derivatives market is often criticized and looked down on, owing to the high risk associated with trading
in financial instruments.
2. Sensitivity and volatility unpredictability of the market
Many investors and traders avoid the derivatives market because of its high volatility. Most financial
instruments are very sensitive to small changes such as a change in the expiration period, interest rates, etc., which
makes the market highly volatile in nature.
3. Complexity
Owing to the high-risk nature and sensitivity of the derivatives market, it is often a very complex subject
matter. Because derivatives’ trading is so complex to understand, it is most often avoided by the general public, and
they often employ brokers and trading agents in order to invest in financial instruments.
4. Legalized gambling
Owing to the nature of trading in financial markets, derivatives are often criticized for being a form
of legalized gambling, as it is very similar to the nature of gambling activities.

TYPES OF DERIVATIVES

1. FORWARDS
However, forwards are more flexible contracts because the parties can customize the underlying commodity as
well as the quantity of the commodity and the date of the transaction. On the other hand, futures are standardized
contracts that are traded on the exchanges. Forwards are unstandardized futures that do not have a presence on the
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stock market. However, much like futures, the people who are a part of such a contract are bound to exercise it.
Forwards are traded over-the-counter and can be customized as per the requirements of the traders themselves.

Explaining a forward contract on the Indian derivatives market

Suppose you need to buy some gold ornaments say from a local jewelry manufacturer Gold Inc. Further,
assume you need these gold ornaments some 3 months later in the month of October. You agree to buy the gold
ornaments at INR 32000 per 10 gram on 15 October 2018. The current price, however, is INR 31800 per gram.
This will be the forward rate or the delivery price four 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 you
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 32100 per 10 gram. In this situation, Gold Inc will lose
INR 100 per 10 gram and you 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.

2. FUTURES
These are financial contracts that obligate the contracts’ buyers to purchase an asset at a pre-agreed price on a
specified future date. These standardized contracts allow individuals to sell or buy an asset on a particular day at a
specific price. However, unlike options, the parties who enter into futures are bound to make the transaction on the
prescribed day. Such derivatives are commonly traded and transacted on the stock exchange, with their every-day
value fluctuating as per the market trend. Both forwards and futures are essentially the same in their nature.
How future contracts differ forward contracts on Indian derivative market?
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.

3. OPTIONS
Options provide the buyer of the contracts the right, but not the obligation, to purchase or sell the underlying
asset at a predetermined price. Based on the option type, the buyer can exercise the option on the maturity date
(European options) or on any date before the maturity (American options). These derivative contracts allow buyers to
sell (put options) or buy (call options) an underlying asset within a specified time interval at a particular price. In such
cases, the one who sells the option is called an option writer and the price at which the option is sold is referred to as
strike price.
However, the buyer does not necessarily have to exercise the option. There are various foreign options and
they differ in their manner of operation. For instance, an American option may be exercised any time before expiry,
whereas a European option can be used only on the day of its expiry.

Basics of options trading in the Indian derivatives market

Consider the same example. Let us now suppose that the seller Gold Inc. believes that the spot price may rise
above INR 32000 per 10 gram during the forward contract agreement with you. So to limit loss, Gold Inc. purchases a
call option for Rs. 105 at the exercise price of INR 32000 per 10 gram with the three months expiration date.
The exercise price is technically known as a strike price. Similarly, the price of the call option is technically known as
the option price or the premium.
Actually, the call option gives the seller the right to buy the gold at the strike price on the expiration date.
However, there is no obligation to buy on the expiration date. He may or may not exercise his right on the expiration
date. For instance, if the spot price decline below INR 31800 our Gold Inc will choose not to exercise the option. In
this way, his loss would be limited to the premium of INR 105 per 10 gram.
In an alternative situation, when you expect the price to fall below the spot price in the future, you have
the option to purchase put options. Buying a put option provides you the advantage to sell at the strike price on the
expiration date. Here also you have no obligation to exercise your right.

3. SWAPS
Swaps are derivative contracts that allow the exchange of cash flows between two parties. The swaps usually

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involve the exchange of a fixed cash flow for a floating cash flow. The most popular types of swaps are interest rate
swaps, commodity swaps, and currency swaps. These derivative contracts enable two individuals to exchange their
financial obligations. And the resulting cash flow has a rate of interest attached to it. While one cash flow remains
fixed, the other fluctuates based on the interest rate. Swaps are also over-the-counter derivatives, which are not traded
on stock exchanges.

ORIGIN OF THE DERIVATIVES MARKET IN INDIA / DERIVATIVES MARKET INDIA

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.
Derivatives trading commenced in Indian market in 2000 with the introduction of Index futures at BSE, and
subsequently, on National Stock Exchange (NSE). Since then, derivatives market in India has witnessed tremendous
growth in terms of trading value and number of traded contracts. Here we may discuss the performance of derivatives
products in India markets as follows.

Derivatives Products Traded in Derivatives Segment of BSE

The BSE created history on June 9, 2000 when it launched trading in Sensex based futures contract for the
first time. It was followed by trading in index options on June 1, 2001; in stock options and single stock futures (31
stocks) on July 9, 2001 and November 9, 2002, respectively. Currently, the number of stocks under single futures and
options is 1096 . BSE achieved another milestone on September 13, 2004 when it launched Weekly Options, a unique
product unparalleled worldwide in the derivatives markets. It permitted trading in the stocks of four leading companies
namely; Satyam, State Bank of India, Reliance Industries and TISCO (renamed now Tata Steel). Chhota (mini)
SENSEX7 was launched on January 1, 2008. With a small or 'mini' market lot of 5, it allows for comparatively lower
capital outlay, lower trading costs, more precise hedging and flexible trading. Currency futures were introduced on
October 1, 2008 to enable participants to hedge their currency risks through trading in the U.S. dollar-rupee future
platforms. Table 2 summarily specifies the derivative products and their date of introduction on the BSE
Derivatives Products Traded in Derivatives Segment of NSE
NSE started trading in index futures, based on popular S&P CNX Index, on June 12, 2000 as its first
derivatives product. Trading on index options was introduced on June 4, 2001. Futures on individual securities started
on November 9, 2001. The futures contracts are available on 2338 securities stipulated by the Securities & Exchange
Board of India (SEBI). Trading in options on individual securities commenced from July 2, 2001. The options
contracts are American style and cash settled and are available on 233 securities. Trading in interest rate futures was
introduced on 24 June 2003 but it was closed subsequently due to pricing problem. The NSE achieved another
landmark in product introduction by launching Mini Index Futures & Options with a minimum contract size of Rs 1
lakh. NSE crated history by launching currency futures contract on US Dollar-Rupee on August 29, 2008 in Indian
Derivatives market.

STRUCTURE OF THE DERIVATIVES MARKET IN INDIA

The derivatives market in India consists of the unorganized forward market and the exchange-traded futures &
options market. Derivatives trading for our purpose basically refer to the exchange traded derivatives market. The
principal trading products in the derivative market in India are futures and options. An example of the forward market
in India is the inter-bank forward dollar market used for currency hedging.
There are some basic problems with forward trading markets. Firstly, they are customized and hence if
somebody wants to exit a forward transaction then it is not possible unless someone with a similar requirement also
comes in. Secondly, what happens if one of the parties to a forward transaction defaults? There is no recourse except
to go to court and try and enforce the contract. In futures market on the stock exchanges, all transactions are
guaranteed by the clearing corporation. That means; the clearing corporation acts as the counter party for every
transaction so the default risk is almost zero.

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REGULATORY FRAMEWORK FOR DERIVATIVE TRADING IN INDIA

With the amendment in the definition of ''securities'' under SC(R)A (to include derivative contracts in the
definition of securities), derivatives trading takes place under the provisions of the Securities Contracts (Regulation)
Act, 1956 and the Securities and Exchange Board of India Act, 1992. Dr. L.C Gupta Committee constituted by
SEBI had laid down the regulatory framework for derivative trading in India. SEBI has also framed suggestive bye-
law for Derivative Exchanges/Segments and their Clearing Corporation/House which lays down the provisions for
trading and settlement of derivative contracts.
The Rules, Bye-laws & Regulations of the Derivative Segment of the Exchanges and their Clearing
Corporation/House have to be framed in line with the suggestive Bye-laws. SEBI has also laid the eligibility
conditions for Derivative Exchange/Segment and its Clearing Corporation/House. The eligibility conditions have been
framed to ensure that Derivative Exchange/Segment & Clearing Corporation/House provide a transparent trading
environment, safety & integrity and provide facilities for redressal of investor grievances. Some of the important
eligibility conditions are -
1. Derivative trading to take place through an online screen based Trading System.
2. The Derivatives Exchange/Segment shall have online surveillance capability to monitor positions, prices, and
volumes on a real time basis to deter market manipulation.
3. The Derivatives Exchange/ Segment should have arrangements for dissemination of information about trades,
quantities and quotes on a real time basis through at least two information vending networks, which are easily
accessible to investors across the country.
4. The Derivatives Exchange/Segment should have arbitration and investor grievances redressal mechanism operative
from all the four areas / regions of the country.
5. The Derivatives Exchange/Segment should have satisfactory system of monitoring investor complaints and
preventing irregularities in trading.
6. The Derivative Segment of the Exchange would have a separate Investor Protection Fund.
7.The Clearing Corporation/House shall perform full novation, i.e. the Clearing Corporation/House shall interpose
itself between both legs of every trade, becoming the legal counterparty to both or alternatively should provide an
unconditional guarantee for settlement of all trades.
8. The Clearing Corporation/House shall have the capacity to monitor the overall position of Members across both
derivatives market and the underlying securities market for those Members who are participating in both.
9. The level of initial margin on Index Futures Contracts shall be related to the risk of loss on the position. The concept
of value-at-risk shall be used in calculating required level of initial margins. The initial margins should be large
enough to cover the one-day loss that can be encountered on the position on 99% of the days.
10. The Clearing Corporation/House shall establish facilities for electronic funds transfer (EFT) for swift movement of
margin payments.
11. In the event of a Member defaulting in meeting its liabilities, the Clearing Corporation/House shall transfer client
positions and assets to another solvent Member or close-out all open positions.
12. The Clearing Corporation/House should have capabilities to segregate initial margins deposited by Clearing
Members for trades on their own account and on account of his client. The Clearing Corporation/House shall hold the
clients’ margin money in trust for the client purposes only and should not allow its diversion for any other purpose.
13. The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the trades executed on Derivative
Exchange / Segment.