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BASICS OF DERIVATIVES

BASICS OF DERIVATIVES

Basics of Derivatives

  • Definition: A derivative is a contract or product whose value is derived from the value of another asset, known as the underlying.
  • Underlying Assets: Derivatives are based on a wide range of underlying assets, including:
    • Metals such as Gold, Silver, Aluminium, Copper, Zinc, Nickel, Tin, Lead, etc.
    • Energy resources such as Oil (crude oil, products, cracks), Coal, Electricity, Natural Gas, etc.
    • Agri commodities such as Wheat, Sugar, Coffee, Cotton, Pulses, etc.
    • Financial assets such as Shares, Bonds, and Foreign Exchange.

Derivatives Market – History & Evolution

  • Early Beginnings: The history of derivatives dates back to several centuries, with evidence of contracts for future delivery of goods in European trade fairs as early as the 12th century.
  • Historical Milestones:
    • 13th Century: English Cistercian Monasteries sold wool up to 20 years in advance to foreign merchants.
    • 1634-1637: Tulip Mania in Holland led to fortunes being lost after a speculative boom in tulip futures burst.
    • Late 17th Century: A futures market in rice was developed in Japan to protect rice producers from bad weather or warfare.
  • Key Events in Derivatives Market Evolution:
    • 1848: The Chicago Board of Trade (CBOT) facilitated trading of forward contracts on various commodities.
    • 1865: CBOT listed the first “exchange traded” derivative contract in the US, known as “futures contracts”.
    • 1919: Chicago Butter and Egg Board, a spin-off of CBOT, was reorganised to allow futures trading and later became the Chicago Mercantile Exchange (CME).
    • 1972: CME introduced the International Monetary Market (IMM), allowing trading in currency futures.
    • 1973: Chicago Board Options Exchange (CBOE) became the first marketplace for trading listed options.
    • 1975: CBOT introduced Treasury bill futures contract, the first successful pure interest rate futures.
    • 1977: CBOT introduced T-bond futures contract.
    • 1982: CME introduced Eurodollar futures contract, and Kansas City Board of Trade launched the first stock index futures.
    • 1983: CBOE introduced options on stock indices with the S&P 100® (OEX) and S&P 500® (SPXSM) Indices.
  • Factors Influencing Growth:
    • Increased Price Fluctuations: Fluctuations in underlying asset prices in financial markets.
    • Global Market Integration: Integration of financial markets globally.
    • Technological Advancements: Reduction of transaction costs due to the latest technology in communications.
    • Risk Management: Enhanced understanding of market participants on sophisticated risk management tools to manage risk.
    • Innovations in Derivatives: Frequent innovations in derivatives market and newer applications of products.

Indian Derivatives Market

  • Introduction: The Indian derivatives market was introduced by SEBI, which set up a committee under Dr. L. C. Gupta in 1996 to develop a regulatory framework for derivatives trading.
  • Regulatory Framework: The committee recommended that derivatives be declared as securities, and subsequently, the Securities Contract Regulation Act (SCRA) was amended in 1999 to include derivatives within the domain of securities.
  • Key Milestones:
    • June 2000: Exchange-traded derivatives started in India with SEBI permitting BSE and NSE to introduce the equity derivatives segment.
    • June 2000: Trading in index futures contracts based on Nifty and Sensex commenced.
    • June 2001: Trading in Index options commenced.
    • July 2001: Trading in options on individual stocks commenced.
    • November 2001: Futures contracts on individual stocks started.
    • February 2013: Metropolitan Stock Exchange of India Limited (MSEI) started trading in derivative products.

Products in the Derivatives Market

  • Forwards: A contractual agreement between two parties to buy/sell an underlying asset at a pre-decided price on a certain future date. Forwards are Over-the-counter (OTC) contracts and are customized.
  • Futures: A standardized contract that is similar to a forward, but traded on an organized and regulated exchange. Futures are exchange-traded forward contracts.
  • Options: A contract that gives the right, but not an obligation, to buy or sell the underlying asset on or before a stated date and at a stated price.
  • Swaps: An agreement between two parties to exchange cash flows in the future according to a prearranged formula. Swaps are a series of forward contracts that help manage risks associated with volatile interest rates, currency exchange rates, and commodity prices.

3. Market Participants

  • Hedgers: They face risk associated with the prices of underlying assets and use derivatives to reduce their risk. Corporations, investing institutions, and banks all use derivative products to hedge or reduce their exposures to market variables such as interest rates, share prices, bond prices, currency exchange rates, and commodity prices.
  • Speculators/Traders: They try to predict the future movements in prices of underlying assets and based on the view, take positions in derivative contracts. Derivatives are preferred over underlying assets for trading purposes, as they offer leverage, are less expensive (cost of transaction is generally lower than that of the underlying), and are faster to execute in size (high volumes market).
  • Arbitrageurs: They exploit a price difference in a product in two different markets by purchasing an asset cheaply in one location and simultaneously arranging to sell it at a higher price in another location, thus closing the price gap at different locations.

Types of Derivatives Market

  • Definition: Derivatives markets can be categorized into two main types: Exchange Traded Derivatives and Over-the-counter (OTC) Derivatives.
  • Details: Exchange traded derivatives are traded on organized exchanges, while OTC derivatives are agreed upon directly between counterparties over the telephone or through electronic media.

Key Characteristics of OTC Derivatives

  • Market Structure: The OTC market is a collection of broker-dealers scattered across the country, with buying and selling of contracts matched through a negotiated bidding process over a network of telephone or electronic media.
  • Participants: OTC derivative markets have banks, financial institutions, and sophisticated market participants like hedge funds, corporations, and high net-worth individuals.
  • Regulation: OTC derivative market is a less regulated market because transactions occur in private among qualified counterparties.

Comparison of OTC and Exchange Traded Derivatives

  • Contract Customization: OTC contracts are tailor-made to fit the specific requirements of dealing counterparties, while exchange-traded contracts are standardized.
  • Risk Management: OTC derivatives have decentralized management of counter-party (credit) risk, while exchange-traded derivatives have a clearing corporation that guarantees contract performance.
  • Market Stability: OTC derivatives have no formal rules or mechanisms for risk management to ensure market stability and integrity, while exchange-traded derivatives have formal rules and mechanisms in place.
  • Disclosure: OTC transactions are private with little or no disclosure to the entire market, while exchange-traded transactions are public with prices determined by the interaction of buyers and sellers through an anonymous auction platform.

3. Significance of Derivatives

  • Price Discovery: Derivatives markets help in improving price discovery based on actual valuations and expectations, allowing for more accurate pricing of assets.
  • Risk Transfer: They enable the transfer of risk from those who are exposed to risk but have a low risk appetite (such as hedgers) to participants with a high risk appetite (such as traders).
  • Speculative Trade Regulation: Derivatives markets allow for the shift of speculative trades from the unorganized market to the organized market, providing stability to the financial system through risk management mechanisms and surveillance of participant activities.

Various Risks Faced by Participants in Derivatives

  • Counterparty Risk: The risk of default by the counterparty in a derivatives contract.
  • Price Risk: The risk of loss on a position due to an adverse price move.
  • Liquidity Risk: The risk of being unable to exit from a position due to lack of market liquidity.
  • Legal or Regulatory Risk: The risk of enforceability of contracts due to legal or regulatory issues.
  • Operational Risk: The risk of losses due to fraud, inadequate documentation, improper execution, etc.

Important Considerations for Market Participants

  • Market participants should carefully consider whether trading in derivatives is suitable for them based on their resources, trading experience, and risk tolerance.
  • Participants should read the Model Risk Disclosure Document provided by the broker at the time of signing the agreement.
  • The Model Risk Disclosure Document contains important information on trading in Equities and F&O Segments of exchanges.

Key Terms

  • Derivatives: Leveraged instruments that carry various risks.
  • Model Risk Disclosure Document: A document issued by exchange members that contains important information on trading in equities and F&O segments.
  • Risk Tolerance: The ability of a market participant to withstand potential losses.
  • Operational Risks: Include losses due to inadequate disaster planning, fraud, inadequate documentation, improper execution, etc.
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