Derivatives Market Along With Its Types

Background of Derivatives

Derivatives are financial contracts entered into between two or more parties based upon the asset, commonly known as underlying, under which payments are to be made between the parties upon a certain date or upon happening or not happening of certain events. Price of the derivative is directly linked to value of the underlying asset and therefore, it is affected by the fluctuations in the value of underlying asset. Since it is a derivative of underlying asset, that asset need not be bought or sold. Thus, these types of transactions allow participants to participate in the market value of an asset without actually owning it. 

Origin of the concept

Agriculture is one of the oldest professions invented by the mankind which has been pursued even today. It’s also true that this profession is exposed to vagaries of nature (even today despite the high degree of mechanisation) which makes the result (crop) highly uncertain. This very nature of the profession has paved the way for origin and growth of the concept of derivatives.

 

A paddy cultivator, for example, after sowing has to wait till harvesting, that is, more than four months, to sell rice in the market and get the money. In case he is in urgent need of money in the intervening period he has to borrow the same from, say, money lenders by paying high rate of interest. Instead, if he can sell his crop even before it is harvested, he can save himself from the trouble of borrowing from the money lenders by paying high rate of interest. On the other hand, buyer gets paddy at comparatively cheaper price than he would have paid during harvesting season. This is basic and crudest form of derivative trading where right to harvest is transferred, much in advance of harvesting season, through a contract. Here the transaction can become much advanced when the buyer transfers his harvesting rights to another person and so on.       

 

Modern derivatives market owes its origin and subsequent growth to Chicago Board of Trade (CBT). In CBT also initially transactions used to happen between buyers and sellers who used to negotiate their own customised trading. Later on, rules were liberalised allowing everyone and trades were standardised which helped to derivatives trading to grow. 

 

Today derivatives are used for stocks, bonds, commodities, currencies, interest rates, and market indexes. They are used for hedging as well as speculation purposes. 

 

In India, there was Badla system which was not a derivative system in its purest form but used by the traders for carry forward the stocks (without owning it) till the next settlement. This system used to allow the traders to trade in stocks with help of funds provided by the Badla Financiers. Through this system traders were able to carry forward their trades without taking the actual delivery of stocks. The system was completely stopped in 2001 when futures and options trading system was introduced on Indian bourses.  

Financial derivatives

There are different types of derivatives which the market participants use to mitigate the risk associated with investments in financial assets. In fact, derivatives are classified using different criteria for different purposes. Thus, they can be classified based on the type of underlying asset or the relationship between the underlying asset and the derivative or the market in which they trade. 

Classification based on underlying

Based on underlying asset, derivatives can be classified such as equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives and credit derivatives. These are primarily financial derivatives that enable parties to trade specific financial risks to those who are more capable of managing these risks.

 

Equity derivatives: Equity derivatives are those derivatives whose value is either partly or wholly derived from one or more underlying equity securities. It may be noted that equity derivatives include both individual stocks as well as stock indices. Futures and options are the most common derivatives used in this category. Both of these derivatives give holder the right to buy or sell a specific asset at a specific price on a specified future date. However, in case of option the holder will have only the right and not obligation to buy or sell the specific asset. 

 

Currency derivatives: Currency derivatives are contracts to exchange one currency for another at a specified date in the future. In this contract, buying/selling price (exchange rate) is fixed on the purchase date of the contract. Usually, businessmen who have international dealings enter into such contracts to hedge against foreign exchange risk. In India, among the various currencies available for trade against Indian rupee, the market for US dollar-rupee is the largest, accounting for more than 80% of the volume. 

 

Commodity derivatives: It’s in fact commodities, particularly agricultural commodities and the uncertainties surrounding their production and prices that led to the development of derivatives market. However, the growth of commodities market is somewhat handicapped by the fact that the underlying tends to be associated with a physical commodity. Despite that, studies have shown that well-functioning commodity futures market helps in improving the price discovery of the commodity.

 

Interest rate derivative: In this case the underlying will be the interest rate, prices of interest rate instruments, or interest rate indices. This is financial derivative contract and is comparatively of recent origin. Such derivatives can be ether interest rate futures or interest rate options. Future contracts are available on Government of India securities, Treasury bills and MIBOR while options are available on Government of India securities only.

 

Credit derivatives: In case of a loan transaction, the biggest risk the lender faces is the risk of payment default by the borrower. To mitigate this risk the concept of credit derivatives has been evolved and has become popular since 90s. A credit derivative acts as an insurance policy and helps the lender to transfer the risk on a credit asset to another party. Banks, hedge funds, insurance companies, pension funds, and other corporates are the usual participants of credit derivatives market.

 

Classification based on parties’ rights: Derivatives can also be classified based on the rights and obligations of parties involved in the contract.

 

Forwards and futures: A forwards and futures contract gives the buyer a right to buy an asset at a pre-agreed price at a future date. Between forwards and futures, former is more flexible contracts while the latter is a standardised contract traded in exchanges. In case of forward derivatives, parties to contract can customize the underlying asset, price, date and other obligations to their requirement which makes the derivative more flexible. 

 

Options: An option derivative is a contract wherein the buyer gets a right and not an obligation to buy or sell the underlying asset on or before a specified future date (expiry date) at a specified price. At the same time, the option creates a corresponding obligation on the option seller, that is, option writer, to fulfil the transaction (to sell or buy) if the option buyer exercises the right. An option can be call option or put option. A call option gives the buyer the right to buy the underlying asset whereas a put option gives the buyer (of the option) to sell the underlying asset on a specified date.

 

Swaps: Swap derivative is a transaction wherein two parties to a contract agree to swap (exchange) liabilities or cash flows from separate financial instruments for a given period of time. Swaps are used to hedge against interest rate risk or speculate currency fluctuations. Today swaps are one of the most heavily traded financial derivatives in the world.

 

Classification based trading platform: Derivatives can also be classified based on where they are traded:

 

Exchange traded: As the name itself suggests, exchange traded derivatives are those derivatives that are traded on specialised derivative exchanges or other exchanges. For example, National Commodity and Derivatives Exchange (NCDEX) provides platform to trade in commodity derivatives while National Stock Exchange (NSE) allows trading of stocks and stock derivatives. Since 2000, both NSE and BSE have been trading in derivatives. Today, India is one of the most successful developing countries in terms of a vibrant market for exchange traded derivatives.

 

Over the counter (OTC) derivatives: OTC derivatives are traded directly between the parties without going through an exchange. Mostly, products such as swaps and forward rate agreements are traded through OTCs. These are mostly unregulated markets as the details of deals are not usually made public. In India, onshore OTC markets in equity derivatives are not permitted while offshore OTC trades take place through Participatory Notes and Offshore Derivative Instruments.  

 

Regulated derivatives market is good for growth of financial markets as they provide hedging opportunities to the participants. With India becoming the focal point of global economic growth, there is bound to be increased overseas financial activities on Indian assets which is evident with the rising activities in derivatives in Indian rupee and Indian stock index, Nifty in recent years.   

Frequently Asked Questions

What is the difference between stocks and stock derivatives?

Stock derivative derives its value/price from the underlying stock. Thus, it’s the stock price that moves stock derivative’s price and not vice versa. 

 

Why do people trade in derivatives?

People trade in derivatives either to hedge their equity positions or for speculation purposes. 

 

Whether derivative trading is allowed in all the listed stocks?

No. Stocks are chosen for derivative trading based on certain criteria. For example, NSE selects stocks (for derivatives) from the top 500 stocks in terms of average daily market capitalization and average daily traded value in the previous six months on a rolling basis.

 

Whether a separate account needs to be opened to deal in stock derivatives?

Not necessary. You can play in stock derivatives in your normal stock trading account. However, normally brokers ask for additional information such as IT Return acknowledgement or Bank Statements before activating the derivative segment in your account.