Tuesday, 12 January 2016

What Are Derivatives ?

Derivatives are financial contracts whose value/price is dependent on the behavior of the price of one or more basic underlying assets (often simply known as the underlying). These contracts are legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in future. The asset can be a share, index, interest rate, bond, rupee dollar exchange rate, sugar, crude oil, soybean, cotton, coffee and what have you.

A very simple example of derivatives trading is curd, which is derivative of milk. The price of curd depends upon the price of milk which in turn depends upon the demand and supply of milk.

Products In Derivatives Market

Forward Contract :- 

It is a contractual agreement between two parties to buy/sell an underlying asset at a certain future date for a particular price that is pre-decided on the date of contract. Both the contracting parties are committed and are obliged to honour the transaction irrespective of price of the underlying asset at the time of delivery. Since forwards are negotiated between two parties, the terms and conditions of contracts are customized. These are OTC contracts.

It is a negotiated contract between two parties and hence exposed to counter party risk. eg: Trade takes place between A&B@ 100 to buy & sell x commodity.
After 1 month it is trading at Rs.120. If A was he buyer he would gain Rs. 20 & B Loose Rs.20. In case B defaults you are exposed to counter party Risk i.e. you will now entitled to your gains. In case of Future, the exchange gives a counter guarantee even if the counter party defaults you will receive Rs.20/- as a gain.

India has been trading derivatives contracts in silver, gold, spices, coffee, cotton and oil etc for decades in the gray market. Trading derivatives contracts in organized market was legal before Morarji Desai's government banned forward contracts.
Derivatives on stocks were traded in the form of Teji (Bull run) and Mandi (Bear run) in unorganized markets.

Futures Contract :- 

A futures contract is similar to a forward, except that the deal is made through an organized and regulated exchange rather than being negotiated directly between two parties. Indeed, we may say futures are exchange traded forward contracts.

he standard terms in any futures contract are:

  • Quantity of the underlying asset
  • Quality of the underlying asset (not required in case of financial futures)
  • Expiration date
  • The unit of price quotation (not the price)
  • Minimum fluctuation in price (tick size)
  • Settlement style

For example: when you are dealing in Jan 2016 NIFTY futures contract, you know that the market lot, ie the minimum quantity you can buy or sell, is 75 quantity of NIFTY 50, the contract would expiry on Jan 28, 2016, the price is quoted per share, the tick size is 5 paise per share or (75*0.05) = Rs3.75 per contract/market lot, the contract would be settled in cash and the closing price in the cash market on expiry day would be the settlement price.

Options :- 

An Option is a contract that gives the right, but not an obligation, to buy or sell the underlying on or before a stated date and at a stated price. While buyer of option pays the premium and buys the right, writer/seller of option receives the premium with obligation to sell/ buy the underlying asset, if the buyer exercises his right.

Swaps :- 
A swap is an agreement made between two parties to exchange cash flows in the future according to a prearranged formula. Swaps are series of forward contracts. Swaps help market participants manage risk associated with volatile interest rates, currency exchange rates and commodity prices.

1.4 Market Participants
There are broadly three types of participants in the derivatives market - hedgers, traders (also called speculators) and arbitrageurs. An individual may play different roles in different market circumstances.

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 values, bond prices, currency exchange rates and commodity prices.

Speculators :-  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 asset for speculation purpose, 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 :- Arbitrage is a deal that produces profit by exploiting a price difference in a product in two different markets. Arbitrage originates when a trader purchases an asset cheaply in one location and simultaneously arranges to sell it at a higher price in another location. Such opportunities are unlikely to persist for very long, since arbitrageurs would rush in to these transactions, thus closing the price gap at different locations.

Types of Derivatives Market

In the modern world, there is a huge variety of derivative products available. They are either traded on organised exchanges (called exchange traded derivatives) or agreed directly between the contracting counter parties over the telephone or through electronic media (called Over-the-counter (OTC) derivatives). Few complex products are constructed on simple building blocks like forwards, futures, options and swaps to cater to the specific requirements of customers. 
Over-the-counter market is not a physical marketplace but a collection of broker-dealers scattered across the country. Main idea of the market is more a way of doing business than a place. Buying and selling of contracts is matched through negotiated bidding process over a network of telephone or electronic media that link thousands of intermediaries. OTC derivative markets have witnessed a substantial growth over the past few years, very much contributed by the recent developments in information technology. The OTC derivative markets have banks, financial institutions and sophisticated market participants like hedge funds, corporations and high net-worth individuals. OTC derivative market is less regulated market because these transactions occur in private among qualified counterparties, who are supposed to be capable enough to take care of themselves. 
The OTC derivatives markets – transactions among the dealing counterparties, have following features compared to exchange traded derivatives:

  • Contracts are tailor made to fit in the specific requirements of dealing counterparties.
  • The management of counter-party (credit) risk is decentralized and located within individual institutions.
  • There are no formal centralized limits on individual positions, leverage, or margining.
  • There are no formal rules or mechanisms for risk management to ensure market stability and integrity, and for safeguarding the collective interest of market participants.
  • Transactions are private with little or no disclosure to the entire market.

On the contrary, exchange-traded contracts are standardized, traded on organized exchanges with prices determined by the interaction of buyers and sellers through anonymous auction platform. A clearing house/ clearing corporation, guarantees contract performance (settlement of transactions)

Significance of Derivatives 

Like other segments of Financial Market, Derivatives Market serves following specific functions:

  • Derivatives market helps in improving price discovery based on actual valuations and expectations.
  • Derivatives market helps in transfer of various risks from those who are exposed to risk but have low risk appetite to participants with high risk appetite. For example hedgers want to give away the risk where as traders are willing to take risk.
  • Derivatives market helps shift of speculative trades from unorganized market to organized market. Risk management mechanism and surveillance of activities of various participants in organized space provide stability to the financial system.
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