Derivatives

About Derivatives

1. Definition: A financial contract whose value is derived from an underlying asset or variable, such as shares, commodities, currencies, indices or interest rates.
2. Nature: A derivative is a contract, not an asset itself.
3. Legal Framework: Governed under the Securities Contracts (Regulation) Act, 1956 (SCRA).

Uses of Derivatives

1. Hedging: Reduces potential losses from adverse price movements by taking an offsetting position.
2. Speculation: Taking a position to gain from an expected rise or fall in the price of an underlying asset.
3. Arbitrage: Earning from price differences for the same or equivalent asset in different markets.

Major Types of Derivatives

1. Forward Contract

• Nature: A customised Over-the-Counter (OTC) contract between two parties to buy or sell an underlying asset at a predetermined price on a future date.
• Risk: Since it is not exchange-traded through a central clearing mechanism, it involves counterparty risk—the possibility that one party may fail to fulfil the contract.

2. Futures Contract

• Nature: Similar to a forward but standardised contract traded on recognised exchanges.
• Settlement: Subject to daily mark-to-market settlement, with gains or losses settled based on the prevailing market price.
• Risk Management: Clearing corporations manage settlement and reduce counterparty risk through mechanisms such as margins and default arrangements.

3. Options Contract

• Nature: Gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined strike price. The seller has the corresponding obligation if the option is exercised.
• Premium: The buyer pays a premium to the seller for this right.
• Types:
  • Call Option: Right to buy the underlying asset; generally purchased when prices are expected to rise.
  • Put Option: Right to sell the underlying asset; generally purchased when prices are expected to fall.
• Risk: If the option is not exercised, the buyer can let it expire and generally loses only the premium paid.

4. Swap Contract

• Nature: An agreement to exchange specified cash flows or financial obligations according to predetermined terms.
• Types: Common forms include interest-rate swaps and currency swaps.
• Trading: Generally traded OTC, so counterparty risk remains relevant.

Regulation in India

1. SEBI (Securities and Exchange Board of India): Regulates exchange-traded securities and derivatives, including equity, commodity and currency derivatives.
2. RBI (Reserve Bank of India): Regulates specified OTC currency and interest-rate derivatives.
3. Major Exchanges: NSE, BSE, Multi Commodity Exchange (MCX) and National Commodity & Derivatives Exchange (NCDEX) offer derivatives based on different underlying assets.

Significance

1. Risk Management: Helps manage price, currency and interest-rate risks.
2. Price Discovery: Futures and options help determine market expectations of future prices.
3. Market Efficiency: Arbitrage reduces unjustified price differences across markets.
4. Financial Flexibility: Allows participants to manage risks without directly trading the underlying asset.

Challenges

1. Counterparty Risk: Higher in OTC contracts as one party may default.
2. Leverage Risk: The ability to take large positions with small capital can lead to large losses, especially when prices move against the investor.
3. Market Volatility: Sharp price movements can lead to significant losses.
4. Complexity: Lack of understanding can result in excessive risk-taking.

FAQs

Q1. What is a derivative?
Ans. A derivative is a financial contract whose value is derived from an underlying asset, index, commodity, currency, interest rate or other variable.

Q2. What is the key difference between forwards and futures?
Ans. Forwards are generally customised OTC contracts, while futures are standardised contracts traded on exchanges.

Q3. What is counterparty risk?
Ans. It is the risk that one party to a financial contract may fail to fulfil its contractual obligation.

Q4. What is mark-to-market settlement?
Ans. It is the regular settlement of gains and losses on futures contracts based on the current market value of the contract.