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Financial Derivatives

Financial Derivatives

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Published by: Revathialekhya Saradhi on May 06, 2011
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06/20/2014

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A derivative is afinancial instrumentthat derives or gets it value from some realgood or stock. It is in its most basic form simply a contract between two parties toexchange value based on the action of a real good or service. Typically, the sellerreceives money in exchange for an agreement to purchase or sell some good orservice at some specified future date.Infinance, a
derivative
is a financial instrument (or, more simply, an agreementbetween two parties) that has a value, based on the expected future pricemovements of the asset to which it is linked—called theunderlying asset
suchas ashareor acurrency. The term `Derivative' indicates that it has no independent value, i.e. its value isentirely `derived' from the value of the underlying asset. Theunderlying asset can besecurities, commodities, bullion, currency, livestock oranything else. In other words,derivative means a forward, future, option or anyother hybrid contract of pre-determined fixed duration, linked for the purpose of contract fulfillment to the valueof a specified real or financial asset or to an index of securities. There are many kinds of derivatives, with the most commonbeingswaps,futures, andoptions. Derivatives are a form of alternative investment.
Definition of Financial Derivatives
Section 2(ac) of Securities Contract Regulation Act (SCRA) 1956 definesDerivative as:a) “a security derived from a debt instrument, share, loan whether secured orunsecured, riskinstrument or contract for differences or any other form of security;b) “a contract which derives its value from the prices, or index of prices, of underlying securities”.
 Underlying Asset in a Derivatives Contract
As defined above, the value of a derivative instrument depends upon theunderlying asset. The Underlying asset may assume many forms:i. Commodities including grain, coffee beans, orange juice;ii. Precious metals like gold and silver;iii. Foreign exchange rates or currencies;iv. Bonds of different types, including medium to long term negotiable debtsecurities issued bygovernments, companies, etc.v. Shares and share warrants of companies traded on recognized stock exchangesand Stock Indexvi. Short term securities such as T-bills; andvii. Over- the Counter (OTC)2 money market products such as loans or deposits.
Derivatives are used by investors to:
provideleverage(or gearing), such that a small movement in the underlyingvalue can cause a large difference in the value of the derivative;
 
speculate and make a profit if the value of the underlying asset moves theway they expect (e.g., moves in a given direction, stays in or out of aspecified range, reaches a certain level);
hedgeor mitigate risk in the underlying, by entering into a derivativecontract whose value moves in the opposite direction to their underlyingposition and cancels part or all of it out;
obtain exposure to the underlying where it is not possible to trade in theunderlying (e.g., weather derivatives);
createoptionability where the value of the derivative is linked to a specificcondition or event (e.g., the underlying reaching a specific price level).
The need for a derivatives market
 The derivatives market performs a number of economic functions:1. They help in transferring risks from risk averse people to risk oriented people2. They help in the discovery of future as well as current prices3. They catalyze entrepreneurial activity4. They increase the volume traded in markets because of participation of riskaverse people in greater numbers5. They increase savings and investment in the long run
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. Thefutures contracts are available on 2338 securities stipulated by the Securities& Exchange Board of India (SEBI). Trading in options on individual securitiescommenced from July 2, 2001. The options contracts are American style andcash settled and are available on 233 securities. Trading in interest ratefutures was introduced on 24 June 2003 but it was closed subsequently dueto pricing problem. The NSE achieved another landmark in productintroduction by launching Mini Index Futures & Options with a minimumcontract size of Rs 1 lac.
NSE crated history by launching currency futures contract on US Dollar-Rupeeon August 29, 2008 in Indian Derivatives market. Table 3 presents adescription of the types of products traded at F& O segment of NSE.( As Traded on May 29, 2009. Chhota SENSEX was launched on January 1, 2008.With a small or 'mini' market lot of 5, it allows for comparatively lower capitaloutlay, lower trading costs, more precise hedging and flexible trading. It is astep to encourage and enable small investors to mitigate risk and enableeasy access to India's most popular index, SENSEX, through futures &options)
Development of derivatives market in India
 
 The first step towards introduction of derivatives trading in India was thepromulgation of the Securities Laws(Amendment) Ordinance, 1995, whichwithdrew the prohibition on options in securities. The market for derivatives,however, did not take off, as there was no regulatory framework to governtrading of derivatives. SEBI set up a 24–member committee under theChairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriateregulatory framework for derivatives trading in India. The committeesubmitted its report on March 17, 1998 prescribing necessary pre–conditionsfor introduction of derivatives trading in India. The committee recommendedthat derivatives should be declared as ‘securities’ so that regulatoryframework applicable to trading of ‘securities’ could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivativesmarket in India. The report, which was submitted in October 1998, workedout the operational details of margining system, methodology for charginginitial margins, broker net worth, deposit requirement and real–timemonitoring requirements.
 The Securities Contract Regulation Act (
SCRA
) was amended in December1999 to include derivatives within the ambit of ‘securities’ and the regulatoryframework was developed for governing derivatives trading. The act alsomade it clear that derivatives shall be legal and valid only if such contractsare traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the three–decade oldnotification, which prohibited forward trading in securities.
Derivatives trading commenced in India in June 2000 after SEBI granted thefinalapproval to this effect in May 2001. SEBI permitted the derivative segmentsof two stock exchanges, NSE and BSE, and their clearing house/corporation tocommence trading and settlement in approved derivatives contracts. Tobegin with, SEBI approved trading in index futures contracts based on S&PCNX Nifty and BSE–30(Sensex) index. This was followed by approval fortrading in options based on these two indexes and options on individualsecurities.
 The trading in BSE Sensex options commenced on June 4, 2001 and thetrading in options on individual securities commenced in July 2001. Futurescontracts on individualstocks were launched in November 2001. Thederivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 andtrading in options on individual securities commenced on July 2, 2001.
Single stock futures were launched on November 9, 2001. The index futuresand options contract on NSE are based on S&P CNX
 Trading and settlement in derivative contracts is done in accordance with therules, By laws, and regulations of the respective exchanges and their clearinghouse/corporation duly approved by SEBI and notified in the official gazette.Foreign Institutional Investors(FIIs) are permitted to trade in all Exchangetraded derivative products.
The following are some observations based on the trading statisticsprovided in the NSE report on the futures and options (F&O):
Single-stock futures continue to account for a sizable proportion of the F&O

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