What is Derivative?

The Derivatives Market is meant as the market where exchange of derivatives takes
place. Derivatives are one type of securities whose price is derived from the underlying
assets. And value of these derivatives is determined by the fluctuations in the underlying
assets. These underlying assets are most commonly stocks, bonds, currencies, interest
rates, commodities and market indices. As Derivatives are merely contracts between two
or more parties, anything like weather data or amount of rain can be used as underlying
assets. The Derivatives can be classified as Future Contracts, Forward Contracts,
Options, Swaps and Credit Derivatives.

Futures and options represent two of the most common form of "Derivatives".
Derivatives are financial instruments that derive their value from an 'underlying'. The
underlying can be a stock issued by a company, a currency, Gold etc., The derivative
instrument can be traded independently of the underlying asset.

The value of the derivative instrument changes according to the changes in the value of
the underlying.

Derivatives are of two types -- exchange traded and over the counter.

Exchange traded derivatives, as the name signifies are traded through organized
exchanges around the world. These instruments can be bought and sold through these
exchanges, just like the stock market. Some of the common exchange traded derivative
instruments are futures and options.

Over the counter (popularly known as OTC) derivatives are not traded through the
exchanges. They are not standardized and have varied features. Some of the popular OTC
instruments are forwards, swaps, swaptions etc.
Futures and Options

Futures

A 'Future' is a contract to buy or sell the underlying asset for a specific price at a pre-
determined time. If you buy a futures contract, it means that you promise to pay the price
of the asset at a specified time. If you sell a future, you effectively make a promise to
transfer the asset to the buyer of the future at a specified price at a particular time. Every
futures contract has the following features:

 Buyer
 Seller
 Price
 Expiry

Options

Options contracts are instruments that give the holder of the instrument the right to buy or
sell the underlying asset at a predetermined price. An option can be a 'call' option or a
'put' option.

A call option gives the buyer, the right to buy the asset at a given price. This 'given price'
is called 'strike price'. It should be noted that while the holder of the call option has a
right to demand sale of asset from the seller, the seller has only the obligation and not the
right.

Similarly a 'put' option gives the buyer a right to sell the asset at the 'strike price' to the
buyer. Here the buyer has the right to sell and the seller has the obligation to buy.

So in any options contract, the right to exercise the option is vested with the buyer of the
contract. The seller of the contract has only the obligation and no right. As the seller of
the contract bears the obligation, he is paid a price called as 'premium'. Therefore the
price that is paid for buying an option contract is called as premium.
The buyer of a call option will not exercise his option (to buy) if, on expiry, the price of
the asset in the spot market is less than the strike price of the call.

REGULATION OF FUTURE AND OPTION IN INDIA

1. The Board may prescribe Regulations from time to time for the functioning and
operations of the F & O Segment and to regulate the functioning and operations of the
clearing members of the F & O Segment.

2. Without prejudice to the generality of the above, the Board may prescribe regulations
from time to time, inter alia, with respect to :

(1) norms, procedures, terms and conditions for admission of Exchanges;

(2) norms, procedures, terms and conditions to be complied with for admission of deals
for clearing and settlement in the F & O Segment by the Clearing Corporation;

(3) norms, procedures, terms and conditions for clearing and settlement of deals in the F
& O Segment;

(4) forms and conditions of deals to be entered into, and the time, mode and manner for
performance of deals between clearing members inter se or between clearing members
and their constituents;

(5) norms, procedures, terms and conditions for guaranteed settlement by the F & O
Segment;

(6) prescription, from time to time, and administration of penalties, fines and other
consequences, including suspension/expulsion of clearing members from the F & O
Segment for defaults;

(7) norms, procedures, terms and conditions for imposition and administration of
different types of margins and other charges and restrictions that may be imposed by the
F & O Segment from time to time.
(8) determination from time to time, of fees, system usage charges, deposits, margins and
other monies payable to the Clearing Corporation by clearing members of the F & O
Segment and the scale of clearing and other charges that may be collected by such
clearing members;

(9) supervision of the clearing operations and promulgation of such Business Rules and
Codes of Conduct as it may deem fit;

(10) inspection and audit of records and books of accounts;

(11) settlement of disputes, complaints, claims arising between clearing members inter-se
as well as between clearing members and persons who are not clearing members relating
to any deal in securities cleared and settled through the F & O Segment including
settlement by arbitration;

(12) norms, procedures, terms and conditions for arbitration;

(13) administration, maintenance and investment of the corpus of the Fund(s) set

up by the F & O Segment including Settlement Fund(s);

(14) establishment, norms, terms and conditions, functioning and procedures of clearing
house, clearing through depository or other arrangements including custodial services for
clearing and settlement;

(15) norms, procedures, terms and conditions in respect of, incidental to or consequential
to closing out of deals;

(16) dissemination of information and announcements;

(17) any other matter as may be decided by the Board.

 REGULATION OF FUTURE AND OPTION IN USA

There are three pillars of such prudential regulation, and they apply in their own way to
derivatives markets.

Registration and Reporting Requirements:

The first pillar relates to reporting and registration requirements for OTC derivatives
dealers and the use of derivatives. These are designed to improve the transparency – and
thus the pricing efficiency – in the markets.
Under current US law, banks and other depository institutions are required to obtain a
state or federal bank or other relevant charter. Similarly, securities brokers and dealers are
required to register with the Securities and Exchange Commission. Brokers for exchange
traded futures and options are required to register with the Commodity Futures Trading
Commission. In addition, the individuals responsible for customer accounts are also
required to pass competency standards (such as the Series 7 exams for securities brokers)
in order to register. This process helps establish minimum initial capital requirements for
financial institutions, and it allows for a background check on individuals for criminal
conviction for fraud. Those convicted are usually given life-time ban from the securities
markets. Registration is thus a principal step to rule enforcement in financial markets.

Capital and Collateral Requirements:

The second pillar of prudential regulatory measures involves capital and collateral
requirements. Capital requirements function to provide both a buffer against the
vicissitudes of the market and a governor on the tendency of market competition to drive
participants out along the “capital market line” where they seek higher yields by taking
on greater risks. Capital requirements govern risk taking by requiring financial
institutions to a minimum amount of certain types of capital in proportion to the credit
risk exposure on their balance sheet and off-balance sheet positions. In the case of
derivatives, the Tables 1 and 3 above show that the notional amount of outstanding
derivatives is much greater than the gross market value, and after adjusting for legally
enforceable netting agreements the gross market value is higher than credit exposure.
Gross market value is the amount by which contracts are currently “in the money” when
marked to market or assessed at fair value (when no market value exists). It is how the
much the firm would lose, before netting, if all its winning positions were to fail due to
counterparty default. This figure for credit exposure does not take into account the degree
to which firms have required that collateral to posted against this open exposure. It is the
credit exposure that is subject to capital requirements, and the amount of credit exposure
can be further reduced through the use of collateral.

In this way, capital requirements apply to financial institutions for the credit risk that they
face on all their combined assets after adjusting for netting and collateral.

Orderly Market Rules:

The third pillar of prudential market regulation is a collection of market regulatory

measures that has proven to be effective in reducing vulnerability to financial distortions
and disruptions while increasing efficiency. The list below is not complete, but is
illustrative of the types of measures that improve both market stability and efficiency.
• Detect and deter manipulation and fraud in order to protect the integrity of the
information embedded in market prices

The fact that prices play an important role in markets outside that in which they are
established means that there is an externality to the information embodied in such prices.
This basic insight is reflected in the laws written to regulate futures markets in the United
States. Section 3 of the Commodity Exchanges Act, entitled “The Necessity of
Regulation,” states that futures are "affected with a national public interest." "The prices
in such transactions are generally quoted and disseminated throughout the United States...
for determining the prices to producer and consumer of commodities and the products
and by-products thereof and to facilitate the movements thereof in interstate commerce."

• Require OTC derivatives dealers to act as market-makers by maintaining bid-ask

quotes throughout trading day. This obligation compares with the privileges of being
a dealer, and is similar to requirements for dealers in the over-the-counter US
Treasury securities markets.

Markets work better when they are liquid, but liquidity is often reduced during financial
crises and even lesser disruptions. In order to better ensure the orderliness of the market,
derivatives dealers should face the responsibilities of market making just as they capture
the benefits of that market position.
• “Know thy customer” provisions should be extended to all entities engaging in
derivatives transactions. It holds derivatives dealers or other sellers responsible for
 engaging in transactions that are inappropriate and potentially destructive to their
counterparties.

This provision will discourage sharp trading and sales practices that sometimes lead to
the “blowing-up” of customers. For example, the PERLs served no positive purpose for
East Asian investors and were primarily a stealth vehicle for financial institutions in
developed countries to acquire long-dated short positions in developing country
currencies. This provision already exists in US securities markets and a comparable
measure exists for US banking markets. It should be extended to derivatives markets
where there is even greater concern with the implications of large differences in the
degree of financial sophistication between market participants.

• Price limits and stand-still provisions should be available to maintain or restore order
in the market place.

Price limits have already demonstrated their effectiveness on securities markets and for
futures and options trading on exchanges. Similar measures should be available to
regulatory authorities in the OTC derivatives market. Stand-still provisions are useful in
order to facilitate the rescheduling and reorganization of debt as well as derivatives
obligations.
Bibliography:
www.nseindia.com
www.sec.gov.com