Derivative market in India

Forwards:

A forward contract is an agreement between two parties to buy or sell an asset at a

specified point of time in the future. In case of a forward contract the price which is paid/
received by the parties is decided at the time of entering into contract. It is the simplest form of
derivative contract mostly entered by individuals in day to day’s life.

Futures:
A futures contract is an agreement between two parties to buy or sell an Asset at a
certain time in the future at a certain price. Futures contracts are special types of forward
contracts in the sense that the former are standardized exchange-traded contracts.
Options:
Options are of two types - calls and puts. Calls give the buyer the right but not the
obligation to buy a given quantity of the underlying asset, at a given price on or before a given
future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the
underlying asset at a given price on or before a given date.
Warrants:
Options generally have lives of up to one year, the majority of options traded on options
exchanges having a maximum maturity of nine months. Longer-dated options are called warrants
and are generally traded over-the-counter.
Derivatives concepts

The term ‘derivatives, refers to a broad class of financial instruments which mainly
include options and futures. These instruments derive their value from the price and other related
variables of the underlying asset. They do not have worth of their own and derive their value
from the claim they give to their owners to own some other financial assets or security.

A simple example of derivative is butter, which is derivative of milk. The price of butter
depends upon price of milk, which in turn depends upon the demand and supply of milk. The
general definition of derivatives means to derive something from something else.

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Another example,

The price of gold to be delivered after two months will depend, among so many things,
on the present and expected price of this commodity.

As defined above, the value of a derivative instrument depends upon the underlying asset. The
Underlying asset may assume many forms: commodity, stock, precious metals exchange rates,
short term securities,

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Institutional and legal frame work

(i) Exchange

An exchange provides buys and sellers to futures and option contract the infrastructure they
need to trade. In the outcry system of trading, the exchange has a trading pit, in which the
exchange members and other representatives assemble during a fixed trading period and execute
transaction. In the on line trading system, the exchange provides with real-time access to
information online and also aloe them to execute their order. The exchange plays an important
role in the success of a derivative market. There can be separate exchanges for financial
instrument and commodity/or a common exchange for both.

(ii) Clearing house

An clearing house the transaction executed in a futures and option exchange. A clearing
house may be a separate company or division of the exchange. It guarantees the performance
of contract, which is why it is also a counter party to each contract. Transactions are
conducted between members and the clearing house. The clearing house ensures the solvency
of the members of the exchange by imposing various limits on them. The clearing house also
devises a suitable margin system to condition. This boosts the confidence of the people in the
future and option exchange.

(iii) Custodian/warehouse

Future and option contracts do not generally result in delivery, but they needa smooth and
standard delivery mechanism to ensure the proper functioning of the market. The issue of
delivery may not arise in stock index futures and options, which are cash settled contracts,

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but it would aeries in stock futures and option, commodity futures and option and interest
rate future and option. In the absence of a proper custodial or warehouse, the delivery of the
financial assets and commodity will be a cumbersome task and the futures prices will not
reflect equilibrium price for the convergence of the price and the futures price on maturity.

(iv) regulatory frame work

A regulator creates confidence in the market and provides a level playing filed for all concerned.
The RBI is the regulatory authority authority for the forex and money market, so it can take the
initiative in starting futures and option trade in currency and interest rate. SEBI regulates the
capital market. along with the physical market in stock, it also regulate the stock index futures.
The forward market commission set up a national commodities and derivative exchange
(NCDEX). The regulator’s approach and outlook directly affect the strength and volume of the
market.

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