INTRODUCTION TO DERIVATIVES.

Derivatives have been associated with a number of high-profile corporate events

that roiled the global financial markets over the past two decades. To some critics,
derivatives have played an important role in the near collapses or bankruptcies of
Long-term Capital Management in 1998, Enron in 2001, Lehman Brothers in 2008
and American International Group (AIG) in 2008. Warren Buffet even viewed
derivatives as time bombs for the economic system and called them financial
weapons of mass destruction (Berkshire Hathaway Inc (2002)). But derivatives,
if “properly” handled, can bring substantial economic benefits.

These instruments help economic agents to improve their management of market

and credit risks. They also foster financial innovation and market developments,
increasing the market resilience to shocks. The main challenge to policymakers is
to ensure that derivatives transactions being properly traded and prudently
supervised. This entails designing regulations and rules that aim to prevent the
excessive risk-taking of market participants while not slowing the financial
innovation aspect. And it also calls for improved data quantity and quality to
enhance the understanding of derivatives markets.

In the Commodities Market (Sem III), we have studied the Commodities Market.
The Origin, types of Commodities, SPOT, Forwards & Future Markets, Development
over the years, Initiatives by the Govt. to develop the Commodity market in India
and International Commodity Market.

This chapter provides an overview of derivatives, covering three main aspects of

these securities: instruments, markets and participants. It begins with a quick
review of some key concepts, including what derivatives are; different types; who
use these instruments, what are Commodity Derivatives, How and when did this
concept hit India, where are they traded, and for what purpose.  It also discusses
the factors that influence the demand-supply of Commodities, their impact on
Derivative Prices and Connections of Indian Commodity market with Global
Market.

1.1DERIVATIVES DEFINITION:

The Oxford dictionary defines a derivative as, “something derived or

obtained from another, coming from a source; not original”.
In the field of finance, a derivative security is generally referred to- “a
financial contract whose value is derived from the value of an underlying
asset or simply underlying”.
There are a wide range of financial assets that have been used as
underlying, including equities or equity index, fixed-income instruments,
foreign currencies, commodities, credit events and even other derivative
securities. Depending on the types of underlying, the values of the
derivative contracts can be derived from the corresponding equity prices,
interest rates, exchange rates, commodity prices and the probabilities of
certain credit events. These financial instruments help you make profits by
betting on the future value of the underlying asset. So, their value is derived
from that of the underlying asset. This is why they are called ‘Derivatives’.

Illustration:
Assuming Mr. X is a Goldsmith and deals in physical Gold for his business
activity. Here, he can also deal in a Derivative Contract between the buyer
and the seller which will derive its value from the underlying asset that is
Gold. As the market price of Gold will change depending upon the market
forces, the value of the Derivative contract will also change.
Thus, if after buying a derivative contract at a certain price, the market price
of the underlying asset (i.e. Gold) goes higher, than the Goldsmith- the
buyer of the contract will make money. But if the market prices goes down
than the Goldsmith will make a loss on the contract he has bought.

The derivative market in India, like its counterparts abroad, is increasingly

gaining significance. Since the time derivatives were introduced in the year
2000, their popularity has grown manifold. This can be seen from the fact
that the daily turnover in the derivatives segment on the National Stock
Exchange currently stands at Rs. crore, much higher than the turnover
clocked in the cash markets on the same exchange.

In 2016, 25 billion derivative contracts were traded.  Asia commanded 36

percent of the volume, while North America traded 34 percent. Twenty
percent of the contracts were traded in Europe. These contract were worth
$570 trillion in 2016. That's six times more than the economic output of the
world. 
NSE has emerged as the world largest derivative exchange in 2020 by the
no.of contracts traded based on the statistics maintained by FIA- Futures
Industry Association.

1.1.2. HISTORY OF DERIVATIVES-

Derivatives have a long history and early trading can be traced back to
Venice in the 12th century. Credit derivative deals at that period took the
form of loans to fund a ship expedition with some insurance on the ship not
returning. Later in the 16th century, derivatives contracts on commodities
emerged. During that time, the slow speed in communication and high
transportation costs presented key problems for traders. Merchants thus
used derivatives contracts to allow farmers to lock in the price of a
standardized grade of their produces at a later delivery date.

A number of fundamental changes in global financial markets have

contributed to the strong growth in derivative markets since the 1970s.
First, the collapse of the Bretton Woods system of fixed exchange rates in
1971 increased the demand for hedging against exchange rate risk. The
Chicago Mercantile Exchange allowed trading in currency futures in the
following year. Second, the changing of its monetary policy target
instrument by the US Federal Reserve (FED) promoted various derivatives
markets. The adoption of a target for money growth by the FED in 1979 has
led to increased interest-rate volatility of Treasury bonds. That in turn raised
the demand for derivatives to hedge against adverse movements in interest
rates. Later in 1994 when the US Federal Open Market Committee moved to
explicitly state its target level for the federal funds rate, that policy has
spurred the growth of derivatives on the federal funds rates. Third, the
many emerging market financial crises in the 1990s, which were often
accompanied by a sharp rise in corporate bankruptcy, greatly increased the
demand of global investors for hedging against credit risk.
1.2TYPES OF DERIVATIVES

Majorly there are four main types of derivatives contracts: forwards; futures,
options and swaps. This section discusses the basics of these four types of
derivatives with the help of some specific examples of these instruments.

1. Forwards contracts :
2. A forward contract is a customizable derivative contract between two
parties to buy or sell an asset at a specified price on a future date.
3. Forward contracts can be tailored to a specific commodity, amount, and
delivery date.
4. Forward contracts do not trade on a centralized exchange and are
considered over-the-counter (OTC) instruments.
5. For example, forward contracts can help producers and users of agricultural
products hedge against a change in the price of an underlying asset or
commodity.
6. Financial institutions that initiate forward contracts are exposed to a greater
degree of settlement and default risk compared to contracts that are
marked-to-market regularly.

2. Futures contracts:

1. A future contract is a standardized derivative contract between exchange

and buyer or sell, with respect to an asset at a specified price on a future
date.
2. Futures are exchange traded derivative contracts.
3. Futures are standardized contracts, as per prescribed by the exchange with
respect to Quality, Quantity, Expiry, etc.
4. Futures are identified by their expiration month.
5. Futures allow investors to take leverage with initial Margins
6. Futures are used for Hedging and Speculation.

Forward and futures contracts are usually discussed together as they share a
similar feature: a forward or futures contract is an agreement to buy or sell a
specified quantity of an asset at a specified price with delivery at a specified
date in the future. But there are important differences in the ways these
contracts are transacted. First, participants trading futures can realise gains
and losses on a daily basis while forwards transaction requires cash settlement
at delivery. Second, futures contracts are standardised while forwards are
customised to meet the special needs of the two parties involved
(counterparties). Third, unlike futures contracts which are settled through
established clearing house, forwards are settled between the counterparties.
Fourth, because of being exchange-traded, futures are regulated whereas
forwards, which are mostly over-the-counter (OTC) contracts, and loosely
regulated (at least in the run up to the global financial crisis). This importance
of exchange-traded versus OTC instruments will be discussed further in later
section.

1. Options contracts:

Options contracts can be either standardised or customised. There are two

types of option: call and put options. Call option contracts give the purchaser
the right to buy a specified quantity of a commodity or financial asset at a
particular price (the exercise price) on or before a certain future date (the
expiration date). Similarly, put option contracts give the buyer the right to sell a
specified quantity of an asset at a particular price on a before a certain future
date. These definitions are based on the so-called American-style option. And
for a European style option, the contract can only be exercised on the
expiration date. In options transaction, the purchaser pays the seller – the
writer of the options – an amount for the right to buy or sell. This amount is
known as the option premium. Note that an important difference between
options contracts and futures and forwards contracts is that options do not
require the purchaser to buy or sell the underlying asset under all
circumstances. In the event that options are not exercised at expiration, the
purchaser simply loses the premium paid. If the options are exercised,
however, the option writer will be liable for covering the costs of any changes
in the value of the underlying that benefit the purchasers.

3.Swaps:

Swaps are agreements between two counter parties to exchange a series of

cash payments for a stated period of time. The periodic payments can be
charged on fixed or floating interest rates, depending on contract terms. The
calculation of these payments is based on an agreed-upon amount, called the
notional principal amount or simply the notional.
 1.3PRODUCTS

✔ Equity Derivatives:

Equity derivative is a class of derivatives whose value is at least partly derived

from one or more underlying equity securities. Options and futures are by far the
most common equity derivatives. This section provides you with an insight into
the daily activities of the equity derivatives market segment. Two major products
under Equity derivatives are Futures and Options, which are available on
Individual Stocks of listed companies. NSE became the first exchange in India to
launch trading in options on individual securities from July 2, 2001. Futures on
individual securities were introduced on November 9, 2001. Futures and Options
on individual securities are available on 175 securities stipulated by SEBI.

✔ Index Derivatives: The National Stock Exchange of India Limited (NSE)

commenced trading in derivatives with the launch of index futures on
June 12, 2000. The futures contracts are based on the popular equity
benchmark like- Nifty 50 Index.
The Exchange introduced trading in Index Options on June 4, 2001.
The Exchange has also introduced trading in Futures and Options contracts based
on Nifty IT, Nifty Bank, and Nifty Midcap 50, Nifty Infrastructure, Nifty PSE, Nifty
CPSE indices.
No. of Put Call Premium
Product Turnover( cr.) *
contracts Ratio Turnover ( cr.)
Index Futures 1,87,686 15,951.46 - -
Vol Futures 0 0.00 - -
Stock Futures 13,97,962 1,01,057.50 - -
Index Options 40,67,473 3,54,973.72 1.29 1661.36
Stock Options 6,22,642 47,222.04 0.37 515.66
F&O Total 62,75,763 5,19,204.72 1.10 2177.01
(Source: nseindia.com, daily reports as of 26/12/17)
✔ Currency Derivatives:
A currency future, also known as FX future, is a futures contract to exchange one
currency for another at a specified date in the future at a price (exchange rate)
that is fixed on the purchase date. On NSE the price of a future contract is in terms
of INR per unit of other currency e.g. US Dollars. Currency future contracts allow
investors to hedge against foreign exchange risk. Currency Derivatives are
available on four currency pairs viz. US Dollars (USD), Euro (EUR), Great Britain
Pound (GBP) and Japanese Yen (JPY). Currency options are currently available on
US Dollars.

✔ Bond Futures:

An Interest Rate Futures contract is "an agreement to buy or sell a debt

instrument at a specified future date at a price that is fixed today." The
underlying security for Interest Rate Futures is either Government Bond
or T-Bill. Thus, Interest Rate Futures are called as “Bond Futures”.
Exchange traded Interest Rate Futures on NSE are standardized contracts
based on 6 year, 10 year and 13 year Government of India Security (NBF
II) and 91-day Government of India Treasury Bill (91 DTB).

✔ Commodity Derivatives:
Commodity Derivatives contract is an agreement to buy or sell a specific
Commodity of a specific quality at a price that is fixed today. The
underlying asset here is any commodity like- Gold, Silver, Metals,
Agri-Commodities. etc. MCX is the Largest Commodity Derivative
Exchange in India.
1.4   PARTICIPANTS

MAJOR PLAYERS IN THE FINANCIAL DERIVATIVES TRADING There are three

major players in the financial derivatives trading:

1. Hedgers: Hedgers are traders who use derivatives to reduce the risk that
they face from potential movements in a market variable and they want to
avoid exposure to adverse movements in the price of an asset. Majority of the
participants in derivatives market belongs to this category. Hedgers want to
 avoid their risk, which is taken over by speculators. In Commodity derivatives
market, Producers and Consumers who want to reduce the Price risk come to
exchange and Hedge their original positions.

2. Speculators: Speculators are traders who buy/sell the assets only to sell/buy
them back profitably at a later point in time. They want to assume risk. They
use derivatives to bet on the future direction of the price of an asset and take a
position in order to make a quick profit. They can increase both the potential
gains and potential losses by usage of derivatives in a speculative venture.

In the Indian markets, there are two types of speculators – day traders and the
position traders.
● A day trader tries to take advantage of intra-day fluctuations in prices. All their
trades are settled by undertaking an opposite trade by the end of the day. They
do not have any overnight exposure in the markets.
● On the other hand, position traders greatly rely on news, tips and technical
analysis – the science of predicting trends and prices, and take a longer view,
say a few weeks or a month in order to realize better profits. They take and
carry position for overnight or a long term.

2. Arbitrageurs: Arbitrageurs are traders who simultaneously buy and sell the
same (or different, but related) assets in an effort to profit from unrealistic
price differentials. They attempts to make profits by locking in a riskless
trading by simultaneously entering into transaction in two or more markets.
They try to earn riskless profit from discrepancies between futures and spot
prices and among different futures prices

3. Margin traders: Many speculators trade using of the payment mechanism

unique to the derivative markets. This is called margin trading. When you
trade in derivative products, you are not required to pay the total value of
your position up front. . Instead, you are only required to deposit only a
fraction of the total sum called margin. This is why margin trading results in
a high leverage factor in derivative trades. With a small deposit, you are
able to maintain a large outstanding position. The leverage factor is fixed;
there is a limit to how much you can borrow. The speculator to buy three to
five times the quantity that his capital investment would otherwise have
allowed him to buy in the cash market. For this reason, the conclusion of a
 trade is called ‘settlement’ – you either pay this outstanding position or
conduct an opposing trade that would nullify this amount.

To conclude Speculators, margin traders and arbitrageurs are the lifeline of

the capital markets as they provide liquidity to the markets by taking long
(purchase) and short (sell) positions. They contribute to the overall
efficiency of the Derivatives markets.

1.4 FUNCTIONS OF DERIVATIVES

1. Management of risk: One of the most important services provided by

the derivatives is to control, avoid, shift and manage efficiently
different types of risk through various strategies like hedging,
arbitraging, spreading etc. Derivative assist the holders to shift or
modify suitable the risk characteristics of the portfolios. These are
specifically useful in highly volatile financial conditions like erratic
trading, highly flexible interest rates, volatile exchange rates and
monetary chaos.

2. Price discovery: The important application of financial derivatives is

the price discovery which means revealing information about future
cash market prices through the future market. Derivative markets
provide a mechanism by which diverse and scattered opinions of
 future are collected into one readily discernible number which
provides a consensus of knowledgeable thinking.

3. Liquidity and reduce transaction cost : As we see that in derivatives

trading no immediate full amount of the transaction is required since
most of them are based on margin trading. As a result, large number
of traders, speculators, arbitrageurs operates in such markets. So,
derivatives trading enhance liquidity and reduce transaction cost in
the markets of underlying assets. Measurement of Market:
Derivatives serve as the barometers of the future trends in price
which result in the discovery of new prices both on the spot and
future markets. They help in disseminating different information
regarding the future markets trading of various commodities and
securities to the society which enable to discover or form suitable or
correct or true equilibrium price in the markets. As a result, the
assets will be in an appropriate and superior allocation of resources
in the society.

4. Efficiency in trading: Financial derivatives allow for free trading of risk

components and that leads to improving market efficiency. Traders
can use a position in one or more financial derivatives as a substitute
for a position in underlying instruments. In many instances, traders
find financial derivatives to be a more attractive instrument than the
underlying security. This is mainly because of the greater amount of
liquidity in the market offered by derivatives as well as the lower
transaction costs associated with trading a financial derivative as
compared to the costs of trading the underlying instruments in cash
market.

5. Speculation and arbitrage: Derivatives can be used to acquire risk,

rather than to hedge against risk. Thus, some individuals and
institutions will enter into a derivative contract to speculate on the
value of the underlying asset, betting that the party seeking
insurance will be wrong about the future value of the underlying
asset. Speculators look to buy an asset in the future at a low price
according to a derivative contract when the future market price is
high, or to sell an asset in the future at a high price according to
 derivative contract when the future market price is low. Individual
and institutions may also look for arbitrage opportunities, as when
the current buying price of an asset falls below the price specified in
a futures contract to sell the asset.

6. Hedging : Hedge or mitigate risk in the underlying, by entering into a

derivative contract whose value moves in the opposite direction to
their underlying position and cancels part or all of it out. Hedging
also occurs when an individual or institution buys an asset and sells it
using a future contract. They have access to the asset for a specified
amount of time, and can then sell it in the future at a specified price
according to the futures contract of course; this allows them the
benefit of holding the asset.

7. Price stabilization function: Derivative market helps to keep a

stabilizing influence on spot prices by reducing the short term
fluctuations. In other words, derivatives reduce both peak and
depths and lends to price stabilization effect in the cash market for
underlying asset.

8. Gearing of value: Special care and attention about financial

derivatives provide leverage (or gearing), such that a small movement
in the underlying value can cause a large difference in the value of
the derivative.

9. Develop the complete markets : It is observed that derivative trading

develop the market towards “complete markets” complete market
concept refers to that situation where no particular investors be
better of than others, or patterns of returns of all additional
securities are spanned by the already existing securities in it, or there
is no further scope of additional security.

10. Encourage competition : The derivatives trading encourage the

competitive trading in the market, different risk taking preference at
market operators like speculators, hedgers, traders, arbitrageurs etc.
resulting in increase in trading volume in the country. They also
 attract young investors, professionals and other experts who will act
as catalysts to the growth of financial market.

11. Other uses : The other uses of derivatives are observed from the
derivatives trading in the market that the derivatives have smoothen
out price fluctuations, squeeze the price spread, integrate price
structure at different points of time and remove gluts and shortage in
the markets. The derivatives also assist the investors, traders and
managers of large pools of funds to device such strategies so that
they may make proper asset allocation increase their yields and
achieve other investment goals.

- Derivatives transactions are now common among a wide range of entities,

including commercial banks, investment banks, central banks, fund
managers, insurance companies and other non-financial corporations.
- Participants in derivatives markets are often classified as either “hedgers”
or “speculators”.

❖ EXCHANGE TRADED vs. OTC DERIVATIVES

Exchange traded derivative: Those derivative instruments that are traded

via specialized derivatives exchange of other exchange. A derivatives
exchange is a market where individual trade standardized contracts that
have been defined by the exchange. Derivative exchange act as an
intermediary to all related transactions and takes initial margin from both
sides of the trade to act as a guarantee. They may be followings: (i) Futures
(ii) Options (iii) Interest rate (iv) Index product (v) Convertible (vi) Warrants
(vii) Others

OTC- (over the counter): OTC derivative contracts are those derivative
instruments that are traded without any exchange, but via an exclusive
dealer Network. The contracts traded here are result of bilateral
agreements between Producers and consumers. The OTC derivative market
is the largest market for derivatives and largely unregulated with respect to
disclosure of information between parties. They are following: (i) Swaps (ii)
Forward rate agreements (iii) Exotic options (iv) Other exotic derivative
 Exchange Traded Derivatives
Meaning Derivatives traded on a
regulated exchange
Nature The contracts are specified
by the exchange
There is no scope for
Negotiation Negotiation
Structure Centralized – traded via
exchange only
Regulations Highly regulated by
authorities (SEBI)
Risk Credit and Default risk taken
over by the exchange
Scope Large scope for big and small
players
Transparency Transactions here are highly
transparent
OTC Derivatives
Derivatives traded over the
counter, with no exchange
in between
The Contracts terms are
determined by buyer &
seller
There is complete scope for
negotiation
Decentralized- traded via
many brokers
No regulations governing
OTC trades
Absence of regulation and
exchange increases the risk
manifold on OTC.
Limited scope for small
players
Visibility and transparency
is lower.