What is Derivatives?

Narendra Kumar

21 Dec, 2020

DERIVATIVE is a financial instrument, whose value is entirely derived from the value of the underlying assets.  Basically, the derivative itself is a contract between two or more parties based on the asset or assets. Its value is mainly determined by fluctuations in the value of the underlying asset which can be in the form of Securities, Stocks, Bonds, Commodities, Bullion, Currency, etc.

For example, imagine you own a house worth Rs. 50, 00,000. You get it insured for a premium of Rs 15000 (It is a very risky house!) Now you think about policy (ignoring the house) as an investment. • In case, Suppose the house is fine after 1 year. You have lost the premium of Rs 15000. • But if it gets fully damaged and broken in one year. You receive Rs 50,00,0000 on just paying a premium of Rs 15,000. If you have bought insurance of any sort you have bought an option. The option is one type of derivative.

Features of Derivatives:

1. It can be traded on an exchange.
2. All transactions in derivative take place on a future specified date.
3. It has a low transaction cost
4. There is no compulsory physical trading of underlying assets.
5. Derivatives are basically hedging device so it reduces risk.

It can be traded either over- the- counter or exchange.  OTC derivatives^[1] constitute the greater proportion of derivatives in existence and are unregulated, whereas derivatives traded on exchanges are standardized.

Types of derivatives: Its description as described below

Forward Contract: Forward Contract is a contract that commits one party to buy and others to sell a given quantity of an asset for a fixed price on a specified future date. In these types of contracts, one of the parties assumes a long position and agrees to buy the underlying asset at a certain future date for a certain price. This specified price is known as the delivery price.

FEATURES OF forwarding CONTRACT:

1. It is negotiated a contract between two parties.
2. Each contract is custom designed and hence unique in terms of contract size, expiration date, asset quality, asset type, etc.
3. It has to be settled in delivery or cash on the expiration date

In case, if one of two parties wish to reverse a contract, he has to compulsorily go to the other party. The counterparty is in a monopoly situation can command the price he wishes.

FUTURE CONTRACTS: In future contracts, there is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. They are the special type of forwarding contracts, in the sense that the former are standardized exchange-traded contracts. The Futures are usually performed by payment of the difference between the strike price and the market price on a fixed future date and not by the physical delivery and payment in full on that date.

Read our article:Commodity Hedging – Revamped Laws For Commodity Derivative Transactions

Features of future contract:

1. It is an organized exchange.
2. These contracts are standardized contracts and are traded on the stock exchange
3. A futures contract is a standardized contract with standard underlying instruments. A standard quantity and quality of the underlying instrument can be delivered at standard time for such settlement transactions.
4. In these types of contracts, there is an existence of a regulatory authority.
5. Margin requirements and daily settlement to act as a safeguard.
6. Leveraged positions–only margin required.
7. Trading in either direction–short/long

They are basically two kinds of Swaps:

1. Interest Rate Swap Currency Swaps

OPTION: Options are contracts that give the buyers the right (but not the obligation) to buy or sell a specified quantity of certain underlying assets at a specified price on or before a specified date. On the other hand, the seller is under obligation to perform the contract (buy or sell).

There are basically two types of Options:

A Call Option gives an investor the right to buy an underlying item during the specified period of time at an agreed-upon price while put option confers the right to sell it. But before exercising these options it is necessary to understand American and European Option.

Regulatory Framework in India:

With the amendment in the definition of ”securities” under SC(R)A in order to include derivative contracts in the definition of securities, derivatives trading takes place under the governing provisions of the Securities Contracts (Regulation) Act, 1956 and the Securities and Exchange Board of India Act, 1992^[2].

Dr. L.C Gupta Committee has provided the regulatory responsibility between SEBI and exchange, suggestive bye-law for Derivative Exchanges/Segments and their Clearing Corporation/House in which they had laid down all the provisions for trading. Moreover, SEBI has also laid the eligibility conditions for Derivative Exchange/Segment and its Clearing Corporation/House. The main motive for which they have defined the eligibility criteria is to get ensured that Derivative Exchange/Segment & Clearing Corporation/House should provide a transparent trading environment, safety & integrity and also, provide facilities for the redressal of investor grievances.

Some of the important eligibility conditions are as described below 1. An online screen-based Trading System should be available for derivative trading.
2.  Online surveillance capability in derivative exchange should be maintained to monitor positions, prices, and volumes on a real-time basis to deter market manipulation.
3. Arrangements for the dissemination of information about trades, quantities and quotes on a real-time basis through at least two information vending networks, which are easily accessible to investors across the country shall be maintained by the derivative exchange/ segment.
4. A proper arbitration and investor grievances redressal mechanism should be operative from all the four areas/regions of the country.
5. The system of monitoring investor complaints should be satisfactory and also helps in preventing irregularities in trading.
6. Separate Investor Protection Fund should be maintained in exchange.
7. The Clearing Corporation/House should have the capacity or shall be able to monitor the overall position of Members who are participating in both markets i.e. across the derivatives market and as well as the underlying securities market.
9. The level of initial margin on Index Futures Contracts shall be related to the risk of loss on the position. The initial margins should be large enough and able to cover the one-day loss that can be encountered on the position on 99% of the days.
10. These houses should also establish facilities for electronic funds transfer (EFT) for swift movement of margin payments.
11. In case, if a member defaults in meeting its liabilities, then the Clearing Corporation/House shall transfer the client positions and assets to another solvent Member or close-out all open positions.
12. The Clearing Corporation/House should have capabilities to segregate initial margins deposited by Clearing Members for trades on their own account and on account of his client. These houses will hold the clients’ margin money in trust for their purposes only and also not allow them to divert it for any other purpose.
13. A separate Trade Guarantee Fund for the trades executed on Derivative Exchange / Segment should be maintained by the clearing corporation/houses.
In the current scenario, SEBI has permitted Derivative Trading on the Derivative Segment of BSE and the F&O Segment of NSE.

Nowadays, the secondary market contributes significantly to the Indian financial market among which derivatives as a financial product have become popular. Detailed information is provided on our website i.e www.enterslice.com

Read our article:Offshore Parent MNC Role in the Indian Derivative Market