Basics of Derivatives :
- A derivative is a financial product whose value is based on an underlying asset.
- The underlying assets for derivatives can include:
- Metals (e.g., Gold, Silver, Copper).
- Energy resources (e.g., Oil, Natural Gas).
- Agricultural commodities (e.g., Wheat, Sugar, Cotton).
- Financial assets (e.g., Shares, Bonds, Foreign Exchange).
Derivatives Market – History & Evolution :
- Derivatives have existed since the 12th century, with early contracts in European trade fairs.
- By the 13th century, English monasteries sold wool via long-term contracts, even 20 years in advance.
- The Tulip Mania (1634–1637) in Holland was an early speculative bubble involving tulip futures.
- Japan developed a rice futures market in the late 1600s to hedge against weather and war risks.
- In 1848, the Chicago Board of Trade (CBOT) introduced forward trading in commodities.
- 1865 marked the start of exchange-traded futures in the US by CBOT.
- Key milestones:
- 1919: Chicago Mercantile Exchange (CME) evolved from Butter and Egg Board.
- 1972: IMM at CME introduced currency futures.
- 1973: CBOE launched listed options trading.
- 1975–1983: Introduction of interest rate, Eurodollar, stock index futures, and stock index options.
- Major growth drivers for derivatives markets include:
- Price volatility in assets,
- Global financial integration,
- Advancements in technology,
- Better risk management awareness,
- Continuous financial innovation.
Indian Derivatives Market :
- SEBI Initiatives: In 1996, SEBI formed a committee led by Dr. L.C. Gupta to draft a regulatory framework for derivatives trading; it recommended classifying derivatives as securities.
- Risk Measures: In 1998, another committee under Prof. J.R. Varma proposed risk management mechanisms, including margin systems and position monitoring.
- Legal Framework: In 1999, SCRA was amended to include derivatives as securities; the ban on forward trading was repealed in 2000.
- Launch of Derivatives: Exchange-traded derivatives began in June 2000 with index futures on NSE and BSE; options and stock futures followed between 2001–2001; MSEI entered in 2013.
- Derivatives Products:
- Forwards: Customized OTC contracts to buy/sell assets at a future date at a fixed price.
- Futures: Standardized exchange-traded contracts, functioning like regulated forwards.
- Options: Contracts granting the right (not obligation) to buy/sell assets; buyers pay a premium.
- Swaps: Agreements to exchange cash flows, used to manage interest rate, currency, and commodity risks.
Market Participants :
- Three main participants in the derivatives market: hedgers, speculators (traders), and arbitrageurs.
- Hedgers use derivatives to minimize risk from market variables like interest rates and commodity prices.
- Speculators aim to profit from predicting price movements and prefer derivatives for leverage and lower transaction costs.
- Arbitrageurs exploit price differences across markets for profit, which helps align prices across locations quickly.
Types of Derivatives Market :
- Derivatives markets are divided into two types: Exchange-Traded and Over-the-Counter (OTC).
- OTC derivatives are privately negotiated contracts between counterparties, often done via phone or electronic means, not on a formal exchange.
- Growth in OTC markets is driven by advancements in information technology.
- OTC markets involve sophisticated participants like banks, hedge funds, and corporations, and are less regulated.
- Key features of OTC contracts:
- Customization to counterparties’ needs.
- Decentralized risk management.
- No centralized limits or formal risk control mechanisms.
- Lack of transparency in transactions.
- In contrast, exchange-traded derivatives are standardized, transparent, and cleared by a central clearing corporation ensuring performance and market integrity.
Significance of Derivatives :
- Derivatives markets improve price discovery.
- They facilitate risk transfer between low and high risk appetite participants.
- They move speculative trading from unregulated to regulated markets, enhancing financial system stability.
Various risks faced by the participants in derivatives :
- Derivatives involve various risks: counterparty, price, liquidity, legal/regulatory, and operational.
- Not suitable for individuals with limited resources, experience, or low risk tolerance.
- Participants should assess their suitability before trading.
- Brokers must provide a Model Risk Disclosure Document during agreement signing.
- This document contains essential information for trading in Equities and F&O segments.