Chapter 1: An Introduction to Derivatives

1.1 What is a Derivative?

1.2 Evolution and History of Derivatives Market:

1.3 Indian Derivatives Market:

1.4 Market Participants:

1.5 Types of Derivatives Market:

1.6 Importance of Derivatives:

1.7 Diverse risks that each of the participants in derivatives bear

1.1 What is a Derivative:

A derivative is an instrument on which value depends upon the base value of some other existing asset, popularly termed as an underlying asset. Such assets may include:

Commodities: Gold and Silver, Copper, and Zinc

Energies: Oil, Coal, Natural Gas, Electricity, and many others.

Agricultural Commodities: Wheat, Sugar, Coffee, Cotton.

Financial Assets: Stocks, Bonds, Foreign Exchange.

Derivatives are used to manage risk, speculate on price movements or arbitrage price differences in markets.

1.2 Evolution and History of Derivatives Market:

The History of Derivatives starts from several centuries back by important landmarks being:

(a). 12th Century: Contracts regarding future deliveries were signed inside the trade fairs.

(b). 13th Century: Woollen merchandises of English monasteries were being sold ahead of 20 years

(c). 1634 -1637: Tulip Mania in Holland with resultant fantastic losses through speculative futures

(d). Late 17th Century: Japan established futures market of rice to moderate the effects of weather risks and wars.

(e). 1848: CBOT started commodity forwards trading.

(f). 1865: CBOT launched the first futures contracts.

(g). 1919: CBOT spun off the CME.

(h). 1972-1983: CME and CBOE unveiled currency, stock index futures, and options.

Growth Drivers:

Higher asset price volatility.
Increased global market integration.
Improvements in communication technology.
Better risk management techniques.
Derivatives product innovation is continuous.

1.3 Indian Derivatives Market:

The derivatives market in India initiated trading towards the end of the 1990s with the following landmark developments:

1996: A committee was constituted by SEBI to work out a regulatory framework.
1998: Derivatives were classified under 'securities', and a risk containment committee was also formed.
1999: SCRA was amended with the incorporation of derivatives.
2000: Government withdrew the forward trading ban, and SEBI permitted the exchange traded derivatives.
June 2000: BSE and NSE introduced equity derivatives, beginning with index futures.
2001-2002: Index options and stock options/futures were launched, with MCX-SX entering in 2013.

Derivatives Types:

(a). Forwards: Customized over-the-counter contracts for future delivery.

(b). Futures: Standardized exchange-traded contracts with the exchange acting as an intermediary.

(c). Options: Contracts that confer a right (but not obligation) to buy or sell an asset at a specified price within a time frame.

(d). Swaps: A series of agreements to exchange cash flows in the future that are used frequently for hedging interest rate, currency, or commodity-related risks.

1.4 Market Participants:

There are three kinds of market participants in the derivatives market:

(a). Hedgers: Hedgers include corporations, banks, and other institutions, which employ derivatives to reduce risks linked to asset price fluctuations such as interest rates, stock prices, or commodity prices.

(b). Speculators/Traders: Speculators look for gains from the price movement of future. They favor derivatives over the underlying asset due to benefits such as leverage, low transaction cost, and speedy execution.

(c). Arbitrageurs: Arbitrageurs make money by exploiting price differences of the same asset in two markets. They buy at one price and sell at a different price, and therefore are of immense help to the markets to close the gaps fast.

Every participant in the derivatives market has his distinct role in it that increases the liquidity and efficiency of it.

1.5 Types of Derivatives Market:

There exist two key markets through which the derivatives are traded:

(a). ETD: Standardized contracts are traded on an exchange with prices determined by an auction, while a clearing house ensures settlement. The process is transparent and secure.

(b). OTC: Privately negotiated contracts among banks, hedge funds, and corporations offer flexibility but with less regulation, decentralized risk management, and private transactions.

1.6 Importance of Derivatives:

Derivatives in the financial markets are important for:

(a) Improve Price Discovery: They help in determining true market prices in accordance with real values and expectations.

(b) Risk transfer: the possibility to transfer the risk from risk averse participants to those with higher risk appetite.

(c) Shifting speculation to organized markets: which brings about a better stabilizing effect in terms of more effective management and regulation of risks.

1.7 Diverse risks that each of the participants in derivatives bear:

In trading derivatives, the different risks involved range from the risk of defaulting counterparts, price, liquidity, legal and/or regulatory risks, and the operational risks. Since derivative instruments leverage both gains and losses, they are more suitable for individuals with great experience or large resources while low tolerance to risk might make this not the best suited option for them.

Participants should evaluate whether derivatives work for them and read, with caution, the Model Risk Disclosure Document offered to them by the brokers. This document details key equities and derivatives (F&O segments) risk and is an important point of reference for informed choice and risk management.

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Chapter 1: An Introduction to Derivatives