17.1 Financial derivatives

Hanumant Dhokle

What is a derivative? A derivative is an instrument whose value is derived from the value of one or more basic variables called bases (underlying asset, index, or reference rate) in a contractual manner. So the term derivative indicates that it has no independent value, i.e, its value is entirely derived from the value of the underlying asset. The underlying asset can be equity, commodity, forex or any other asset. What the phrase means is that the derivative on its own does not have any value. It is considered important because of the importance of the underlying. When we say a Reliance future or a reliance option, these carry a value only because of the value of reliance. Financial derivatives such as options, futures, forwards, and swaps inherit their value directly from their parents.

In fact, a financial derivative would not have a price at all if the parent ceased to exist (Stopped trading). Derivatives are usually broadly categorized by the type of underlying – for example, if underlying asset is an equity, it is equity derivatives, then we have commodity derivative, and foreign exchange derivative etc.

Derivative can be classified into exchange traded and Over the Counter (OTC) etc. based on the market in which they trade. Development of Derivative Market in India. Derivatives have been a recent development in the Indian financial markets. But there have been derivatives in the commodities market (this would be covered in detail in the next chapter). Globally too, the first derivatives started with the commodities, way back in 1894. Financial derivatives are a relatively late development, coming into existence only in the 1970’s. The first exchange where derivatives were traded is the Chicago Board of Trade (CBOT). In India, the first derivatives were introduced by National Stock Exchange (NSE) in June 2000 and followed by BSE in 2001.

The first derivatives were index futures. The index used was Nifty. Option trading was started in June 2001, for index as well as stocks. In November 2001, futures on stocks were allowed. Currently, there are 190 stocks (as on March 2010) under NSE NSE’s F&O segment on which derivative trading is allowed. After the market crash of 2008, the exchange had to remove shares of several companies from the segment as they had turned illiquid. At the peak of the stock market boom, there were nearly 225 scrips in the derivatives segment of NSE.

What kind of people will use derivatives?

Derivatives will find use for the following set of people:

Speculators: People who buy or sell in the market is to make profits. For example, if the stock price of Reliance is expected to go upto Rs.400 in 1 month, one can buy a 1 month future of Reliance at Rs. 350 and make profits.

Hedgers: People who buy or sell to minimize their losses. In equity derivatives, hedging is an act of protecting or guarding the investment against an undesired price movement. Suppose a long term investor owns a portfolio of stocks worth Rs 10 lacs. Although he is optimistic about the stocks he has in the portfolio, he is not very comfortable with the overall movement of the market. Such an investor can hedge his portfolio by selling Index Futures (like Nifty future) and thereby removing the risk of macro variables from his portfolio. Did you capture it all right? I think no. So don’t worry as we move forward. This would be clearer to you.

Arbitrageurs: People who buy or sell to make money on price differentials in different markets. For example, a futures price is simply the current price plus the interest cost. If there is any change in the interest, it presents an arbitrage opportunity. We will understand more about these concepts as we move forward through this chapter and commodities chapter. Basically, every investor assumes one or more of the above roles to participate in derivative markets.

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