Overview of Derivatives
Author: Denny B Justin
Derivatives are financial instruments whose value is derived from an underlying asset or a group of assets. These assets range from stocks, bonds, commodities, currencies, interest rates, or market indices. The derivatives market is a financial marketplace where derivative contracts are bought and sold. Derivatives have reshaped financial markets, offering diverse risk management tools while introducing complexities that demand prudent oversight. The 2008 financial crisis highlighted the vulnerabilities associated with derivatives, prompting regulatory reforms to mitigate risks and enhance transparency.
Various types of derivatives include futures, options, swaps, and forwards. Each type has its unique characteristics and uses. Derivatives markets facilitate price discovery by reflecting market sentiments and expectations. Market participants use arbitrage strategies to exploit price differences between related assets or markets. Derivatives enable businesses to hedge against fluctuations in interest rates, currencies, commodities, and more, safeguarding against unforeseen market movements. SEBI establishes the regulatory framework governing derivatives in India. It formulates rules, regulations, and guidelines concerning the trading, clearing, and settlement of derivative contracts.
Futures
Futures and forwards are contracts that obligate the parties involved to buy or sell an asset at a predetermined price on a future date. Futures contracts are traded on various underlying assets like stocks, indices, commodities, and currencies. Traders and investors use derivatives to speculate on the future direction of prices in the underlying assets. An investor holding a portfolio of stocks might use index futures to hedge against overall market fluctuations. Investors and businesses use futures contracts to hedge against price volatility. SEBI lays down the guidelines and regulations for trading, participant eligibility, margin requirements, and risk management to ensure market integrity and investor protection.
Stock Futures: Future contracts based on individual stocks allow investors to speculate on the future price movements of specific companies listed on Indian stock exchanges like the NSE (National Stock Exchange) and BSE (Bombay Stock Exchange).
Index Futures: Future contracts based on market indices such as the Nifty 50 or Sensex. Traders use these to speculate on the broader market movement rather than specific stocks.
Commodity Futures: Futures contracts are also available for commodities like gold, silver, crude oil, agricultural products, etc. These contracts are traded on commodity exchanges like MCX (Multi Commodity Exchange) and NCDEX (National Commodity and Derivatives Exchange).
Options
Options give the purchaser the right, without imposing an obligation, to purchase or sell an asset at a predetermined price within a defined timeframe. They come with a strike price (the agreed buying or selling price) and an expiration date, after which the option is no longer valid. Options provide flexibility, providing the potential for higher returns with a smaller investment compared to buying the asset directly.
Call Options: Give the buyer the right to purchase an asset at a specified price within a particular time frame. Allows the buyer to benefit from an increase in the underlying asset’s price. If the asset’s price rises above the strike price, the holder can exercise the call option, purchasing the asset at the lower strike price and potentially selling it at the higher market price for a profit.
Put Options: Contracts that grant the holder the right, but not the obligation, to sell an underlying asset at a predetermined price (strike price) within a specific period (until expiration). If the asset’s price falls below the strike price, the holder can exercise the put option, selling the asset at the higher strike price and potentially buying it back at the lower market price, thus profiting from the price difference.
Swaps
Swaps involve the exchange of cash flows or assets between two parties, often used to manage interest rates or currency risks. Swaps are highly customizable contracts that allow parties to tailor the terms to their specific needs and risk management strategies. Swaps are widely used for hedging against various risks like interest rates, currency, commodity prices, and credit risks. Swaps are predominantly traded over the counter, they are privately negotiated between parties, offering flexibility in terms and conditions.
Interest Rate Swaps (IRS): Exchange of fixed-rate and floating-rate interest payments. One party pays a fixed interest rate while the other pays a floating (variable) rate. Interest rate swaps are commonly used to hedge against interest rate risk or to modify the cash flow structure.
Currency Swaps: Two parties exchange a principal amount and interest payments in different currencies. Currency swaps help manage currency exposure and can be used to obtain better borrowing rates in different markets.
Commodity Swaps: Exchanging cash flows based on the future price of a commodity. These are utilized to hedge against commodity price fluctuations. Producers enter a commodity swap to lock in a fixed price for future production, ensuring predictable revenue regardless of market fluctuations.
Credit Default Swaps (CDS): Financial derivatives transfer credit risk between two parties. The buyer of the swap pays a premium to the seller and receives protection in case of a credit event, like a default, on the underlying asset.
Forwards
Forward contracts are derivatives that involve an agreement between two parties to buy or sell an asset at a specified price (the forward price) on a future date. Participants use forward contracts to hedge against future price fluctuations of assets, thereby managing risk. Speculators may participate through forward contracts based on their beliefs about future asset prices, aiming to profit from price movements.
Credit Derivatives
Credit derivatives are financial instruments whose value is derived from the credit risk of an underlying asset, typically a bond or a loan. Credit derivatives hedge against credit risk in investment portfolios, reducing the impact of potential default events. Institutions and investors use credit derivatives to manage their liquidity needs and optimize their balance sheets. Credit derivatives carry risks that need careful consideration and risk management strategies when investing or trading.
Weather Derivatives
Weather derivatives are financial instruments whose value is linked to specific weather conditions. They enable businesses or individuals to hedge against the risk of financial losses caused by variations in weather patterns. Accurately defining and measuring the weather parameters and designing appropriate contracts can be complex.
Currency derivatives
Currency derivatives are financial contracts whose value is derived from the exchange rate of one currency against another. Currency derivatives offer flexibility and opportunities to manage currency-related risks or gain exposure to currency movements without holding the actual currencies. Business firms use currency derivatives to hedge against currency exchange rate fluctuations that could impact their international transactions.
Derivatives are commonly used for risk management, speculation, hedging, and arbitrage. They allow investors and businesses to mitigate risks by protecting against adverse price movements in the market. Derivatives aid in discovering fair market prices by exploiting price discrepancies between related assets or markets. The derivatives market operates through organized exchanges, such as stock exchanges or dedicated derivatives exchanges, and over-the-counter markets. These markets provide a platform for buying and selling derivative contracts, clearing services, and settlement of transactions.
In conclusion, derivatives enhance market liquidity, contribute to price discovery, and foster financial innovation, their intricate nature necessitates comprehensive understanding and prudent usage. A lack of knowledge of derivatives may result in unintended exposure to risks that exceed one’s expectations. Investors utilize derivatives to speculate on price movements, amplifying potential returns or losses.
