What is mean by Derivative

A derivative can be defined as something which derives its value from an underlying product being a stock, currency, commodity or anything that carries a market price. Derivatives are formally defined in the SCRA, India to include : A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security, and A contract which derives its value from the prices, or index of prices, or underlying securities.

Categorization / Types
Derivatives are usually broadly categorized by the: Relationship between the underlying and the derivative (e.g., forward, option, swap) Type of underlying (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives or credit derivatives) Market in which they trade (e.g., exchange-traded or over-the-counter) Another arbitrary distinction is between: 1) vanilla derivatives (simple and more common) 2) exotic derivatives (more complicated and specialized) There is no definitive rule for distinguishing one from the other, so the distinction is mostly a matter of custom.

Derivatives market : overview

Derivative Market
The Derivatives Market is meant as the market where exchange of derivatives takes place. Derivatives are one type of securities whose price is derived from the underlying assets. And value of these derivatives is determined by the fluctuations in the underlying assets. These underlying assets are most commonly stocks, bonds, currencies, interest rates, commodities and market indices. The Derivatives can be classified as Future Contracts, Forward Contracts, Options, Swaps .

Derivative Market Structure

Exchange traded
Traditionally exchanges have used the open-outcry system, but increasingly they are switching to electronic trading Contracts are standard there is virtually no credit risk

Over-the-counter (OTC)
A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers Contracts can be non-standard

Derivative Structure
Derivative Structure can be divided into exchange-traded derivatives and over-thecounter (OTC) derivatives

Derivatives ETD (Exchange trade derivatives)

OTC(Over the counter)

Types of ETD
ETD (Exchange Traded derivatives)
Future Contracts

Options

Types of OTC

OTC (Over the Counter)

Swaps

Forward rate Agreements

Exotic options

The Key Diffrences

Key DifferencesOTC vs. Exchange-Traded Derivatives Over-the-Counter Exchange-Traded Private transaction Public price quote Credit risk Wide range of structures and contract size Many currencies Any maturity Limited credit risk due to clearing house Standard contracts and size Major currencies Standard expiration dates

Common Derivative contract Types

There are three major classes of derivatives: FUTURES/FORWARDS are contracts to buy or sell an asset on or before a future date at a price specified today. A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold, whereas a forward contract is a non-standardized contract written by the parties themselves. EXOTIC DERIVATIVES : These Are non standardized /complex contracts which uses another derivative contract,no role of exchange.

OPTIONS : are contracts that give the owner the right, but
not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. The option contract also specifies a maturity date.

SWAPS : are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets.

The participants in a derivatives market

Hedgers :use futures or options markets to reduce or eliminate the risk associated with price of an asset. Speculators :use futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture. Arbitrageurs :are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

RECENT DEVELOPMENTS

 The trading of the derivatives and its various instruments has been regulated by various laws in India. At present Derivative Trading has been permitted by the SEBI on derivative segment of the BSE and the F&0 segment of the NSE. The natures of derivative contracts permitted are:

Index Futures contracts introduced in June, 2000, Index options introduced in June, 2001, and Stock options introduced in July 2001
The minimum contract size of a derivative contract is Rs.2 lakhs. Besides the minimum contract size, there is a stipulation for the lot size of a derivative contract. The lot size refers to number of underlying securities in one contract. The lot size of the underlying individual security should be in multiples of 100 and tractions, if any should be rounded of to next higher multiple of 100. This requirement along with the requirement of minimum contract size from the basis for arriving at the lot size of contract.

SEBI NOTIFICATIONS

Notification under regulation 3 of the Securities and Exchange Board of India (Certification of Associated Persons in the Securities Markets) Regulations, 2007, No. LAD/NRO/GN/2009-10/04/163097: Notification dated May 13, 2009, SEBI mandated that all the existing approved users /

sales personnel of the trading members in the currency derivative segment shall obtain certification(certification for approved users and sales personnel of the trading members in the currency derivatives segment) by August 10, 2009.
SEBI permitted Mini- Derivatives (F & O) contract on INDEX (SENSEX & NIFTY).

FUTURE OF DERIVATIVES MARKET IN INDIA

Derivatives are an innovation that has redefined the

financial services industry and it has assumed a very significant place in the capital markets. However, trading in derivatives is complicated and risky.

In India, all attempts are being made to introduce derivative instruments in the capital market. The National Stock Exchange has been planning to introduce index-based futures. A stiff net worth criteria of Rs.7 to 10 corers cover is proposed for members who wish to enroll for such trading.

But, it has not yet received the necessary permission from

the securities and Exchange Board of India.

 In the forex market, there are brighter chances of introducing derivatives on a large scale. Infact, the necessary groundwork for the introduction of derivatives in forex market was prepared by a high-level expert committee appointed by the RBI. It was headed by Mr. O.P. Sodhani. Committees report was already submitted to the Government in 1995. As it is, a few derivative products such as interest rate swaps, coupon swaps, currency swaps and fixed rate agreements are available on a limited scale. It is easier to introduce derivatives in forex market because most of these products are OTC products (Over-the-counter) and they are highly flexible.

These are always between two parties and one among

them is always a financial intermediary.

However, there should be proper legislations for the

effective implementation of derivative contracts. What is more important for the success of derivatives is the prescription of proper capital adequacy norms, training of financial intermediaries and the provision of wellestablished indices. Brokers must also be trained in the intricacies of the derivative-transactions.

Now, derivatives have been introduced in the Indian Market in the form of index options and index futures. Index options and index futures are basically derivate tools based on stock index. They are really the risk management tools. Since derivates are permitted legally.

DERIVATIVE MARKET GROWTH

 The Derivatives Market Growth was about 30% in the first half of 2007 when it reached a size of $US 370 trillion. This growth was mainly due to the increase in the participation of the bankers, investors and different companies. The derivative market instruments are used by them to hedge risks as well as to satisfy their speculative needs. The derivative market growth for different derivative market instruments may be discussed under the following heads. :

Derivative Market Growth for the Exchange-tradedDerivatives The Derivative Market Growth for equity reached $114.1 trillion. The open interest in the futures and options market grew by 38 % while the interest rate futures grew by 42%. Hence the derivative market size for the futures and the options market was $49 trillion. Derivative Market Growth for the Global Over-the-Counter Derivatives The contracts traded through Over-the-Counter market witnessed a 24 % increase in its face value and the over-the -counter derivative market size reached $70,000 billion. This shows that the face value of the derivative contracts has multiplied 30 times the size of the US economy. Notable increases were recorded for foreign exchange, interest rate, equity and commodity based derivative following an increase in the size of the Over-the Counter derivative market.

 Derivative Market Growth for the Credit Derivatives The credit derivatives grew from $4.5 trillion to $0.7 trillion in 2001. This derivative market growth is attributed to the increase in the trading in the synthetic collateral Debt obligations and also to the electronic trading systems that have come into existence. The Bank of International Settlements measures the size and the growth of the derivative market. According to BIS, the derivative market growth in the over the counter derivative market witnessed a slump in the second half of 2006. i.e The notional amount of the Credit Default Swap witnessed a growth of 42%. Credit derivatives grew by 54%. The single name contracts grew by 36%. The interest derivatives grew by 11%. The OTC foreign exchange derivatives slowed by 5%, the OTC equity derivatives slowed by 10%. Commodity derivatives also experienced crawling growth pattern.

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