Derivatives

A derivative security is a financial contract whose value is derived from the value of something else, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices. In India most derivatives users describe themselves as hedgers and Indian laws generally requires that derivatives be used for hedging purpose only, another motive for derivative trading is speculation.

In India, derivatives markets have been functioning since the nineteenth century. Derivatives, as exchange traded financial instruments were introduced in India in June 2000. The National Stock Exchange (NSE) is the largest exchange in India in derivatives, trading in various derivatives contracts.

November 18, 1996: L.C. Gupta Committee set up to draft a policy framework for introducing derivatives May 11, 1998: L.C. Gupta committee submits its report on the policy framework May 25, 2000 ; SEBI allows exchanges to trade in index futures June 12, 2000; Trading on Nifty futures commences on the NSE June 4, 2001 ; Trading for Nifty options commences on the NSE

July 2, 2001 ; Trading on Stock options commences on the NSE November 9, 2001; Trading on Stock futures commences on the NSE August 29, 2008; Currency derivatives trading commences on the NSE August 31, 2009; Interest rate derivatives trading commences on the NSE February 2010 ; Launch of Currency Futures on additional currency pairs October 28, 2010; Introduction of European style Stock Options October 29, 2010 ; Introduction of Currency Options

Large market capitalization Liquidity in the underlying

Clearing house that guarantees trades

Physical infrastructure Risk-taking capability and Analytical skills

An equity derivative is a class of derivatives whose value is at least partly derived from one or more underlying equity securities. Options and futures are by far the most common equity derivatives Investors who trade in equity derivatives seek to transfer certain risks associated with the underlying security to another party.

Stock Options Single Stock Futures Warrants Equity futures, options Stock market index futures Single-stock futures

The major commodity markets are in the United Kingdom and in the USA. In India there are 25 recognized future exchanges, of which there are three national level multi-commodity exchanges. After a gap of almost three decades, Government of India has allowed forward transactions in commodities through Online Commodity Exchanges, a modification of traditional business known as Adhat and Vayda Vyapar to facilitate better risk coverage and delivery of commodities.

The three exchanges are: National Commodity & Derivatives Exchange Limited (NCDEX) Multi Commodity Exchange of India Limited (MCX) National Multi-Commodity Exchange of India Limited (NMCEIL)

The commodity derivatives market is a direct way to invest in commodities rather than investing in the companies that trade in those commodities. For example, an investor can invest directly in a steel derivative rather than investing in the shares of Tata Steel. It is easier to forecast the price of commodities based on their demand and supply forecasts as compared to forecasting the price of the shares of a company -- which depend on many other factors than just the demand -- and supply of the products they manufacture and sell or trade in.

Also, derivatives are much cheaper to trade in as only a small sum of money is required to buy a derivative contract. Let us assume that an investor buys a tonne of soybean for Rs 8,700 in anticipation that the prices will rise to Rs 9,000 by June 30, 2005. He will be able to make a profit of Rs 300 on his investment, which is 3.4%. Compare this to the scenario if the investor had decided to buy soybean futures instead. Now let us say the investor buys soybean futures contract to buy one tonne of soybean for Rs 8,700 (exercise price) on June 30, 2005. The contract is available by paying an initial margin of 10%, i.e. Rs 870. Note that the investor needs to invest only Rs 870 here. On June 30, 2005, the price of soybean in the market is, say, Rs 9,000 (known as Spot Price -- Spot Price is the current market price of the commodity at any point in time). The investor can take the delivery of one tonne of soybean at Rs 8,700 and immediately sell it in the market for Rs 9,000, making a profit of Rs 300. So the return on the investment of Rs 870 is 34.5%. On the contrary, if the price of soybean drops to Rs 8,400 the investor will end up making a loss of 34.5%.

The Currency Derivatives trading system of NSE, called NEAT-CDS (National Exchange for Automated Trading Currency Derivatives Segment) trading System, provides a fully automated screenbased trading for currency futures on a nationwide basis as well as an online monitoring and surveillance Mechanism. It supports an order driven market and provides complete Transparency of trading operations. The online trading system is similar to that of trading of equity derivatives in the Futures & Options (F&O) segment of NSE.

Foreign exchange derivatives market is one of the oldest derivatives markets in India. Presently, India has got a well-established dollar-rupee forward market with contrast traded for one month, two months and three months expiration.

Introduction of cross currency options can be considered as another major step towards developing forex derivatives markets in India.

Today, Indian corporate are permitted to purchase cross currency options to hedge exposures arising out of trade. Authorized dealers who offer these products have to necessarily cover their exposure in international markets i.e., they shall not carry the risk in their own books. Cross currency options are essentially meant for buying or selling any foreign currency in terms of US dollar.

This is all the more essential in a market where exchange rates though stated to be market determined, are often found influenced by RBI intervention in the exchange market.