OVERVIEW recent years, the market for financial derivatives

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Last updated: December 27, 2019

OVERVIEW ON DERIVATIVESMARKET INTRODUCTIONIn industrialized countries apart from money marketand capital market securities, a variety of other securities known as”derivatives” have now become available for investment and trading. Thederivatives originate in mathematics and refer to a variable which has beenderived from another variable. A derivative is a financial product which hasbeen derived from another financial product or commodity.            DERIVATIVES            Derivativesare financial instruments that are mainly used to protect against or to managerisks, and very often also for investment purposes, providing variousadvantages compared to securities. Derivatives come in many varieties and canbe differentiated by how they are traded, what they refer to, and the producttype. A derivative is an instrument whosevalue is derived from the value of one or more underlying assets such ascommodities, precious metals, currency, bonds, stocks, etc.

A derivativeinstrument by itself does not constitute ownership. It is, instead, a promiseto convey ownership. All derivatives are based on some “cash” products.

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Theunderlying basis of a derivative instrument may be any product including Commodities like grain, coffee beans, orange juice, etc. Precious metals like gold and silver Foreign exchange rate Bonds of different types, including medium and long-term negotiable debt securities issued by governments, companies, etc. Short-term debt securities such as T-bills EMERGENCEOF FINANCIAL DERIVATIVESDerivative products initially emerged ashedging devices against fluctuations in common prices. Financial derivativescame into limelight in the post-1970s due to growing instability in thefinancial markets.

However, since their emergence, financial derivativesproducts have become very popular and in 1990’s, overtaking the commodityderivatives they accounted for about two-thirds of total transaction inderivative market. In recent years, the market for financial derivatives hasgrown tremendously in terms of variety of instruments available, theircomplexity and also in terms of turnover. In the class of equity derivativesworld, futures and options on stock indices have gained more popularity than onindividual stocks, especially among institutional investors, who are the majorusers of index-linked derivatives. The lower cost associated with indexderivatives than derivative products based on individual securities is anotherreason for their growing use. HISTORY OF DERIVATIVEMARKET IN INDIADerivatives markets inIndia have been in existence in one form or the other for a long time. In thearea of commodities, the Bombay Cotton Trade Association started futurestrading way back in 1875. In 1952, the Government of India banned cashsettlement and options trading. Derivatives trading shifted to informalforwards markets.

In recent years, government policy has shifted in favour ofan increased role of market-based pricing and less suspicious derivativestrading.  The first step towardsintroduction of financial derivatives trading in India was the promulgation ofthe Securities Laws (Amendment) Ordinance, 1995. It provided for withdrawal ofprohibition on options in securities. The last decade 2000, saw lifting of banon futures trading in many commodities. Around the same period, nationalelectronic commodity exchanges were also set up. Derivatives trading commencedin India in June 2000 after SEBI granted the final approval to this effect inMay 2001 on the recommendation of L. C Gupta committee.

Securities and ExchangeBoard of India (SEBI) permitted the derivative segments of two stock exchanges,NSE3 and BSE4, and their clearing house/corporation to commence trading andsettlement in approved derivatives contracts. Initially, SEBIapproved trading in index futures contracts based on various stock marketindices such 3 The National Stock Exchange (NSE), located in Bombay is thefirst screen based automated stock exchange. It was set up in 1993 to encouragestock exchange reform through system modernization and competition. It openedfor trading in mid1994 and today accounts for 99% market shares of derivativestrading in India. Bombay Stock Exchange (BSE), which is Asia’s Oldest BrokingHouse, was established in 1875 in Mumbai.

It is also called as Dalal Street.The BSE Index, called the Sensex, is calculated by Free Float Method byincluding scrips of top 30 companies selected on the market capitalizationcriterion. The trading in BSESensex options commenced on June 4, 2001 and the trading in options onindividual securities commenced in July 2001. Futures contracts on individualstocks were launched in November 2001.

The derivatives trading on NSE commencedwith S&P CNX Nifty Index futures on June 12, 2000. The trading in indexoptions commenced on June 4, 2001 and trading in options on individualsecurities commenced on July 2, 2001. Single stock futures were launched onNovember 9, 2001. The index futures and options contract on NSE are based onS&P CNX.

In June 2003, NSE introduced Interest Rate Futures which weresubsequently banned due to pricing issue. SIGNIFICANCE OF DERIVATIVE MARKETThe derivatives market performs a number of economic functions;they are Price Discovery: Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. Thus derivatives help in discovery of future as well as current prices. Risk Transfer: Due to the inherent link of derivatives market with the underlying cash market, witnesses higher trading volumes because of participations by more players who would not have otherwise participated for lack of an arrangement to transfer risk. Controlled Speculative Trading: Speculative trades shift to a more controlled environment due to the existence of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets and margining, monitoring and surveillance of the activities of various participants become extremely difficult in derivative markets.

Financial Architecture: The derivative has a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new business, new products and new employment opportunities, the benefit of which is immense. Enhancing Volume of Activity: Derivatives market help to increase savings and investment in the long run and transfer of risk enables the market participants to expand their volume of activity. CLASSIFICATION OF DERIVATIVESThere are two groups of derivativecontracts, which are distinguished by the way they are traded in the market.1.     Over-the-counterderivatives2.     Exchange-tradedderivatives Over-the-counter (OTC) derivatives arecontracts that are traded (and privately negotiated) directly between twoparties, without going through an exchange or other intermediary.

Products suchas swaps, forward rate agreements, exotic options and other exotic derivativesare almost traded in this way. The OTC derivative market is the largest marketfor derivatives, and is mostly unregulated with respect to disclosure ofinformation between the parties. Exchange-tradedderivative contracts (ETD) are those derivatives instruments that are tradedvia specialized derivatives exchanges or other exchanges. A derivatives exchangeis a market where individual trade standardized contracts that have beendefined by the exchange. It acts as an intermediary to all relatedtransactions, and takes initial margin from both sides of the trade to act as aguarantee.

 The most commonly used derivatives contracts are1.     Forward2.     Future3.     Option4.     Swap.  Forward Contracts:A forward contract is an agreementbetween two parties to buy and sell a commodity or financial asset at certainfuture time for a certain price.

A forward contract is traded in theover-the-counter market usually between two financial institutions or between afinancial institution and one of its clients. One of the parties to a forwardcontract assumes a long position and agrees to buy the underlying asset on acertain specified future date for a certain specified price. The other partyassumes a short position and agrees to sell the asset on the same date for thesame price. Futures Contracts:A futures contract is an agreementbetween two parties to buy or sell an asset at a certain time in the future fora certain price.

Futures contracts are normally traded on an exchange. As thetwo parties to the contract do not necessarily know each other, the exchangeprovides a mechanism that gives the two parties a guarantee that the contractwill be honoured. The largest exchanges on which futures contracts are tradedare the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange(CME). On these and other exchanges throughout the world, a very wide range ofcommodities and financial assets form the underlying assets in the variouscontracts.

The commodity includes even pork bellies, live cattle, sugar, wool,lumber, copper, aluminium, gold, and tin. The financial assets include stockindices, currencies, and treasury bonds.  The contract is referred to by itsdelivery month, and the exchange specifies the period during the month whendelivery must be made.

For commodities, the delivery period is often the entiremonth. The holder of the short position has the right to choose the time duringthe delivery period when it will make delivery. The exchange specifies theamount of the asset to be delivered for one contract and how the futures priceis to be quoted. In the case of a commodity, the exchange also specifies theproduct quality and the delivery location. Options ContractsOptions are traded both on exchanges andin the over-the-counter market.

There are two basic types of options.  A calloption gives the holder the right to buy the underlying asset by a certaindate for a certain price. A putoption gives the holder the right to sell the underlying asset by a certaindate for a certain price.  The price in the contract is known asthe exercise price or strike price; the date in the contract is known as theexpiration date or maturity date.

The price paid by the buyer to the seller to acquire the right to buy or sellis known as the Premium. The one who is obligated to buy the underlying assetin case of the buyer of the option decides to exercise his option is known asthe option seller/ writer. The one who buys an option which can be a call or aput option is known as the option holder. When the option’s strike price is equal to theunderlying asset price, the option is said to be ‘at-the-money’. A call optionis said to be ‘in-the-money’ when the strike price of the option is less thanthe underlying asset price. A call option is said to be ‘out-the-money’ whenthe strike price is greater than the underlying asset price.

 Swap contracts            Swaprefers to an exchange of one financial instrument for another between theparties concerned. This exchange takes place at a predetermined time, asspecified in the contract.The two commonly used swaps are interest rate swaps and currency swaps. Interest rate swaps: These involve swapping only the interest related cash flows between the parties in the same currency.

Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. PLAYERS IN DERIVATIVE MARKETSThree broad categories of traders can beidentified among the players in the market:              Hedgers Speculators ArbitrageursHedgers use futures, forwards, and options to reducethe risk that they face from potential future movements in a market variable.Speculators use them to bet on the future direction of a market variable.Arbitrageurs take offsetting positions in two or more instruments to lock in aprofit.

 Hedgers Hedgersare the traders who wish to eliminate the risk associated with the price of anasset and they may take a long position or short position on a commodity tolock in existing profits. The main purpose is to reduce the volatility of aportfolio, by reducing the risk. An option contract involves an initial cost.In the event of call is not exercised, the premium paid for it becomes a netloss while if it is exercised, the profit resulting from the call exercisecompensates the cost. SpeculatorsSpeculators are those who are willing totake such risk. These are the people who take positions in the market andassume risks, to gain profit from fluctuations in prices. In fact, thespeculators consume information, make forecasts about the prices and put their moneyin these forecasts.

By taking positions, they are betting that a price would goup or they are betting that it would go down. Depending on their perceptions,they may take long or short positions on futures or options or may hold spreadpositions.Speculators in the derivatives market may be categorized as Scalpers – Scalpers attempt to makeprofit from small changes in the contract price.Day traders – Day traders speculateon the price movements during single trading day, thus open and close positionsmany times a day but do not carry any position at the end of the day.Position traders – Positiontraders attempt to gain from price fluctuations by keeping their positions openfor longer durations – may be for a few days, weeks or even months. ArbitrageursArbitrageurs attempt to earn risk-freeprofits by exploiting market imperfections. An arbitrageur profits by trading agiven commodity or other items that sell for different prices in differentmarkets.

Thus, arbitrage involves making riskless profit by simultaneouslyentering into transactions in two or more markets. If a certain share is quotedat a lower rate on the NSE and at a higher rate on the BSE, an arbitrageurwould make profit by buying the share at NSE and simultaneously selling it atBSE. This type of arbitrage is “arbitrage over space”.  INDEX BASED DERIVATIVES            Asprice volatility in individual stocks is very high, futures based on individualstocks are not very common. In India, L.C. Gupta committee has not mentionedfutures on individual stocks as a possible derivative contract.

The index basedderivatives is very popular.            The value of an index is derivedfrom the value it underlying. For example, the value of the BSE 30 Sensex, isderived from the value of the 30 shares on which the index is based. These arethe shares of large well-established sound companies.            According to the Committee on Derivatives set up thesecurities and Exchange Board of India (SEBI) under the chairmanship of L.C.Gupta, stock index futures are internationally the most popular form of equityderivatives for the following reasons:1.      Theyprovide portfolio hedging facility.

2.      Thereis less risk in manipulation of stock index as compared to individual stockprices.3.

      Theirgreater popularity makes them more liquid.4.      Stockindex is generally less volatile than individual stock prices.Boththe Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) havelaunched index futures in June 2000. CONCLUSIONFinancial derivativeshave earned a well deserved extremely significant place among all the financialinstruments (products), due to innovation and revolutionized the landscape.

Derivatives are tool for managing risk. Derivatives provide an opportunity totransfer risk from one to another. Launch of equity derivatives in Indianmarket has been extremely encouraging and successful. The growth of derivativesin the recent years has surpassed the growth of its counterpart globally. REFERENCEBooks: Francis Cherunilam, “BUSINESS ENVIRONMENT”, 17th Edition – February 2006.

E. Gordon, “FINANCIAL MARKET AND SERVICES”, 10th Edition – May 2016. Rangarajan K. Sundaram, “DERIVATIVES IN FINANCIAL MARKET DEVELOPMENT”, February 2013.Journals:  Dr. P.

V. Raveendra, “A STUDY OF DERIVATIVES MARKET IN INDIA AND ITS CURRENT POSITION IN GLOBAL FINANCIAL DERIVATIVES MARKET”.Website: WWW.NCDEX.COM 

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