The Definitive Guide to Derivatives

Derivatives occupy an important place as a risk reducing machinery. They are useful instruments for risk management. With the integration of financial markets and free mobility of capital, risks multiply. These risks can be fluctuations in exchange rates, interest rates, etc. Companies use Derivatives to ensure that these risks are hedged by using derivatives like forwards, futures, options, swaps, etc. To hedge the various risks that one faces in the financial market today, derivatives are absolutely essential.

Here, we discuss the overview of Derivatives -  From the definition to its origin , its Evolution , the various types of derivatives , commodities and financial Derivatives , participants , role and functions of derivatives , derivatives in India and its regulation, we have everything in this one lesson!

by Siddharth Jogani
11 months ago

Derivatives are instruments which derive their value from an underlying asset. For instance, equity share itself derives its value based on the fundamentals of the company and its demand and supply. In a strict sense, derivatives are based upon all those major financial instruments which are traded like equities, debt instruments, foreign exchange instruments and commodity based contracts. We cover these aspects in detail at a later stage. The most commonly used derivatives contracts are forwards, futures and options which we shall discuss later in detail.

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The concept of derivatives can be traced back to the 18th century when the farmers protected themselves against fluctuations in the price of their crop. This price uncertainty would prevail right from the time of sowing to the time of crop harvest. Through the use of simple derivative products, it was possible for the farmer to partially or fully transfer price risks by locking-in asset prices. These were simple contracts developed to reduce farmers risk. In years of scarcity, he would probably obtain attractive prices and vice-versa. On the other hand, a merchant with an ongoing requirement of grains too would face a price risk - that of having to pay exorbitant prices during dearth, although favourable prices could be obtained during periods of oversupply. Under such circumstances, it clearly made sense for the farmer and the merchant to come together and enter into a contract whereby the price of the grain to be delivered at a later date could be decided earlier. What they would then negotiate happened to be a futures-type contract, which would enable both parties to eliminate the price risk.

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In 1848, the Chicago Board of Trade (CBOT) was established to bring farmers and merchants together. A group of traders got together and created the `to-arrive' contract that permitted farmers to lock in to price upfront and deliver the grain later. These to-arrive contracts proved useful as a device for hedging and speculation on price changes. These were eventually standardised, and in 1925 the first futures clearing house came into existence. Today, derivative contracts exist on a variety of commodities such as corn, pepper, cotton, wheat, silver, etc. Besides commodities, derivatives contracts also exist on a lot of financial underlying like stocks, interest rate, exchange rate, etc.

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Here we define some of the more popularly used derivative contracts.

1. Forwards

A forward contract is an agreement between two entities to buy or sell the underlying asset at a future date, at today's pre-agreed price. They are the oldest of all the derivatives. The promised asset may be currency, commodity, instrument etc. These contracts are usually known as ‘Forward Rate Contract’ (FRC). They are traded over the counter (OTC) and not in the exchanges. They are customized in nature and require no down payment in any form. The payoffs of forwards are always linear. They are illiquid and there is high counter-party or default risk.

2. Futures

A futures contract is an agreement between two parties to buy or sell the underlying asset at a future date at today's future price. Futures contracts differ from forward contracts in the sense that they are standardized and exchange traded. They are exchange-traded.The parties have to deposit certain initial margin (small percentage of the trade amount). They are highly regulated and are liquid. As a result, eliminate the
counter-party risk.

3. Options

An option gives the holder of the option the right to do something. The holder does not have to exercise this right. However for this right the holder pays a
price, known as the option premium. The writer of the option receives this premium.

There are two types of options - call and put.

A Call option gives the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date.

A Put option gives the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

Based on expiration, options can be of two types – American and European. American
options can be exercised at any time before expiration. European options can be
exercised only on expiration date.

4. Swaps

Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:-

Interest rate swaps: These entail 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.

5. Warrants*

Options generally have lives of up to one year, the majority of options traded on options  exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.

6. Baskets*

Basket options are options on portfolios of underlying assets. The underlying asset is usually a weighted average of a basket of assets. Equity index options are a form of basket options.

*These are not so popular. disclaimer - none of these videos is meant to be personalized financial ...
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The basic concept of a derivative contract remains the same whether the underlying 
happens to be a commodity or a financial asset. However, there are some features which are very peculiar to commodity derivative markets.

The Commodity derivative is a contract in commodities like agro products, metals and minerals etc. There are several well established commodity exchanges 

E.g. London Metal Exchange (LME) deals in gold, Chicago Board of Trade (CBT) deals in soyabean oil.

Financial Derivatives are contracts in foreign exchange or financial instruments like T-bills, Commercial paper, stock market index or interest rate. Financial futures are very popular in the western countries as hedging instruments to protect against exchange rate/interest rate fluctuation. There are several exchanges for financial derivatives. 

E.g. London International Financial Futures Exchange (LIFFE) to deal in Euro dollar deposits, New York Futures exchange (NYFE) to deal in sterling, Euro dollar deposits etc.

In the case of financial derivatives, most of these contracts are cash settled.Since financial assets are not bulky, they do not need special facility for storage even in case of physical settlement. On the other hand, due to the bulky nature of the underlying assets, physical settlement in commodity derivatives creates the need for warehousing. Similarly, the concept of varying quality of asset does not really exist as far as financial underlyings are concerned. However, in the case of commodities, the quality of the asset 
underlying a contract can vary largely. This becomes an important issue to be managed.

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Participants who trade in the derivatives market can be classified under the following three broad categories: hedgers, speculators, and arbitragers

1. Hedgers 

The farmer's example that we discussed about was a case of hedging. Hedgers face risk associated with the price of an asset. They use the futures or options markets to reduce or eliminate this risk.

2. Speculators

Speculators are participants who wish to bet on future movements in the price of an asset. Futures and options contracts can give them leverage; that is, by putting in small amounts of money upfront, they can take large positions on the market.
As a result of this leveraged speculative position, they increase the potential for large gains as well as large losses. They are the risk-takers.

3. Arbitragers

Arbitragers work at making profits by taking advantage of discrepancy between prices of the same product across different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they would take offsetting positions in the two markets to lock in the profit. They aim at making risk-free profits.

Speculators freely choose to buy or sell, based on their market opinion. Speculators use pricing ...
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The management of counter-party (credit) risk is decentralised and located within individual institutions.

  1. There are no formal centralised limits on individual positions, leverage, or margining.
  2. There are no formal rules for risk and burden-sharing.
  3. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants.
  4. The OTC contracts are generally not regulated by a regulatory authority and the exchange's self-regulatory organisation, although they are affected indirectly by national legal systems, banking supervision and market surveillance.

The derivatives markets have witnessed rather sharp growth over the last few years, which have accompanied the modernisation of commercial and investment banking and globalisation of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the latter. The largest OTC derivative market is the inter-bank foreign exchange market. Commodity derivatives are typically exchange-traded and not OTC in nature.

Limitations of the Financial Market

After introducing the various instruments and regulations for a more developed and integrated market, the markets yet face certain challenges/weaknesses like:  

1.     Lack of Co-ordination amongst various regulatory bodies ( FMC and SEBI)

2.     Absence of proper infrastructure

3.     Derivative instruments like swaps are a little too complex for everyone to understand

4.     Absence of proper accounting System and inefficient internal control.

5.     Lack of awareness in remote areas.

6.     Inefficiency and mismanagement of funds.

7.     Leveraging and Credit default issues.

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Commodity futures markets have a long history in India. Cotton was the first commodity to attract futures trading in the country leading to the setting up of the Bombay Cotton Trade Association Ltd in 1875. The Bombay Cotton Exchange Ltd. was established in 1893 following the widespread discontent amongst leading cotton mill owners and merchants over the functioning of Bombay Cotton Trade Association.
Subsequently, many exchanges came up in different parts of the country for futures trading in various commodities. Futures trading in bullion began in Mumbai in 1920 and subsequently markets came up in other centres like Rajkot, Jaipur, Jamnagar, Kanpur, Delhi and Kolkata. Calcutta Hessian Exchange Ltd. was established in 1919 for futures trading in raw jute and jute goods. But organized futures trading in raw jute began only in 1927 with the establishment of East Indian Jute Association Ltd. These two associations amalgamated in 1945 to form the East India Jute & Hessian Ltd. to conduct organized trading in both raw jute and jute goods. In due course several other exchanges were also created in the country to trade in such diverse commodities as pepper, turmeric, potato, sugar and gur (jaggery). After independence, with the subject of `Stock Exchanges and futures markets' being brought under the Union list, responsibility for regulation of commodity futures markets devolved on Govt. of India. A Bill on forward contracts was referred to an expert committee headed by Prof. A. D. Shroff and select committees of two successive Parliaments and finally in December 1952 Forward Contracts (Regulation) Act, 1952, was enacted.

The Act provided for 3-tier regulatory system:

  1.  An association recognized by the Government of India on the recommendation of Forward Markets Commission,
  2.  The Forward Markets Commission (it was set up in September 1953) and
  3. The Central Government.

Forward Contracts (Regulation) Rules were notified by the Central Government in July, 1954.

According to FC(R) Act, commodities are divided into 3 categories with reference to extent of regulation, viz: Commodities in which futures trading can be organized under the auspices of recognized association. Commodities in which futures trading is prohibited.Commodities which have neither been regulated nor prohibited for being traded under the recognized association are referred as Free Commodities and the association organized in such free commodities is required to obtain the Certificate of Registration from the Forward Markets Commission.

There are more than 20 recognised commodity futures exchanges in India under the 

purview of the Forward Markets Commission (FMC). The country's commodity
futures exchanges are divided majorly into two categories:·

  1. National exchanges
  2. Regional exchanges

The four exchanges operating at the national level (as on 1st January 2013) are:

i)           National Commodity and Derivatives Exchange of India Ltd. (NCDEX)

ii)          National Multi Commodity Exchange of India Ltd. (NMCE)

iii)         Multi Commodity Exchange of India Ltd. (MCX)

iv)         Indian Commodity Exchange Ltd. (ICEX) which started trading operations on November 27, 2009

The leading regional exchange is the National Board of Trade (NBOT) located at
Indore. There are more than 15 regional commodity exchanges in India.

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Forward Markets Commission (FMC) is a statutory body set up under Forward Contracts (Regulation) Act, 1952, Headquartered in Mumbai. It functions under the administrative control of the Ministry of Consumer Affairs, Food and Public Distribution. Mr. Ramesh Abhishek replaced Mr. B.C. Khatua as the chairman of the commission in 2011. The FMC regulates forward markets in commodities through the recognised associations, recommends to the Government the grant / withdrawal of recognition to the associations organizing forward trading in commodities and makes recommendations for general improvement of the functioning of forward markets in the country.

The Commission can have a minimum of 2 and a maximum of 4 members appointed by the central government. The membership is as follows:

  • 1 nominated by the Central Government to be the chairman
  •  The other member or members shall be either whole-time or part-time as the Central Government may direct

The members can hold their office for a maximum period of 3 years from the date of appointment and a member relinquishing his office on the expiry of his term shall be eligible for re-appointment.

Asia may benefit from pressure to regulate U.S. derivatives. (The Bloomberg Edge)
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Derivatives are good hedging instruments, as they help traders to protect or minimize their losses. However speculators may ruin the pricing and as a result this mis-pricing may lead to defaults. Derivatives in India is limited to Futures and Options. After the 2008 crash, talks of regulating this segment began. However, the regulatory bodies are not given much statutory power till date. Forward Markets Commission is yet in its infantry stage. These instruments are complex and a clear understanding is required for establishing a proper framework. In india, FMC along with SEBI is working and drafting new guidelines for various commodities to be dealt in derivatives form. 

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1. Derivatives Defined
2. Origin
3. Evolution
4. Types of Financial Derivatives
5. Commodities & Financial Derivatives
6. Participants in Derivatives
7. Role and Functions of Derivatives
8. Commodity Derivative Markets in India
9. Regulation
10. Conclusion
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