Introduction To Derivatives

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The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility.

Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.

Derivative products initially emerged, as hedging devices against fluctuations in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. The financial derivatives came into spotlight in post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously both in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives.

Even small investors find these useful due to high correlation of the popular indices with various portfolios and ease of use. The lower costs associated with index derivatives vis-vis derivative products based on individual securities is another reason for their growing use.

The following factors have been driving the growth of financial derivatives:

1.Increased volatility in asset prices in financial markets,
2.Increased integration of national financial markets with the international markets,
3.Marked improvement in communication facilities and sharp decline in their costs,
4.Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and
5.Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets, leading to higher returns, reduced risk as well as trans-actions costs as compared to individual financial assets.

Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the "underlying".

In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines "equity derivative" to include -

1.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.
2.A contract, which derives its value from the prices, or index of prices, of underlying securities.

The derivatives are securities under the SC(R) A and thus the regulatory framework under the SC(R) A governs the trading of derivatives.

Last Updated on 3/4/2011

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