Financial markets are, by nature, extremely volatile and hence the risk factor is an important concern for financial agents. To reduce this risk, the concept of derivatives comes into the picture. Derivatives are products whose values are derived from one or more basic variables called bases. These bases can be underlying assets (for example forex, equity, etc), bases or reference rates. 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. The transaction in this case would be the derivative, while the spot price of wheat would be the underlying asset.
Development of exchange-traded derivatives
Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century and may well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary enthusiasm for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to reduce the possibility that large fluctuations would hamper marketing the commodity after a harvest.
The need for a derivatives market
The derivatives market performs a number of economic functions:
1. They help in transferring risks from risk reluctant people to risk inclined people
2. They help in the discovery of future as well as current prices
3. They promote entrepreneurial activity
4. They increase the volume traded in markets owing to the participation of risk averse people much more.
5. They increase savings and investment in the long run
The participants in a derivatives market
Hedgers use futures or options markets to reduce or eliminate the risk associated with the price of an asset.
Speculators use F&Os contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the probable gains and losses by usage of derivatives in a speculative venture.
Arbitrageurs are in business to take advantage of a incongruity 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 secure a profit.
Types of Derivatives
Forwards: A forward contract is a customised contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price.
Futures: A futures contract is an agreement between two parties to buy or sell an asset at a particular time in the future at a specified price. They are special types of forward contracts in the sense that the former are standardized exchange-traded contracts
Options: Options are of two types - calls and puts. Calls give the buyer the right but not the compulsion to buy a given quantity of the underlying asset, at a given price on or before a specified future date. Puts give 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 specified date.
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.
LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of up to three years.
Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options.
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.
Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.
Factors driving the growth of financial derivatives
1. Increased volatility in asset prices in financial markets.
2. Increased integration of national financial markets with the global ones.
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 transactions costs as compared to individual financial assets.
Development of derivatives market in India
The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24–member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary pre–conditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as ‘securities’ so that regulatory framework applicable to trading of ‘securities’ could also govern trading of securities.
SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and real–time monitoring requirements.
The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include derivatives within the ambit of ‘securities’ and the regulatory framework were developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the three–decade old notification, which prohibited forward trading in securities.
Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE–30 (Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities. The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001.
Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products.
Exchange-traded vs. OTC (Over The Counter) derivatives markets
The OTC derivatives markets have witnessed rather sharp growth over the last few years, which have accompanied the modernization 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. It has been widely discussed that the highly leveraged institutions and their OTC derivative positions were the main cause of turbulence in financial markets in 1998. These episodes of turbulence revealed the risks posed to market stability originating in features of OTC derivative instruments and markets.
The OTC derivatives markets have the following features compared to exchange-traded derivatives:
1. The management of counter-party (credit) risk is decentralized and located within individual institutions,
2. There are no formal centralized limits on individual positions, leverage, or margining,
3. There are no formal rules for risk and burden-sharing,
4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and
5. The OTC contracts are generally not regulated by a regulatory authority and the exchange’s self-regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance.
References:
National Stock Exchange website
Bombay Stock Exchange website
DSP Merrill Lynch website
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