Introduction to derivatives in Indian capital market
Established in 2000, derivatives are financial securities which are included in Securities Law (Second Amendment) Act, 1999. It was were defined under the Securities Contracts Regulations Act as:
- 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.
- A contract which derivatives its value from the prices, or index of prices, of underlying securities .
The underlying asset in this case could be:
- Commodity like grains & coffee beans.
- Precious metal like gold & silver.
- Foreign currencies such as USD, Euro, etc.
- Shares and share warrant of the company.
- OTC money market products loans and deposits.
The main benefit of using derivatives is that it helps in elimination of risks.
Participants of the derivatives market
There can be three type of participants in a derivatives market:
While the hedgers are safe players who use derivatives to reduce or eliminate the risks associated with the price of the underlying asset. Speculators generally bet on derivative contracts (will be discussed in next section) in order to get extra leverage which can increase both potential gains and losses. Arbitrageurs take the advantage of discrepancies in between prices of more or less the same assets or competing assets in different market .
Different types of derivatives in the Indian capital market:
The derivative transactions are built in two financial blocks, forwards and contracts .
In forward contracts two parties agree to trade at a future date, with a specific starting price and quantity. Forward contracts are generally useful in case of hedging and speculation. For example the farmer can sell his grains at a forward price in order to eliminate the price risk. Also a speculator if can speculate the increase in prices of an underlying asset then he/she can go on forward contract and gain leverage.
However, there are some problems associated with forward contracts. They are:
- Lack of centralization in terms of trading activities.
- And counter party risk.
The first two problems are due to flexibility and generality. This is because the participating parties make terms and conditions as per their own convenience which sometimes can make the contracts non-trade-able. Counter party risk can be faced when one of the two parties declare bankruptcy which leads to suffering or counter party.
The future contracts are designed in a way that they resolve all the problems of forward contracts. In terms of basic economics future contracts are very similar to forward contracts. However, these contracts include centralized trading and standardization. Also there is no counter party risk in case of future contracts. There are two types of future contracts, index futures and stock futures.
Option is a right to sell or buy something at date and prices stated and defined earlier. While the “call” option gives the right to buy on the other hand “put” option gives the right to sell. Under options there are two types; Index options and stock options .
Other than these future and option contracts, there are more complex contracts which are also known as exotic contracts and are used in more custom situations. The contracts in this category are custom built based on the requirements of the participating individuals.
The derivative trading in India can take place either on independent derivative exchange or on a separate segment of existing stock exchange. The minimum contract size for operations in the market is Rs. 2 Lacs. The oversight regulator of transactions is Securities and Exchange Boards of India (SEBI) .
- FAQ on Equity and Currency Derivatives [Online] Retrieved from: http://www.sebi.gov.in/faq/derivativesfaq.html.
- Vashishtha A. and Kumar S. (2010). Development of Financial Derivatives Market in India- A Case Study. International Research Journal of Finance and Economics Issue 37. Pp 15-29.
- Gurusamy (2009). Capital Markets. 2nd Ed., McGraw Hill Publications [Online] Retrieved from: http://books.google.co.in/books?id=TREjwESaQu0C&pg=PA120&dq=operations+of+derivatives+market+in+india&hl=en&sa=X&ei=TsIqUpeaHYGPrQfzl4GoDw&ved=0CEAQ6AEwAw#v=onepage&q=operations%20of%20derivatives%20market%20in%20india&f=false.
- NSE India (n.d.) [Online] Retrieved from: http://www.nseindia.com/content/press/faqfo.pdf