Derivatives: Meaning and Types of Derivatives in India

We are starting our journey with this module on the Equity Derivative Market. We will begin by understanding what derivatives are and their fundamental concepts.

Derivatives are financial contracts or instruments that derive their value from an underlying asset. Usually, these underlying assets are stocks, bonds, commodities, currencies, market indices, etc. 

But what does this exactly mean? We know that the value of assets keeps fluctuating in response to market dynamics. For example, crude oil prices fluctuate depending on demand and supply factors. Similarly, the price of a stock fluctuates depending on the company's performance. Derivative contracts allow investors to speculate on the price movement of the assets and benefit from it.

Now, let’s say you have been analysing the stock chart of a company called XYZ Limited. Based on your analysis, you feel that XYZ Limited's stock price will rise by up to 20% over the next few weeks. You can buy a derivative instrument to bet on the upward movement of the stock and make a profit when the stock hits the predetermined target price.

Let’s look at another example. Let’s assume that you predict a decline in crude oil prices due to weak demand in the market, and you wish to leverage the same. You can buy a derivative instrument to bet on the downward movement of the commodity and make a profit when the price of crude oil falls.

In these examples, you did not actually buy the stock of XYZ Limited or crude oil. You only entered into contracts to speculate on the stock's price movement and the commodity. The changes in the stock price of XYZ Limited and crude oil (being the underlying assets here) in the direction that you predicted increased the value of your derivative instruments, thereby making the trade profitable.

Trading in the derivatives market may take place in the following ways - 

• Exchange-Traded Derivatives (ETDs) 

ETDs are traded on centralised marketplaces such as stock exchanges. These derivatives are in standardised form since they are publicly available instruments and have a predefined set of terms, including contract size, price, expiry date, and settlement mechanism. For example, futures and options are traded on the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE). Due to the availability of existing marketplaces, ETDs offer better liquidity and price discovery for traders.

• Over-The-Counter Derivatives (OTC) 

OTC derivatives are traded directly between two private parties. Resultantly, these contracts are customisable in nature to suit the requirements of the parties involved. Forward contracts and swap contracts are popular examples of OTC derivatives.

History of Derivatives in India

The existence of derivatives markets can be traced back to 1875, when the Bombay Cotton Trade Association commenced futures trading. Thereafter, India emerged as one of the largest futures trading markets in the world. In 1952, the Government of India banned cash settlement and options trading. As a result, traders began trading in derivatives through informal forward contacts.

In 1995, the Securities and Exchange Board of India (SEBI) withdrew prohibitions on derivatives by introducing the Securities Law (Amendment) Act, 1995. However, despite lifting the ban, no major developments were seen in derivatives trading due to the absence of a regulatory framework. In 1999, the Securities Contract Regulation Act 1956 was amended to legalise derivative contracts traded on recognised stock exchanges. The ban on futures trading in commodities was lifted in 2000.

After SEBI granted its approval, derivatives trading commenced on BSE in June 2000 when BSE introduced trading in Sensex options. NSE introduced derivatives trading with index futures in June 2000, followed by options trading on individual securities in July 2001 and futures trading in November 2001. Since then, derivative market trading has exponentially grown in India and is now heavily regulated.

Types of Derivatives in India

• Forwards 

Forward contracts are contracts between two parties, i.e., the buyer and the seller agree to buy and sell an asset at a predetermined price and a predetermined price in the future. Forward contracts are customised contracts per the parties' requirements and are not traded on exchanges; rather, they are traded over the counter. These contracts are predominantly used for hedging and protection against market volatility. Since these contracts are traded over the counter, they involve defaulting counterparty risk.

For example, Party Mojo and Party Jojo entered into a contract wherein Party Mojo agreed to buy 10 barrels of crude oil from Party Jojo at a price of ₹7,000 per barrel on a date 90 days later. Let’s say the price of crude oil at the time of the contract is ₹6,800 per barrel. The price after 90 days turns out to be ₹7,100 per barrel. Thus, Party Jojo will incur a loss of ₹100 per barrel, which is the difference between the spot price and the forward price. Similarly, Party Mojo will earn a profit of ₹100 per barrel.

• Options

Options are derivative contracts wherein the buyer and seller agree to buy or sell the underlying asset at a predetermined price on a predetermined date in the future. Options are non-binding contracts, meaning that the party buying the option contract is not obligated to act upon it. By purchasing the option contract, the option holder acquires the right to exercise the option to buy or sell, which may be exercised at the discretion of the option holder. The option holder is required to pay a premium to be able to purchase the option contract.

There are two types of options, i.e., a Put Option and a Call Option. The option holder that buys a Call Option will make a profit if the price of the underlying asset increases and vice versa in the case of a Put Option. Only the premium amount will be lost if the option holder chooses not to execute the contract.

• Futures

Futures are derivative contracts wherein two parties, i.e., the buyer and the seller, enter into a standardised agreement for purchasing a specific quantity of the underlying asset at a specific price and at a specific date in the future. Futures are different from options in that they are binding contracts, meaning that parties are legally bound to honour the contract before the expiry date. Futures can only be traded on stock exchanges, making them averse to defaulting counterparty and credit risks.

Let’s say you buy a Nifty 50 index futures contract, which is trading at a current price of ₹10,000. Since futures are traded in lots comprising multiple units of the underlying asset, the contract value would be ₹5,00,000, assuming one lot comprises 50 units of the index. To execute the trade, you must deposit a certain margin with the broker. Assuming the margin is 10% of the contract value, you deposit ₹50,000 with the broker. If the index rises by ₹50, the value of your futures contract will also increase by ₹50 per unit. At this point, if you decide to sell your futures contract, you will make a profit of ₹2,500 on your trade.

• Swaps

 As the term suggests, swap contracts allow parties to swap or exchange their financial obligations or liabilities. Swaps are generally used for hedging purposes. These are private contracts which are traded over the counter. There are 4 types of swaps, i.e., Interest Rate Swaps, Currency Swaps, Commodity Swaps and Credit Default Swaps.

Credit Default Swaps (CDS) are quite popular. A classic example of the usage of credit default swaps is the 2008 Lehman Brothers case, wherein investors purchased several CDS to protect themselves from rising concerns regarding Lehman Brothers defaulting on its debts. Investors paid a premium to the sellers of CDS in exchange for insurance against any such default. When Lehman Brothers collapsed in 2008, the widespread use of CDS led to a chain reaction and resulted in a broader financial crisis. 

Regulatory Framework in India

The derivatives market is regulated and controlled by the Securities and Exchange Board of India (SEBI), the Reserve Bank of India (RBI) and the Forward Markets Commission (FMC).

While SEBI is authorised to regulate the exchange-traded equity and commodities derivatives market in India, RBI and SEBI jointly regulate the exchange-traded foreign currency and interest rate futures. RBI also regulates foreign currency, credit and interest rate derivatives, which are traded over the counter.

The legislations governing the derivatives market in India include the Securities and Exchange Board of India Act, 1992, the Securities Contract (Regulation) Act, 1956, the Reserve Bank of India Act of 1934 and the corresponding rules and regulations and the notifications, guidelines, and circulars issued thereunder.

Types of Market Participants

• Hedgers 

Hedgers trade in derivative instruments to protect their investments against market risk and price fluctuations. They aim to ensure that their investment in the underlying asset does not get adversely affected due to a loss resulting from price fluctuations. Hence, they take a hedging position in the market by paying a premium to secure their investment.

For example, let’s say you have made a long-term investment in the stocks of XYZ Limited. Still, you anticipate a fall in the stock price due to prevalent market dynamics and wish to be protected against the anticipated decline in stock price and the value of your investment. You may consider taking an opposite position in the market in the form of a put option by paying the applicable premium. If the price falls in the short term as anticipated, you may exercise your put option. This way, you will mitigate or set off value reduction on your long-term investment.

• Speculators 

Speculators are traders who purchase derivative contracts based on their predictions of the price movements in the market. Contrary to hedgers, speculators assume high risk in order to make profits on their bets.

• Arbitrageurs 

Arbitrageurs take advantage of the gaps in the market to make profits. In simple terms, they buy assets in one exchange at b prices and sell them on another exchange at higher prices. The risk involved in this strategy is marginal since arbitrageurs merely identify price gaps across platforms and act quickly to capitalise on the opportunity.

• Margin Traders 

Margin traders do not entirely use their own money. They borrow funds from brokers to trade in derivative instruments. Margin traders are required to deposit a margin amount with brokers. This allows margin traders to buy large positions in the market via borrowed funds, and their deposit or margin amount acts as collateral.

Conclusion

In this chapter, we learnt about derivatives, exploring their historical significance in India, the various types available, the regulatory framework governing them in India, and the diverse participants involved in the derivatives market.

Be sure to stay tuned for our in-depth exploration of futures contracts, including their mechanics, types, and related aspects, which we will cover extensively in the next chapter.