Introduction to Derivatives

Dr. Divya Verma

45. Introduction to Derivatives

Learning Objectives
The following key concepts will be discussed:

1. Meaning of derivatives
2. Factors affecting derivatives
3. Economic functions of derivatives
4. Features
5. Products
6. History
7. Recent developments
8. Players in derivatives market

Introduction to Derivatives

Derivative markets neither create nor destroy wealth - they provide a means to transfer risk

 zero sum game in that one party’s gains are equal to another party’s losses.

 participants can choose the level of risk they wish to take on using derivatives.

 with this efficient allocation of risk, investors are willing to supply more funds
to the financial markets, enables firms to raise capital at reasonable costs.

Derivatives are financial instruments that derive their value from an underlying asset, such as
stocks, bonds, commodities, currencies, or interest rates. They are contracts between two
parties, the buyer and the seller, who agree to exchange cash flows or assets based on the
value of the underlying asset.

Derivatives are powerful instruments - they typically contain a high degree of leverage,
meaning that small price changes can lead to large gains and losses, this high degree of
leverage makes them effective but also ‘dangerous’ when misused.

 A Derivative can be defined as a financial instrument whose value depends on (or

derives from) the value of other, more basic, underlying variable.

1
© All Rights Reserved. This document has been authored by Dr. Divya Verma and is permitted to be used only within this
course “Financial Markets, Institutions and Financial Services” delivered in the MOOC online course format of UGC
SWAYAM allotted under National Coordinator, CEC. No part of this document, including any logo, data, illustrations,
pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise - without the prior permission of the author.
Introduction to Derivatives
Dr. Divya Verma

 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.

 Derivatives are financial contracts of pre-determined fixed duration, whose values are
derived from the value of an underlying primary financial instrument, commodity or
index, interest rates, exchange rates. The asset can be a share, index, interest rate,
bond, rupee dollar exchange rate, sugar, crude oil, soybean, cotton, coffee and what
have you.

A very simple example of derivatives is curd, which is derivative of milk. The price of
curd depends upon the price of milk which in turn depends upon the demand and supply of
milk.

Derivatives Defined

In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines
"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.

Derivatives are securities under the SC(R)A and hence the trading of derivatives is
governed by the regulatory framework under the SC(R)A.

Factors Driving the Growth of Derivatives

Over the last three decades, the derivatives market has seen a phenomenal growth. A large
variety of derivative contracts have been launched at exchanges across the world.
Some of the factors driving the growth of financial derivatives are:

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,

2
© All Rights Reserved. This document has been authored by Dr. Divya Verma and is permitted to be used only within this
course “Financial Markets, Institutions and Financial Services” delivered in the MOOC online course format of UGC
SWAYAM allotted under National Coordinator, CEC. No part of this document, including any logo, data, illustrations,
pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise - without the prior permission of the author.
Introduction to Derivatives
Dr. Divya Verma

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.

Economic Functions of the Derivatives Market

Derivatives have vital economic role in the free market system. Firstly, not every one has the
same propensity to take risks. Hedgers consciously seek to avoid risk, while speculators
consciously take on risk. Thus risk re-allocation is made feasible by active derivatives
markets.

In a free market economy, prices are everything. It is essential that prices accurately convey
all pertinent information, if decision making in such economies is to be optimal.

How does the system ensure that prices fully reflect all relevant information? It does so by
allowing people to trade. An investor whose perception of the value of an asset differs from
that of others, will seek to initiate a trade in the market for the asset. If the perception is that
the asset is undervalued, there will be pressure to buy. On the other hand if there is a
perception that the asset is overvalued, there will be pressure to sell. The imbalance on one or
the other side of the market will ensure that the price eventually attains a level where demand
is equal to the supply.

When new information is obtained by investors, trades will obviously be induced, for such
information will invariably have implications for asset prices. In practice it is easier and
cheaper for investors to enter derivatives markets as opposed to cash or spot markets. This is
because, the investor can trade in a derivatives market by depositing a relatively small
performance guarantee or collateral known as the margin. On the contrary taking a long
position in the spot market would entail paying the full price of the asset. Similarly it is easier
to take a short position in derivatives than to short sell in the spot markets. In fact, many
assets cannot be sold short in the spot market.

Consequently new information filters into derivatives markets very fast. Thus derivatives
facilitate Price Discovery.
3
© All Rights Reserved. This document has been authored by Dr. Divya Verma and is permitted to be used only within this
course “Financial Markets, Institutions and Financial Services” delivered in the MOOC online course format of UGC
SWAYAM allotted under National Coordinator, CEC. No part of this document, including any logo, data, illustrations,
pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise - without the prior permission of the author.
Introduction to Derivatives
Dr. Divya Verma

Because of the high volumes of transactions in such markets, transactions costs tend to be
lower than in spot markets. This in turn fuels even more trading activity. Also derivative
markets tend to be very liquid. That is, investors who enter these markets, usually find that
traders who are willing to take the opposite side are readily available. This enables traders to
trade without having to induce a transaction by making major price concessions.

Derivatives improve the overall efficiency of the free market system. Due to the ease of
trading, and the lower associated costs, information quickly filters into these markets. At the
same time spot and derivatives prices are inextricably linked. Consequently, if there is a
perceived misalignment of prices, arbitrageurs will move in for the kill. Their activities will
eventually lead to the efficiency of spot markets as well.

Finally derivatives facilitate speculation. And speculation is vital for the free market system.
An important incidental benefit that flows from derivatives trading is that it acts as a catalyst
for new entrepreneurial activity. The derivatives have a history of attracting many bright,
creative, well-educated people with an entrepreneurial attitude. They often energize
others to create new businesses, new products and new employment opportunities, the
benefit of which are immense.

In a nut shell, derivatives markets help increase savings and investment in the long run.
Transfer of risk enables market participants to expand their volume of activity.

Features of derivatives
Derivatives are contracts that have no independent value. They derive their value from their
underlying assets. They are used as “ risk shifting” or hedging instruments

Derivatives play a crucial role in reducing risk through several mechanisms:

Hedging: One of the primary uses of derivatives is hedging. Hedging involves taking
offsetting positions in derivatives to mitigate potential losses from adverse price movements
in the underlying asset. For instance, a farmer may use commodity futures to hedge against
the risk of price fluctuations in their crop, while an investor may use equity options to hedge
against potential declines in their stock portfolio. By hedging, market participants can protect
themselves from potential losses and stabilize their financial positions.

4
© All Rights Reserved. This document has been authored by Dr. Divya Verma and is permitted to be used only within this
course “Financial Markets, Institutions and Financial Services” delivered in the MOOC online course format of UGC
SWAYAM allotted under National Coordinator, CEC. No part of this document, including any logo, data, illustrations,
pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise - without the prior permission of the author.
Introduction to Derivatives
Dr. Divya Verma

Price discovery: Derivatives markets contribute to price discovery, which is the process of
determining the fair value of an underlying asset. The trading and pricing of derivatives
provide valuable information about market sentiment, supply and demand dynamics, and
expectations. This information can be used by market participants to assess and manage risks
associated with the underlying assets.

Risk transfer: Derivatives enable the transfer of risk from one party to another. For example,
a speculator who believes that the price of a commodity will rise can buy futures contracts
from a producer who wants to hedge against a potential price decline. In this case, the
speculator assumes the risk of price volatility, while the producer transfers the risk to the
speculator. By transferring risk, derivatives facilitate the efficient allocation of risk among
market participants.

Leverage and capital efficiency: Derivatives allow market participants to gain exposure to the
underlying asset with a relatively small initial investment, known as margin. This leverage
can amplify both potential gains and losses. However, when used responsibly, derivatives can
enhance capital efficiency by requiring a lower capital outlay compared to directly investing
in the underlying asset. This can be beneficial for investors who want to manage their risk
exposure while optimizing the use of available capital.

Arbitrage opportunities: Derivatives markets often present arbitrage opportunities, which are
the chance to profit from price discrepancies between related assets. Arbitrageurs take
advantage of these price differences by simultaneously buying and selling related derivatives
or the underlying assets. By exploiting these opportunities, arbitrageurs help reduce market
inefficiencies and ensure that prices align across different markets and instruments.

Derivatives Products
Forwards: A forward contract is a customized 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
certain time in the future at a certain price. Futures contracts are special types of forward
contracts in the sense that the former are standardized exchange-traded contracts.

5
© All Rights Reserved. This document has been authored by Dr. Divya Verma and is permitted to be used only within this
course “Financial Markets, Institutions and Financial Services” delivered in the MOOC online course format of UGC
SWAYAM allotted under National Coordinator, CEC. No part of this document, including any logo, data, illustrations,
pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise - without the prior permission of the author.
Introduction to Derivatives
Dr. Divya Verma

Options: Options are of two types - calls and puts. Calls give 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. 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 given date.

More Complex Derivatives

Futures Options – Options contracts which are written on futures contracts

Compound options – Options contracts which are written on options contracts

Warrants: Options generally have lives of upto 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 upto three years.

Baskets: Basket options are options on portfolios of underlying assets. The underlying asset
is usually a moving average of 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.

History of Derivatives

Derivatives have a long history that can be traced back to ancient civilizations. Throughout
the ages, derivative-like contracts were used to manage risk and facilitate trade. Here is a
concise overview of the history of derivatives:

Early Origins: The origins of derivatives can be found in ancient times. In ancient Greece,
philosopher Thales of Miletus reportedly used derivative contracts to secure the rights to
olive presses in advance, anticipating a bountiful olive harvest. Similar contracts were
employed in ancient Rome, where farmers would agree to sell future crops at predetermined
prices.

6
© All Rights Reserved. This document has been authored by Dr. Divya Verma and is permitted to be used only within this
course “Financial Markets, Institutions and Financial Services” delivered in the MOOC online course format of UGC
SWAYAM allotted under National Coordinator, CEC. No part of this document, including any logo, data, illustrations,
pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise - without the prior permission of the author.
Introduction to Derivatives
Dr. Divya Verma

Japanese Rice Futures: The first organized futures contracts were traded in 17th century
Japan. The Dojima Rice Exchange in Osaka facilitated the trading of rice futures. These
contracts allowed rice producers and merchants to hedge against price risks associated with
rice production and trade.

Modern Era: The modern era of derivatives began in the 19th century with the establishment
of organized futures exchanges. The Chicago Board of Trade, founded in 1848 (now the
CME Group), played a crucial role in the growth of derivatives trading. Initially focused on
agricultural commodities such as corn and wheat, futures contracts expanded to include other
commodities like cotton, metals, and energy products.

Evolution of Derivatives: As financial markets evolved, derivatives expanded beyond

commodities to encompass financial instruments. In the 1970s, the Chicago Mercantile
Exchange (CME) introduced the first financial futures contracts, starting with currency
futures. This marked the emergence of financial derivatives.

Options Market: The options market gained prominence in the 20th century. The
establishment of the Chicago Board Options Exchange (CBOE) in 1973 marked the
beginning of specialized options trading. Options contracts provide the right but not the
obligation to buy or sell an underlying asset at a predetermined price within a specified
period.

Over-the-Counter (OTC) Market: In addition to organized exchanges, an over-the-counter

(OTC) market for derivatives emerged. OTC derivatives are traded directly between parties
without a centralized exchange. These derivatives include customized contracts such as
swaps, forwards, and various structured products.

Global Expansion: Derivatives markets expanded worldwide, with major financial centers
hosting derivatives exchanges and participants. In the late 20th and early 21st centuries, these
markets experienced rapid growth due to increased demand for risk management and
speculation.

Regulatory Reforms: Regulatory reforms were implemented following the financial crises in
the late 2000s to enhance transparency, risk management, and oversight in derivatives
7
© All Rights Reserved. This document has been authored by Dr. Divya Verma and is permitted to be used only within this
course “Financial Markets, Institutions and Financial Services” delivered in the MOOC online course format of UGC
SWAYAM allotted under National Coordinator, CEC. No part of this document, including any logo, data, illustrations,
pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise - without the prior permission of the author.
Introduction to Derivatives
Dr. Divya Verma

markets. Measures like central clearing and reporting requirements were introduced to
mitigate systemic risks associated with derivatives trading.

The history of derivatives showcases their development from simple agricultural contracts to
complex financial instruments used for risk management, speculation, and investment
purposes. The derivatives market continues to evolve as new products, technologies, and
regulatory frameworks emerge to meet the changing needs of market participants.

Recent Developments in the Indian Capital Market

Financial sector reforms have been an integral part of the liberalization process. Initially the
focus was on streamlining and modernizing the cash market for securities. Various steps were
therefore taken in this regard.

 A modern electronic exchange, the NSE was set up in 1994.

 The National Securities Clearing Corporation (NSCCL) was set up to clear and settle
trades.
 Dematerialized trading was introduced with the setting up of the NSDL.
 The attention then shifted to derivatives, for it was felt that that investors in India
needed access to risk management tools.
 SEBI set up the L.C. Gupta committee in 1996 to develop a framework for
introducing derivatives.
 The committee submitted its report on May 11, 1998. It recommended that derivatives
be declared as securities so that the regulatory framework applicable for the trading of
securities could also be extended to include derivatives trading.
 Trading in derivatives has its inherent risks from the standpoint of non-performance
of a party with an obligation to perform.
 For this purpose SEBI appointed the J.R. Varma Committee to recommend a suitable
risk management framework.
 This committee submitted its report in 1998.
 The Securities Control (Regulation) Act, 1956 was amended in December 1999 to
include derivatives within the ambit of securities.
8
© All Rights Reserved. This document has been authored by Dr. Divya Verma and is permitted to be used only within this
course “Financial Markets, Institutions and Financial Services” delivered in the MOOC online course format of UGC
SWAYAM allotted under National Coordinator, CEC. No part of this document, including any logo, data, illustrations,
pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise - without the prior permission of the author.
Introduction to Derivatives
Dr. Divya Verma

 The Act made it clear that trading in derivatives would be legal and valid only if such
contracts were to be traded on a recognized stock exchange.
 Thus OTC derivatives were ruled out.
 In May 2000 SEBI permitted the NSE and the BSE to commence trading in
derivatives. To begin with trading in index futures was allowed.
 Thus futures on the S&P CNX Nifty and the BSE-30 (Sensex) were introduced in
June 2000.
 Approval for index options and options on stocks was subsequently granted.
 Index options were launched in June 2001 and stock options in July 2001.
 Futures on stocks were launched in November 2001.
 Currency derivative trading commences on NSE on August 29, 2008.
 Interest Rate Derivatives trading commences on NSE on August 31, 2009.

Players in the Market

There are three broad categories of market participants: Hedgers, Speculators and
Arbitrageurs

Hedgers

Hedgers face risk associated with the price of an asset. They use futures or options markets to
reduce or eliminate this risk. These are people who have already acquired a position in the
spot market prior to entering the derivatives market. They may have bought the asset
underlying the derivatives contract, in which case they are said to be Long in the spot. Or else
they may have sold the underlying asset in the spot market without owning it, in which case
they are said to have a Short position in the spot market. In either case they are exposed to
Price Risk. Price risk is the risk that the price of the asset may move in an unfavourable
direction from their standpoint. What is adverse depends on whether they are long or short in
the spot market. For a long, falling prices represent a negative movement. For a short, rising
prices represent an undesirable movement. Both longs and shorts can use derivatives to
minimize, and under certain conditions, even eliminate Price Risk. This is the purpose of
hedging.

Speculators
9
© All Rights Reserved. This document has been authored by Dr. Divya Verma and is permitted to be used only within this
course “Financial Markets, Institutions and Financial Services” delivered in the MOOC online course format of UGC
SWAYAM allotted under National Coordinator, CEC. No part of this document, including any logo, data, illustrations,
pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise - without the prior permission of the author.
Introduction to Derivatives
Dr. Divya Verma

Unlike hedgers who seek to mitigate their exposure to risk, speculators consciously take on
risk. They are not however gamblers, in the sense that they do not play the market for the
sheer thrill of it. They are calculated risk takers, who will take a risky position, only if they
perceive that the expected return is commensurate with the risk. A speculator may either be
betting that the market will rise, or he could be betting that the market will fall.

Hedgers & Speculators

The two categories of investors complement each other. The market needs both types of
players to function efficiently. Often if a hedger takes a long position, the corresponding short
position will be taken by a speculator and vice versa.

Arbitrageurs

These are traders looking to make costless and risk-less profits. Since derivatives by
definition are based on markets for an underlying asset, it is but obvious that the price of a
derivatives contract must be related to the price of the asset in the spot market. Arbitrageurs
scan the market constantly for discrepancies from the required pricing relationships.

If they see an opportunity for exploiting a misaligned price without taking a risk, and after
accounting for the opportunity cost of funds that are required to be deployed, they will seize
it and exploit it to the hilt.

Arbitrage activities therefore keep the market efficient. That is, such activities ensure that
prices closely conform to their values as predicted by economic theory. Market participants,
like brokerage houses and investment banks have an advantage when it comes to arbitrage vis
a vis individuals. Firstly, they do not typically pay commissions for they can arrange their
own trades. Secondly, they have ready access to large amounts of capital at a competitive
cost.

Derivatives in India

The futures contract at NSE is based on S&P CNX Nifty Index.

It has a maximum of 3-month expiration cycle.

Three contracts are available for trading I.e. with 1 month, 2 months and 3 months expiry.

National Stock Exchange

10
© All Rights Reserved. This document has been authored by Dr. Divya Verma and is permitted to be used only within this
course “Financial Markets, Institutions and Financial Services” delivered in the MOOC online course format of UGC
SWAYAM allotted under National Coordinator, CEC. No part of this document, including any logo, data, illustrations,
pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise - without the prior permission of the author.
Introduction to Derivatives
Dr. Divya Verma

The NSE trading system called 'National Exchange for Automated Trading' (NEAT) is a fully
automated screen based trading system, which adopts the principle of an order driven market.

NSE commenced trading in futures on individual securities on November 9, 2001. The

futures contracts are available on 187 securities by the Securities & Exchange Board of India
(SEBI).

Futures contracts have a maximum of 3-month trading cycle - the near month (one), the next
month (two) and the far month (three).

Futures contracts expire on the last Thursday of the expiry month. If the last Thursday is a
trading holiday, the contracts expire on the previous trading day.

Contract size- The value of the futures contracts on individual securities may not be less
than Rs. 2 lakhs at the time of introduction for the first time at any exchange.

Price steps- The price step in respect of futures contracts is Re.0.05.

Base Prices - Base price of futures contracts on the first day of trading (i.e. on introduction)
would be the theoretical futures price. The base price of the contracts on subsequent trading
days would be the daily settlement price of the futures contracts.

Price bands - There are no day minimum/maximum price ranges applicable for futures
contracts. However, in order to prevent erroneous order entry by trading members, operating
ranges are kept at +/- 20 %. In respect of orders which have come under price freeze,
members would be required to confirm to the Exchange that there is no inadvertent error in
the order entry and that the order is genuine. On such confirmation the Exchange may
approve such order.

Quantity freeze - Orders which may come to the exchange as a quantity freeze shall be
based on the notional value of the contract of around Rs.5 crores. Quantity freeze is
calculated for each underlying on the last trading day of each calendar month and is
applicable through the next calendar month. for any reason whatsoever including non-
availability of turnover / exposure limits.

Clearing & Settlement (Derivatives) - National Securities Clearing Corporation Limited

(NSCCL) is the clearing and settlement agency for all deals executed on the Derivatives
(Futures & Options) segment. NSCCL acts as legal counter-party to all deals on NSE's F&O
11
© All Rights Reserved. This document has been authored by Dr. Divya Verma and is permitted to be used only within this
course “Financial Markets, Institutions and Financial Services” delivered in the MOOC online course format of UGC
SWAYAM allotted under National Coordinator, CEC. No part of this document, including any logo, data, illustrations,
pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise - without the prior permission of the author.
Introduction to Derivatives
Dr. Divya Verma

segment and guarantees settlement. A Clearing Member (CM) of NSCCL has the
responsibility of clearing and settlement of all deals executed by Trading Members (TM) on
NSE, who clear and settle such deals through them.

Conclusion

It is important to note that while derivatives can be valuable risk management tools, they also
involve risks and complexities. Market participants should have a thorough understanding of
the instruments and associated risks before engaging in derivatives trading or hedging
activities.

12
© All Rights Reserved. This document has been authored by Dr. Divya Verma and is permitted to be used only within this
course “Financial Markets, Institutions and Financial Services” delivered in the MOOC online course format of UGC
SWAYAM allotted under National Coordinator, CEC. No part of this document, including any logo, data, illustrations,
pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise - without the prior permission of the author.