What Does Derivative Mean?
A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.
DERIVATIVES
INTRODUCTION:
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 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.
Derivatives are risk management instruments, which derive their value from an underlying asset. The underlying asset can be bullion, index, share, bonds, currency, interest etc. Annual turnover of the derivatives is increasing each year from 1986 onwards,
Year Annual turnover
1986 146 millions
1992 453 millions
1998 1329 millions
2002 & 2003 it has reached to equivalent stage of cash market
Derivatives are used by banks, securities firms, companies and investors to hedge risks, to gain access to cheaper money and to make profits Derivatives are likely to grow even at a faster rate in future they are first of all cheaper to world have met the increasing volume of products tailored to the needs of particular customers, trading in derivatives has increased even in the over the counter markets.
In Britain unit trusts allowed to invest in futures & options .The capital adequacy norms for banks in the European Economic Community demand less capital to hedge or speculate through derivatives than to carry underlying assets. Derivatives are weighted lightly than other assets that appear on bank balance sheets. The size of these off-balance sheet assets that include derivatives is more than seven times as large as balance sheet items at some American banks causing concern to regulators
DEFINITION:
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.
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, and 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 the securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A.
PARTICIPANTS
The following three broad categories of participants who trade in the derivatives market:
1. Hedgers
2. Speculators and
3. Arbitrageurs
Hedgers:
Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk.
Speculators:
Speculators wish to bet on future movements in the price of an asset. Futures and Options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture.
Arbitrageurs:
Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets.
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 lock in a profit.
CHARACTERISTICS OF DERIVATIVES:
- Their value is derived from an underlying instrument such as stock index, currency etc.
- There are vehicles for transferring risk.
- They are leveraged instruments.
FUNCTIONS:
The derivatives market performs a number of economic functions. They are:
1. Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level.
2. The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them.
3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.
4. Speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets.
5. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity.
6. Derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity.
TYPES OF DERIVATIVES
The most commonly used derivatives contracts are forwards, futures and options. Here various derivatives contracts that have come to be used are given briefly:
1. Forwards
2. Futures
3. Options
4. Warrants
5. LEAPS
6. Baskets
7. Swaps
8. Swaptions
1. Forwards:
A forward contract is customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price
2. 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.
3. Options:
Options are of two types – calls and puts
Calls give the buyer the right but not the obligation to buy
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.
4. Warrants:
Options generally have two lives of up to one year, the majority of options traded on options exchanges having a minimum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.
5. LEAPS:
The acronym LEAPS means Long-term Equity Anticipation Securities. These are options having a maturity of up to three years
6. 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.
7. 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.
8. Swaptions:
Swaptions are options to buy or sell 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 markets 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.
