Derivatives are nothing but a kind of security whose price or value is determined by the value of the underlying variables. It is more like a contract of future date in which two or more parties are involved to alleviate future risk. Usually, derivatives enjoy high leverage. Its value is affected by the volatility in the rates of the underlying asset. Some of the widely known underlying assets are:
- Indexes (consumer price index (CPI), stock market index, weather conditions or inflation)
- Interest rates
- Exchange rates
- Stocks (equities)
Types of Derivatives
The range of derivatives is really wide. But some of the most commonly known derivatives are:
Forwards-This is a tailor-made contract between two parties. In case of this contract, a settlement is done on a scheduled future date at today's pre-decided rate.
Futures-When two entities decide to purchase or sell an asset at a given time in the future at a given price, it is called futures contract. Futures contracts can be said to be a special kind of forward contracts, as they are customized exchange-traded agreements.
Options-It is of two different kinds such as calls and puts. Those who take calls option, they are not obligated to purchase given quantity of the underlying variable, at a mentioned price on or prior to a scheduled future date. On the other hand, buyers in case of puts option may not necessarily sell a mentioned quantity of the underlying variable at a mentioned price on or prior to a given date.
Swaps-These are private contracts between two entities to deal in cash flows in the future following a pre-decided formula. They are somewhat like forward contracts' portfolios. Swaps are also of two types such as interest rate swaps and currency swaps.
Interest rate swaps-in this case, only interest related cash flows can be exchanged between the entities in one currency.
Currency swaps-in this case of swapping, principal and interest can be exchanged in one currency for the same in other form of currency.
Importance of Derivatives
Financial transactions are fraught with several risk factors. Derivatives are instrumental in alienating those risk factors from traditional instruments and shifting risks to those entities that are ready to take them. Some of the basic risk components in derivatives business are:
- Credit Risk: When one of the two parties fails to perform its role as per the agreement, this is called the credit risk. It can also be referred to as default or counterparty risk. It varies with different sources.
- Market Risk: This is a kind of financial loss that takes place due to the adverse price movements of the underlying variable or instrument.
- Liquidity Risk: When a firm is unable to devise a transaction at current market rates, it can be referred to as liquidity risk. There are two kinds of liquidity risks involved in the scenario. First is concerned with the liquidity of separate items and second is related to supporting the activities of the organization with funds comprising derivatives.
- Legal Risk:Legal issues related with the agreement need to be scrutinized well, as one can deal in derivatives across the different judicial boundaries.
Derivatives Markets in India
India had started with a controlled economic system and from there it moved on to become a destination that witnesses constant fluctuation in prices on a daily basis now. Persistent efforts of Reserve Bank of India (RBI) in building currency forward market and liberalization process provided the risk management agencies their much needed momentum. Derivatives are the indispensable components of liberalization process to handle risk. With National Stock Exchange (NSE) measuring the market demands, the process of launching derivative markets in India got started. In the year 1999, derivatives trading took place in India.
Indian derivatives markets can be divided into two types including 1) the transaction which depends on the exchange, and 2) the transaction which takes place 'over the counter' in one-to-one scenario. They can thus be referred to as:
- Exchange Traded Derivatives
- Over the Counter (OTC) Derivatives
- Over the Counter (OTC) Equity Derivatives
- Operators in the Derivatives Market
- Hedgers-traders who are interested in transferring a risk element of their portfolio.
- Speculators-traders who deliberately go for risk components from hedgers in look out for profit.
- Arbitrators-traders who work in various markets at the same time in order to gain profit and do away with mis-pricing.
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