Derivatives (Part 1)

Meaning & introduction 

A Derivative is a financial instrument that is derived from some other asset, index, event, value or condition (known as the underlying). Rather than trade or exchange the underlying itself, derivative traders enter into an agreement to exchange cash or assets over time based on the underlying. A simple example is a futures contract: an agreement to exchange the underlying asset at a future date.

Derivatives are often leveraged, such that a small movement in the underlying value can cause a large difference in the value of the derivative.

Derivative products were originally designed to help participants to hedge their price risks (or similar risks which arise due to volatility in instruments quoted in the market place). As the world has progressed, these products are used not only for hedging but also for trading or speculation and arbitrage. Derivative products have assumed huge importance in financial markets and their traded volumes in most cases are more than double the traded volumes in the underlying physical articles or instruments.

Derivatives are usually broadly categorised by:

• The relationship between the underlying and the derivative (e.g. forward, option, swap)
• The type of underlying (e.g. Equity derivatives, FX derivatives, credit derivatives)
• The market in which they trade (e.g. exchange traded or over-the-counter)

What do we mean by credit derivative mean?

Privately held negotiable bilateral contracts that allow users to manage their exposure to credit risk. Credit derivatives are financial assets like forward contracts, swaps, and options for which the price is driven by the credit risk of economic agents (private investors or governments). For example, a bank concerned that one of its customers may not be able to repay a loan can protect itself against loss by transferring the credit risk to another party while keeping the loan on its books.

Derivative products are now available on a variety of underlyings (that on which derivatives are created) including commodities, interest rates, forex, equities and even weather. Financial markets have understood that any article that fluctuates can form a good underlying and that it need not be tangible (like an equity index) or be owned by any person (like weather).

Complexity of derivative products has also increased enormously as evident from the disasters which continue to dog these markets. Multi billion dollar enterprises also suffer huge losses from time to time either due to greed or loose controls or lack of understanding of the products or a combination of these and other factors.

Indian equity derivatives started in June 2000 and have now progressed to a level where derivative volumes are more than twice the underlying equity market on most days. Trading volumes exceed Rs. 8,000 crores on most trading days with a peak of almost Rs. 17,000 crores. Commodity markets have also started recently and generate daily volumes on Futures of more than Rs. 2,000 crores on most trading days. Interest rate and forex derivatives are not traded on exchanges but available to market participants through banks if they have an underlying exposure to these risks largely for hedging purposes. Interest Rate Derivatives though listed have not been popular and are planned to be re-introduced with some changes in the design of the contract.Participants in the equity market are largely individuals, brokers, arbitrageurs and Foreign Institutional Investors. Domestic institutions and mutual funds are relatively less found in these markets except for a rather sudden burst of arbitrage funds in the Mutual Funds industry which are just making a beginning.