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Introduction to Derivatives Market: Definition

A derivative is a financial instrument whose value depends on underlying assets. The underlying assets could be prices of traded securities of gold, copper, aluminum and may even cover prices of fruits and flowers. Derivatives have become important in India since 1995, with the amendment of the Securities Contract Regulation Act of 1956.

Derivatives such as options and futures are traded actively on many exchanges. Forward contracts, swaps and different types of options are regularly traded outside exchanges by financial institutions, banks and corporate clients in over-the-counter markets. There is no single market place or an organized exchange.

Organized exchanges began trading in options on securities in 1973, whereas exchange traded debt options started trading in 1982. On the other hand, fixed income futures began trading in 1975, but equity related futures started trading in 1982. The reasons for debt options being stronger than futures are that stock exchanges tend to introduce those instruments that they think will be successful in trading.

In the equity market, a relatively large proportion of the total risk of a security is unsystematic. At the same time, many securities display a high degree of liquidity that can be expected to be maintained for long periods of time.

These to be successful, the underlying instruments have to be traded in large quantities and with some price continuity so that the option related transactions need not create more than a minor disturbance in the market.

In the debt market, a large proportion of the total risk of the security is systematic — in other words, the risk in debt instruments cannot be diversified by investing in a number of securities. Debt instruments are smaller in size in comparison to equity securities.

Derivatives can be classified as:

  1. Commodities derivatives: These are derivatives on commodities like sugar, jute, paper, gur, castor seeds.
  2. Financial Derivatives: These derivatives deal in shares, currencies and gilt-edged securities.
  3. Basic Derivatives: Futures and Options are basic derivatives.
  4. Complex Derivatives: Interest rate futures and swaps are classified as complex derivatives.
  5. Exchange traded derivatives are standard contracts traded according to the rules and regulations of a stock exchange. Only members can trade in exchange traded derivatives and they are guaranteed against counter-party default. Contracts are settled daily.
  6. OTC Derivatives are regulated by statutory provisions. Swaps, forward contracts in foreign exchange are usually OTC derivatives and have a high risk of default.

Participants in Derivatives Market:

  1. Hedgers are those who try to minimize loses of both the parties entering into a derivative contract. At the same time, they protect themselves against price changes in the products that they deal in. They use options and futures and hedge in both financial derivatives and commodities derivatives.
  2. Speculators participate in futures and options. They take high risks for potential gains. Their gains are unlimited but they can take positions and minimize their losses. They trade mainly in futures. They are the major players of the derivatives market.
  3. Arbitrageurs enter into two transactions into two different stock markets. They are able to make a profit through the difference in price of the asset in different markets. They make a risk less profit but they have to analyse the market with speed to ensure profitability.
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