Evolution and features of Derivatives

Nature of Financial Derivatives:

Financial derivatives refer to those financial products or instruments which derive their prices from the prices of their underlying assets. The underlying assets could include stocks, bonds, foreign currency, or interest rates.

The primitive and simplest form of derivative is forward contract. It goes on to take complex forms like swaps, futures, options, share ratios and their different variations. Derivative securities are also called contingent claims. There are certain distinguishing features of financial derivatives.

In the first instance, value of a financial derivative is derived from some other asset.

Secondly, derivatives are used as vehicle for transferring risk from risk adverse investors to risk bearing investors.

Thirdly, financial derivatives provide commitments to prices or rates for the future dates or given protection against adverse movements of prices or exchange rates and thereby reduce the magnitude of financial risk.

Finally, financial derivatives are highly levered.

Evolution and Growth of Financial Derivatives:

According to some financial scholars, future trading dates back in India to around 200 B. C. Evolution of trading methods of futures can be traced in the medieval fairs of France and England as early as the 12th century. The first futures contracts were reportedly done in respect of rice in Japan in the 17th century when forward agreements were entered into for the trading of commodities in Japan.

As per the records, rice was traded for future delivery in Osaka in the 1730s. Wheat and corn futures were reportedly traded in the UK and the USA in the 19th century. The Chicago Board of Trade (CBOT), established in 1848, was an active exchange for handling commodities, especially corn and wheat.

The history of derivatives has two important milestones. The first was the establishment of stock options trade in Chicago — initially OTC and subsequently on the CBOT market in equity derivatives in 1987. The CBOT was set up in 1848 as a meeting place for farmers and merchants. It standardized the quantities and qualities of the grains that were to be traded. The first future type contract was known as ‘to arrive’ contract.

The CBOT now offers futures contract on various assets like corn, soya bean meal, soya bean oil, wheat, silver, bonds, treasury notes, stock index, etc.

In 1874, the Chicago Produce Exchange was established to provide a market for poultry products, butter and other perishable agricultural products. In 1898, the butter and egg dealers detached themselves from this exchange and formed Chicago Butter and Egg Board.

In 1919, this was renamed as Chicago Mercantile Exchange and was reorganized for future trading. In 1972, the International Monetary Market (IMM) was constituted as a division of the Chicago Mercantile Exchange in 1972 for futures trading in foreign currencies.

The first traded financial futures were foreign currency contracts which began trading on the International Commercial Exchange (ICE) in 1970. However, it did not succeed and had to go out of business. Additional foreign currency contracts commenced trading on the Chicago Mercantile Exchange in 1974.

In 1975, the commodity futures trading commission (CFTC) officially designated nine currencies as contract markets on these exchanges, these included British pound, Canadian dollar, Deutschemarks, Dutch guilders, Japanese Yen, Swiss traces, Italian Lira and Mexican Pesos. Global futures market currently include metals, grains, petroleum products financial instruments and a whole lot of other products.

Other futures that trade in futures world over include the Chicago Rice and Cotton Exchange, the New York Future Exchange, the London International Finance Futures Exchange (LIFFE), the Toronto Futures Exchange (TFE) and the Singapore International Monetary Exchange (SIMEX), MATIF (France), EOE (Holland), SOFFEX (Switzerland) and DTB (Germany).

In India, there is no derivative based on interest rate currently. But there is a future market on selected commodities (Castor seed, hessian, gur, potatoes, turmeric and pepper). The Forward Markets Commission (FMC) is the controlling body for these markets.

India also has a strong currency forward market. Daily volume in this market is reportedly over US $ 500 million per day. The forward cover is currently available for a maximum of 6 months. Indian users can also buy derivatives based on foreign currencies on foreign markets for hedging.

Ever since the “Badla” was banned, there has been a crying need for other risk-hedging devices. The Bombay Stock Exchange has been glamorizing for the return of the “Badla” in its old form. But the National Stock Exchange has set into motion the process of introducing futures and options.

The L. C. Gupta Committee on derivatives was of the view that there was need for equity-based derivatives, interest rate derivatives and currency derivatives. But it recommended introduction of equity-based derivatives in the first instance based on futures only, rather than options or futures/options on individual stocks which are considered more risky.

The Committee suggested that the other complex type of derivatives should be introduced at a later stage after the market participants have acquired some degree of comfort and familiarity with the simpler types. The Securities and Exchange Board of India (SEBI) has, of late, accepted the recommendation of the Gupta Committee and allowed phased introduction of derivative trading in the country beginning with a stock index futures.

Amendments to the Securities Contract Act (SCRA) are on the anvil. This will facilitate inclusion of derivative contracts based on index of prices of securities and other derivative contracts in securities trading. The SEBI also approved suggestive by-laws proposed by the Committee covering operational aspects for regulation and control on derivative contracts.

The RBI introduced recently, rupee derivative trading in the country. It formally allowed banks and corporates from July 6, 1999 to hedge against interest rate risks through the use of interest rate swaps (IRS) and forward rate agreements (FRA). According to the guidelines, there would be no restriction on the tenure and size of the IRS and FRA entered into by banks.

The IRS would allow corporates to hedge their interest rate risks and also provide an opportunity to swap their old high cost loans with cheaper ones. However, the RBI has warned that while dealing with corporates, the participants should ensure that they are undertaking FRAs/IRS only for hedging their own balance sheet exposures and not for speculative purposes.

Thus, commercial banks, primary dealers, and corporates can now undertake IRS and FRA as a product for their own balance sheet management and market making purposes.

Derivatives Market:

The derivatives market is the financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets.

Derivative markets are investment markets that are geared toward the buying and selling of derivatives. Derivatives are securities, or financial instruments, that get their value, or at least part of then- value, from the value of another security, which is called the underlier.

The underlier can come in many forms including, commodities, mortgages, stocks, bonds, or currency. The reason investors may invest in a derivative security is to hedge their bet. By investing in something based on a more stable underlier, the investor is assuming less risk than if she invested in a risky security without an underlier.

Derivatives are usually broadly categorized by the:

1. Relationship between the underlying and the derivative (e.g. forward, option, swap)
2. Type of underlying (e.g. equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives or credit derivatives)
3. Market in which they trade (e.g., exchange traded or over-the-counter)
4. Pay-off profile (Some derivatives have non-linear payoff diagrams due to embedded optionality)

Types of derivatives:

OTC and exchange-traded:

Broadly speaking there are two distinct groups of derivative contracts, which are distinguished by the way they are traded in the market:

1. Over-the-Counter (OTC) Derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or .other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way.

The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts are difficult because trades can occur in private, without activity being visible on any exchange.

2. Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange acts as an intermediary to all related transactions, and takes Initial margin from both sides of the trade to act as a guarantee.

The world’s largest derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), and CME Group.