Derivatives


Commodity Derivatives

With commodity derivatives, investors can profit from certain products without actually possessing them. The original objective behind using commodity derivatives was to provide a means of risk protection for farmers where they could promise to sell crops in the future for pre-determined prices.

Price speculation: Trading in commodity derivatives presently is popular with people not involved in the commodities industry and they use this investment tool to speculate on price. Their focus is mainly on supply and demand and they trade on estimations of prices either rising or falling. They make profits when the price of a commodity they have invested in move in their favor. Similarly, they lose money if the price moves in the opposite direction

Buyers and sellers

A trader who buys a derivative contract also buys the right to exchange a commodity for a certain price at a future date. Such a contract buyer can buy the commodity but does not have to pay for the full value of the commodity that he intends buying. What is needed as payment is only a small percentage, known as the margin price.

The person who accepts such a margin price is called a contract seller. He strikes an agreement with the buyer to sell the commodity stated in the contract at a certain price and on a certain date. Traditionally, both the buyer and the seller are required to honor the agreement in spite of any losses that might occur. For instance, a trader may buy a contract from a seller for rights to a ton of tea leaves for Rs 100,000 on a certain date.

The buyer may be required to pay a minimum of Rs10,000 to the seller initially. And on the stipulated date, the seller will transfer the rights of the tea leaves to the buyer. If the current value of the tea leaves is higher than the contract rate, the buyer makes a profit, but if it is lower, he will have to purchase the tea leaves at a loss.

Derivatives market in India

In December 1999, the Securities Contract Regulation Act (SCRA) was amended to include derivatives within the domain of ‘securities’ and the required regulatory framework developed for governing derivatives trading. Actual trading in derivatives commenced in India in June 2000 following the approval by the Securities and Exchange Board of India (SEBI). It permitted the derivative segments of two stock exchanges, the NSE and BSE, and their clearing houses to commence trading and settlement in approved derivatives contracts.

History of equity derivatives

However, equity derivatives have had a long history in India in the over-the-counter (OTC) market. Options such as Teji, Mandi and Fatak in unorganized markets were traded as early as 1900 in Mumbai. The Reserve Bank of India (RBI) first permitted foreign currency options in currency pairs other than the Rupee. Since then, it has permitted options, interest rate swaps, currency swaps and other risk-reductions OTC derivative products.

The clearing and settlement of all trades on the derivative segments must go through a clearing house which functions as an independent entity from the derivative exchange or segment.

The SEBI-constituted Dr. L.C. Gupta Committee has laid down the regulatory framework for derivative trading in India. The regulator has also decreed suggestive by-laws for the derivative exchanges and their clearing houses which include the provisions for trading and settlement of derivative contracts.

Furthermore, the rules, by-laws and regulations of the derivative segment of the exchanges and their clearing houses have to conform to the suggestive by-laws. The SEBI has also provided the eligibility conditions for derivative exchanges and their clearing houses. Conditions have been set up to ensure that these entities provide a transparent trading environment, are safe and function with integrity as also for providing facilities to redress investor grievances. Moreover, an investor's money has to be kept separate at all levels and must be used only against the liability of the investor.

Derivatives Trading

Derivatives trading can be a good alternative for those interested to trade outside of traditional stocks and bonds. Derivatives yield gains over a period of time based on the performance of the underlying assets traded in. Indicators that affect a derivative's performance are diverse and depend on the derivative type. They can be the stock market index, consumer price index, weather conditions and fluctuations in currency exchange rates.

Benefits
Less risky

Trading in derivatives usually does not mean the actual purchase of an underlying asset but an investor takes a risk on the asset’s performance. This does not mean that the investor will not lose money but the risk is relatively less than making an investment. Derivatives trading also allow a much lower initial investment, a good choice for those who cannot or do not want to invest huge amounts in purchasing stocks. Further, derivatives also allow a trader to add balance to his total portfolio and he can spread the risk involved across a range of investments.

Short term investment

If an investor is looking for an investment opportunity that can yield profits in a shorter period, derivatives is a good option. Unlike some stocks and bonds which have to be invested for long periods many years, investments in derivatives can be for a few days, weeks, or a few months. This can provide an investor with the opportunity of breaking into the market and also mixing short and long-term investments.

Variety and Flexibility

Derivatives in essence mean that trading opportunities in this type of investment is unlimited. However, careful research is very essential if an individual is eager to enter this market, while he should also have a trusted financial representative to assist him. The best option is to be armed with both.

Derivatives

A security whose price depends upon or is derived from an underlying asset such as a commodity, bond, equity and currency is called a derivative. The derivative itself is only a contract between two or more parties and fluctuations in the underlying asset determine its value. Since derivatives have no value of their own, they are not standalone assets. But some common types of derivatives are traded in markets before their expiration dates as though they are assets.

The utilization quotient of derivatives
Leveraging dynamics

Investors use derivatives mainly for leveraging so that even if the underlying value makes a slight movement, there can be a huge difference in the value of the derivative.

Speculation

Investors also use them to speculate and can make considerable profits if the underlying asset’s value reaches a level they expect it to.

Hedging

Hedging is aimed at reducing risk in the underlying asset by entering into a derivative contract whose value directional move is opposite to their underlying position thereby acting as a counterbalance.

Exposure

Directives are further used to gain exposure to the underlying asset as part of a risk management strategy to reduce risk associated with inclement weather conditions.

Create option ability

Under the option ability, the value of the derivative is connected to a certain condition or event such as the underlying asset reaching a specific price level.

Common types of derivatives
Over-the-counter (OTC) derivatives

OTC are contracts that are negotiated privately between two parties without using an intermediary such as a stock exchange.

Exchange-traded derivative contracts (ETD)

These derivative instruments are traded via specialized derivative exchanges.

Some common derivative contract types
Futures/forward contracts

These contracts allow the buying or selling of an asset on or before a future date determined at the present.

Options

Options are contracts that give the owner the right, but not the obligation, to buy or sell an underlying asset.

Swaps

Swaps allow cash flows on or before a specified future date based on the underlying value of an asset.

Equity Derivatives

Equity derivatives are instruments with underlying assets based on equity securities. Their values fluctuate with changes in their underlying assets’ equity, which is usually measured by share price. The most common equity derivatives are options and futures.

Benefit

The most important aspect of equity derivatives are that they allow traders to transfer risks associated with the underlying securities. This is usually done by buying or selling options or combinations of options against the cash or futures of the underlying security, the vast majority of which are traded on the stock exchanges. Alternatively, market counterparties can also trade such products against each other on an OTC or off-exchange basis.

Equity options

These are the most common type of equity derivatives. They provide a trader the right, to buy or sell a quantity of stock at a set price within a certain period of time but before the expiry date.

Convertible bonds

Convertible bonds can be converted into shares of stock in the issuing company, usually at a pre-announced ratio. They are also called hybrid securities as they have both features of debt and equity. Investors can use them to obtain the benefit of equity-like returns while safeguarding the drawback with regular bond-like coupons.

Stock market index futures

These can be used to reproduce the performance of an underlying stock market index. These contracts can also be used for hedging against an existing equity position as well as for or speculating on the index’s future movements.

Equity basket derivatives

These consist of more than one stock or stock market index. The baskets can be composed of stocks from one or more industries while they can also be designed to replicate broad market indices. In the latter case, a basket may be used rather than the full index because some index components do not trade actively.

Fixed Income Derivatives

Fixed income derivatives are investments for which fixed payments are received in periodic installments until the principal amount is paid out at maturity. Payments under this investment type are known in advance unlike in variable-income securities where payments change based on certain underlying measures such as short-term interest rates. For example, if a government bond offers 5% as the fixed-rate, then an investment of Rs1, 000 would yield Rs50 as annual payment until maturity when the investor would receive his principal Rs1, 000 back. These types of assets usually offer lower returns on investment because they guarantee income.

Interest rate derivatives and credit derivatives

Interest rate derivatives and credit derivatives come under fixed income derivatives. In an interest rate derivative, the underlying asset is the right to pay or receive a notional amount of money at a fixed interest rate. Generally, investors with customized cash flow needs or certain views on the interest rate movements use these OTC-traded financial instruments. The interest rate derivative has the largest derivatives market in the world. Meanwhile, credit derivatives are privately held negotiable bilateral contracts that allow users to manage their exposure to credit risk. They are financial assets like forward contracts, swaps, and options for which the price is driven by the credit risk of private investors or governments.

Inflation derivatives

derivatives are also often included as fixed income derivatives. These are a subclass of derivative used by individuals to alleviate the effects of potential high inflation levels. The most common under this type are swaps, in which the cash flows of one party are linked to a price index while those of the counterparty are connected to a conventional fixed or floating cash flow.

Besides these, there is a wide range of fixed income derivative products such as options, credit default swaps, interest rate swaps, inflation swaps, government bond futures, interest rate futures and forward rate agreements.

Foreign Currency Derivatives

With a foreign exchange (forex) derivative, the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-determined exchange rate and date. The forex derivatives market is the largest market in the world, with over $US1 trillion traded every single day.

Speculating and hedging

Forex derivatives are principally used for speculating and hedging. Hedgers use forex financial contracts futures to mitigate risk by insulating themselves against potential price shifts in the future. One the other hand, speculators take risks with profit as their objective.

One of the major advantages of using forex derivatives is the availability of trade spreads that are normally lower, often less than three points. Transaction costs are also usually lower with the buyer enjoying more leverage for each contract.

On the demerit front, there is a need for higher capital investments which cannot be afforded by retail investors, the mandatory fees, and the time limitations as forex derivatives can only be used during an exchange trading session.

Tools

Trading strategies are generally the same as standard trading methods while using forex derivatives for speculation. The history and turning points of the currency are evaluated by the method of trend analysis. However, more complex methods are also used to determine the country’s economic indicators and political climate.

Uses

Forex derivatives are often used for hedging to protect sales revenue. For example, an Indian company with stores in England will be making sales in pounds but needs to receive the income in rupees. In such situations, a forex derivative will allow the firm to purchase a contract in the amount of expected sales in order to erase any changes in the currency market. Forex derivatives may also be in the form of forwards where the underlying cash is not paid until the date of expiry.



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