FINANCIAL DERIVATIVES A derivative is a financial instrument or contract that derives its value from an underlying asset. The buyer agrees to purchase the asset on a specific date at a specific price. Derivatives are often used for commodities, such as oil, gasoline, or gold. Another asset class is currencies, often the U.S. dollar. There are derivatives based on stocks or bonds. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. The contract's seller doesn't have to own the underlying asset. He can fulfill the contract by giving the buyer enough money to buy the asset at the prevailing price. He can also give the buyer another derivative contract that offsets the value of the first. This makes derivatives much easier to trade than the asset itself. According to the Securities Contract Regulation Act, 1956 the term ‘Derivative’ includes: i. a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security. ii. a contract which derives its value from the prices or index of prices, of underlying securities. CLASSIFICATION OF DERIVATIVES Derivatives can be classified into broad categories depending upon the type of underlying asset, the nature of derivative contract or the trading of derivative contract. 1. Commodity derivative and Financial derivative In commodity derivatives, the underlying asset is a commodity, such as cotton, gold, copper, wheat, or spices. Commodity derivatives were originally designed to protect farmers from the risk of under- or overproduction of crops. Commodity derivatives are investment tools that allow investors to profit from certain commodities without possessing them. The buyer of a derivatives contract buys the right to exchange a commodity for a certain price at a future date. The buyer may be buying or selling the commodity. In financial derivative the underlying asset is a financial asset such as equity shares, bonds, debentures, interest rates, stock index, exchange rate etc. 2. Elementary derivatives and Complex derivatives Elementary derivatives are the ones which are simple and easily understandable such as futures and options. Complex derivatives have complex provisions and features which make them difficult to understand by the investor such as synthetic futures and options and so on. 3. Exchange traded derivatives and Over The Counter (OTC) derivatives Exchange-traded derivative contracts are standardized derivative contracts such as futures and options contracts that are transacted on an organized futures exchange. They are standardized and require payment of an initial deposit or margin settled through a clearing house. 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, exotic options – and other exotic derivatives – are almost always traded in this way. PARTICIPANTS IN DERIVATIVE MARKET The participants in the derivatives market can be broadly categorized into the following four groups: 1. Hedgers Hedging is when a person invests in financial markets to reduce the risk of price volatility in exchange markets, i.e., eliminate the risk of future price movements. Derivatives are the most popular instruments in the sphere of hedging. It is because derivatives are effective hedges in correspondence with their respective underlying assets. 2. Speculators Speculation is the most common market activity that participants of a financial market take part in. It is a risky activity that investors engage in. It involves the purchase of any financial instrument or an asset that an investor speculates to become significantly valuable in the future. Speculation is driven by the motive of potentially earning lucrative profits in the future. 3. Arbitrageurs Arbitrage is a very common profit-making activity in financial markets that comes into effect by taking advantage of or profiting from the price volatility of the market. Arbitrageurs make a profit from the price difference arising in an investment of a financial instrument such as bonds, stocks, derivatives, etc. FORWARDS A forward contract is an agreement made today between a buyer and seller to exchange the commodity or instrument for cash at a predetermined future date at a price agreed upon today. The agreed upon price is called the ‘forward price’. With a forward market the transfer of ownership occurs on the spot, but delivery of the commodity or instrument does not occur until some future date. In a forward contract, two parties agree to do a trade at some future date, at a stated price and quantity. No money changes hands at the time the deal is signed. For example, a wheat farmer may wish to contract to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such transaction would take place through a forward market. Forward contracts are not traded on an exchange, they are said to trade over the counter (OTC). The quantities of the underlying asset and terms of contract are fully negotiable. The secondary market does not exist for the forward contracts and faces the problems of liquidity and negotiability. FUTURES The futures contract is traded on a futures exchange as a standardised contract, subject to the rules and regulations of the exchange. It is the standardisation of the futures contract that facilitates the secondary market trading. The futures contract relates to a given quantity of the underlying asset and only whole contracts can be traded, and trading of fractional contracts are not allowed in futures contracting. The terms of the futures contracts are not negotiable. A futures contract is a financial security, issued by an organised exchange to buy or sell a commodity, security or currency at a predetermined future date at a price agreed upon today. The agreed upon price is called the ‘futures price’. Types of Futures Contract Futures contracts may be classified into two categories: 1. Commodity Futures: Where the underlying is a commodity or physical asset such as wheat, cotton, butter, eggs etc. Such contracts began trading on Chicago Board of Trade (CBOT) in 1860s. In India too, futures on soya bean, black pepper and spices have been trading for long. 2. Financial Futures: Where the underlying is a financial asset such as foreign exchange, interest rates, shares, Treasury bills or stock index. Important Features of Futures Contract The important features of futures contract are given below: 1. Standardisation: The important feature of futures contract is the standardisation of contract. Each futures contract is for a standard specified quantity, grade, coupon rate, maturity, etc. The standardisation of contracts fetches the potential buyers and sellers and increases the marketability and liquidity of the contracts. 2. Clearing house: An organisation called ‘futures exchange’ will act as a clearinghouse. In futures contract, the obligation of the buyer and the seller is not to each other but to the clearing house in fulfilling the contract, which ensure the elimination of the default risk on any transaction. 3. Time Spreads: There is a relationship between the spot price and the futures price of Notes contract. The relationship also exists between prices of futures contracts, which are on the same commodity or instrument but which have different expiry dates. The difference between the prices of two contracts is known as the ‘time spread’, which is the basis of futures market. 4. Margins: Since the clearing house undertakes the default risk, to protect itself from this risk, the clearing house requires the participants to keep margin money, normally ranging from 5% to 10% of the face value of the contract. 5. Exchange based trading: trading takes place on a formal exchange which provides a place to engage in these transactions and sets a mechanism for the parties to trade these contracts. 6. No default risk: Future contracts have no default risk because the exchange acts as a counterparty and guarantees delivery and payment with the help of clearing houses. Uses of Futures Contracting The uses of futures contracting are as follows: 1. Hedging: The classic hedging application would be that of a wheat farmer futures selling his harvest at a known price in order to eliminate price risk. Conversely, a bread factory may want to buy wheat futures in order to assist production planning without the risk of price fluctuations. 2. Price discovery: Price discovery is the use of futures prices to predict spot price that will prevail in the future. These predictions are useful for production decisions involving the various commodities. 3. Speculation: If a speculator has information or analysis which forecasts an upturn in a price, then he can go long on the futures market instead of the cash market, wait for the price rise, and then take a reversing transaction. The use of futures market here gives leverage to the speculator. COMPARISON BETWEEN FORWARDS AND FUTURES Basis Forward Contract Futures Contract Definition A forward contract is an A futures contract is a agreement between two parties standardized contract, traded to buy or sell an asset (which on a futures exchange, to buy can be of any kind) at a pre- or sell a certain underlying agreed future point in time at a instrument at a certain date in specified price. the future, at a specified price. Structure & Customized to customer needs. Standardized. Initial margin Purpose Usually no initial payment payment required. Usually required. Usually used for used for speculation. hedging. Transaction Negotiated directly by the Quoted and traded on the method buyer and seller Exchange Market Not regulated Government regulated regulation market (the Commodity Futures Trading Commission or CFTC is the governing body) Institutional The contracting parties Clearing House guarantee Risk High counterparty risk Low counterparty risk Guarantees No guarantee of settlement until Both parties must deposit an the date of maturity only the initial guarantee (margin).