Derivatives
Definition of Derivatives
One of the most significant events in the securities markets has been the development and
expansion of financial derivatives. The term “derivatives” is used to refer to financial
instruments which derive their value from some underlying assets. The underlying assets could
be equities (shares), debt (bonds, T-bills, and notes), currencies, and even indices of these
various assets, such as the Nifty 50 Index. Derivatives derive their names from their respective
underlying asset. Thus if a derivative’s underlying asset is equity, it is called equity derivative
and so on. Derivatives can be traded either on a regulated exchange, such as the NSE or off the
exchanges, i.e., directly between the different parties, which is called “over-the-counter” (OTC)
trading. (In India only exchange traded equity derivatives are permitted under the law.) The
basic purpose of derivatives is to transfer the price risk (inherent in fluctuations of the asset
prices) from one party to another; they facilitate the allocation of risk to those who are willing
to take it. In so doing, derivatives help mitigate the risk arising from the future uncertainty of
prices. For example, on November 1, 2009 a rice farmer may wish to sell his harvest at a future
date (say January 1, 2010) for a pre-determined fixed price to eliminate the risk of change in
prices by that date. Such a transaction is an example of a derivatives contract. The price of this
derivative is driven by the spot price of rice which is the "underlying".
Origin of derivatives
While trading in derivatives products has grown tremendously in recent times, the earliest
evidence of these types of instruments can be traced back to ancient Greece. Even though
derivatives have been in existence in some form or the other since ancient times, the advent of
modern day derivatives contracts is attributed to farmers’ need to protect themselves against a
decline in crop prices due to various economic and environmental factors. Thus, derivatives
contracts initially developed in commodities. The first “futures” contracts can be traced to the
Yodoya rice market in Osaka, Japan around 1650. The farmers were afraid of rice prices falling
in the future at the time of harvesting. To lock in a price (that is, to sell the rice at a
predetermined fixed price in the future), the farmers entered into contracts with the buyers.
These were evidently standardized contracts, much like today’s futures contracts.
In 1848, the Chicago Board of Trade (CBOT) was established to facilitate trading of forward
contracts on various commodities. From then on, futures contracts on commodities have
remained more or less in the same form, as we know them today.
In India, derivatives markets have been functioning since the nineteenth century, with
organized trading in cotton through the establishment of the Cotton Trade Association in 1875.
Derivatives, as exchange traded financial instruments were introduced in India in June 2000.
The National Stock Exchange (NSE) is the largest exchange in India in derivatives, trading in
various derivatives contracts. The first contract to be launched on NSE was the Nifty 50 index
futures contract. In a span of one and a half years after the introduction of index futures, index
options, stock options and stock futures were also introduced in the derivatives segment for
trading. NSE’s equity derivatives segment is called the Futures & Options Segment or F&O
Segment. NSE also trades in Currency and Interest Rate Futures contracts under a separate
segment.
A series of reforms in the financial markets paved way for the development of exchange-traded
equity derivatives markets in India. In 1993, the NSE was established as an electronic, national
exchange and it started operations in 1994. It improved the efficiency and transparency of the
stock markets by offering a fully automated screen-based trading system with real-time price
dissemination. A report on exchange traded derivatives, by the L.C. Gupta Committee, set up
by the Securities and Exchange Board of India (SEBI), recommended a phased introduction of
derivatives instruments with bi-level regulation (i.e., self-regulation by exchanges, with SEBI
providing the overall regulatory and supervisory role). Another report, by the J.R. Varma
Committee in 1998, worked out the various operational details such as margining and risk
management systems for these instruments. In 1999, the Securities Contracts (Regulation) Act
of 1956, or SC(R)A, was amended so that derivatives could be declared as “securities”. This
allowed the regulatory framework for trading securities, to be extended to derivatives. The Act
considers derivatives on equities to be legal and valid, but only if they are traded on exchanges.
The Securities Contracts (Regulation) Act, 1956 defines "derivatives" to include:
1. 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.
2. A contract which derives its value from the prices, or index of prices, of underlying
securities.
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