Derivatives

Derivatives are financial instruments that derive value from the underlying. The underlying can be stocks, currency, bonds or commodities.

Derivatives instruments in India involve futures and options. Futures can be termed as bundle of stocks or indices that can be bought or sold on exchanges at a predetermined price and date. Options on the other hand give the buyer a right but not an obligation to buy or sell and underlying at a predetermined price.

Advantages

Futures can be used to hedge a portfolio. They can also be used for arbitrage which may arise from difference between futures and spot price. Futures can also be used to benefit from expected increase/decrease in price of the underlying by paying initial margin. Options provide lucrative trading opportunities for people with low risk appetite. Options can also be used to hedge the risk associated with buying or selling futures. Options being flexible can be used to devise synthetic positions.

Risk

Individuals tend to over leverage their positions which can result in significant loss. Options can result in time decay if underlying continues to trade in range. Options are also exposed to risk arising from increase/decrease in implied volatility.

Commodity derivatives markets have been in existence for years, driven by the efforts of commodities producers, users, traders and investors to manage their business and financial risks.

Producers want to manage the exposure to changes in the prices they receive for their produce. They are mostly focused on achieving the same effect as fixed prices on contracts to sell their produce. A silver producer, for example, wants to hedge its losses from a fall in the price of silver for its current silver inventory. Agri producers need to hedge the risk of price changes in cotton, coffee, beans and other commodities they sell.

End-users want to hedge the prices at which they can purchase commodities. An oil refinery and oil marketing company wants to lock in the price of the crude oil it needs to purchase in order to satisfy the peak in demand.

Investors and financial intermediaries can either buy or sell commodities through the use of derivatives. Today, the commodity derivatives market is the primary economic sector for the exchange/trading of essential goods and products.

Currency derivatives are a contract between the seller and buyer, whose value is to be derived from the underlying asset i.e. the currency value. A derivative based on currency exchange rate is an agreement that two currencies can be exchanged in a specific quantity of a particular currency pair at a future date.Currency Derivatives can be Future and Options contracts which are similar to the Stock Futures and Options but the underlying happens to be currency pair (i.e. USDINR, EURINR, JPYINR OR GBPINR) instead of Stocks. Currency Derivatives are available on four currency pairs viz. US Dollars (USD), Euro (EUR), Great Britain Pound (GBP) and Japanese Yen (JPY). Currency options are currently available on US Dollars.