Swaps, options, futures, forwards, financial markets
With globalization of the financial sector, it's time to recast the architecture of the financial market. The liberalized policy being followed by the
Government of India and the gradual withdrawal of the procurement and distribution channel necessitated setting in place a market mechanism to perform the economic functions of price discovery and risk management. Till the mid –
1980's, the Indian financial system did not see much innovation. In the last 18 years, financial innovation in India has picked up and it is expected to grow in the years to come, as a more liberalized environment affords greater
scope for financial innovation at the same time financial markets are, by nature, extremely volatile and hence the risk factor is an important concern for financial agents. To reduce this risk, the concept of derivatives comes into
the picture. Derivatives are products whose values are derived from one or more basic variables called bases. India is traditionally an agriculture country with strong government intervention. Government arbitrates to maintain
buffer stocks, fix prices, impose import-export restrictions, etc. This paper focuses on the basic understanding about derivatives market and its development in India.
Derivatives are financial
contracts whose values are derived from the value of an underlying primary financial instrument, commodity or index, such as: interest rates, exchange rates, commodities, and equities. Derivatives include a wide assortment of
financial contracts, including forwards, futures, swaps, and options. The International Monetary Fund defines derivatives as "financial instruments that are linked to a specific financial instrument or indicator or commodity and
through which specific financial risks can be traded in financial markets in their own right. The value of financial derivatives derives from the price of an underlying item, such as asset or index. Unlike debt securities, no
principal is advanced to be repaid and no investment income accrues."
While some derivatives instruments may have very complex structures, all of them can be divided into basic building blocks of options, forward contracts or some combination thereof. Derivatives allow financial institutions and other participants to identify, isolate and manage separately the market risks in financial instruments and commodities for the purpose of hedging, speculating, arbitraging price differences and adjusting portfolio risks.
The emergence of the market for derivatives products, most notable forwards, futures, options and swaps can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising
out of fluctuations in asset prices. By their very nature, the financial markets can be subject to a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks
by locking-in asset prices. As instruments of risk management, derivatives products generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivatives products minimize the
impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.
Factors generally attributed as the major driving force behind growth of financial derivatives are:
(a) Increased Volatility in asset prices in financial markets,
(b) Increased integration of national financial markets with the international markets,
(c) Marked improvement in communication facilities and sharp decline in their costs,
(d) Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and
(e) Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets, leading to higher returns, reduced risk as well as transaction costs as compared to individual
Development of exchange-traded derivatives
Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th
century, and May well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for pre-arranging a buyer or
seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest.
The need for a derivatives market
The derivatives market performs a number of economic functions:
1. They help in transferring risks from risk adverse people to risk oriented people
2. They help in the discovery of future as well as current prices
3. They catalyze entrepreneurial activity
4. They increase the volume traded in markets because of participation of risk adverse people in greater numbers
5. They increase savings and investment in the long run
Types of Derivatives
Derivative contracts have several variants. The most common variants are forwards, futures, options and swap.
A forward contract is an agreement between two
parties – a buyer and a seller to purchase or sell something at a later date at a price agreed upon today. Forward contracts, sometimes called forward commitments, are very common in everyone life. For example, an apartment
lease is a forward commitment. By signing a one-year lease, the tenant agrees to purchase the service – use of the apartment – each month for the next twelve months at a predetermined rate. Like-wise, the landlord agrees to provide
the service each month for the next twelve months at the agreed-upon rate. Now suppose that six months later the tenant finds a better apartment and decides to move out. The forward commitment remains in effect, and the only way
the tenant can get out of the contract is to sublease the apartment. Because there is usually a market for subleases, the lease is even more like a futures contract than a forward contract.
Any type of contractual agreement
that calls for the future purchase of a good or service at a price agreed upon today and without the right of cancellation is a forward contract.
A futures contract is an agreement between
two parties – a buyer and a seller – to buy or sell something at a future date. The contact trades on a futures exchange and is subject to a daily settlement procedure. Future contracts evolved out of forward contracts and possess
many of the same characteristics. In essence, they are like liquid forward contracts. Unlike forward contracts, however, futures contracts trade on organized exchanges, called future markets. For example, the buyer of a future
contact, who has the obligation to buy the good at the later date, can sell the contact in the future market, which relieves him or her of the obligation to purchase the good. Likewise, the seller of the futures contract, who is
obligated to sell the good at the later date, can buy the contact back in the future market, relieving him or her of the obligation to sell the good. Future contacts also differ from forward contacts in that they are subject to a
daily settlement procedure. In the daily settlement, investors who incur losses pay them every day to investors who make profits.
Options are of two types - calls and puts. Calls give the
buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the
underlying asset at a given price on or before a given date.
Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded
as portfolios of forward contracts. The two commonly used swaps are interest rate swaps and currency swaps.
Interest rate swaps:
These involve swapping only the interest related cash flows between the parties in the same currency.
These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.
Derivatives Market in India
Derivatives markets have had a slow start in India. The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendments) Ordinance, 1995, which withdrew the prohibition on
options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24-member committee under the Chairmanship of Dr. L.C. Gupta on 18th
November 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee recommended that derivatives should be declared as 'securities' so that regulatory framework applicable to trading of
'securities' could also govern trading of securities. SEBI was given more powers and it starts regulating the stock exchanges in a professional manner by gradually introducing reforms in trading. Derivatives trading commenced in
India in June 2000 after SEBI granted the final approval in May 2000. SEBI permitted the derivative segments of two stock exchanges, viz NSE and BSE, and their clearing house/corporation to commence trading and settlement in
approved derivative contracts.
Introduction of derivatives was made in a phase manner allowing investors and traders sufficient time to get used to the new financial instruments. Index futures on CNX Nifty and BSE Sensex
were introduced during 2000. The trading in index options commenced in June 2001 and trading in options on individual securities commenced in July 2001. Futures contracts on individual stock were launched in November 2001. In June
2003, SEBI/RBI approved the trading in interest rate derivatives instruments and NSE introduced trading in futures contract on June 24, 2003 on 91 day Notional T-bills. Derivatives contracts are traded and settled in accordance
with the rules, bylaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette.
1. Richard A. Brealey
and Stewart C. Myers, Principles of Corporate Finance, Tata McGraw-Hill Publishing Company Ltd.
2. Don M. Chance, Options and Futures, the Dryden Press.
3. Chartered Financial Analyst, the ICFAI University Press, December 2004.
4. The Financial Express, December 2004.
5. I.M. Pandey, Financial Management, 8th Edition, Vikas Publishing House, Mumbai, 2002.