What is a Derivative?

A derivative is a financial contract whose value is derived from the performance of an underlying entity — which could be an equity share, stock index, commodity, currency pair, or interest rate.

The underlying asset does not change hands in most derivative transactions. Instead, the parties settle based on the price change of the underlying.

Types of Derivatives

1. Forwards

A forward is an OTC (over-the-counter) agreement between two parties to buy/sell an asset at a future date at a price agreed today. Forwards are customised but carry counterparty risk — the risk that the other party defaults.

2. Futures

Futures are standardised forwards traded on an exchange. Counterparty risk is eliminated because the exchange clearing corporation (NSCCL for NSE) guarantees settlement. All equity futures in India are cash-settled.

3. Options

Options give the buyer a right but not an obligation to buy or sell. The buyer pays a premium; the seller earns the premium but takes on the obligation. NSE lists both index options (Nifty, Sensex) and single-stock options.

4. Swaps

Swaps are OTC agreements to exchange cash flows (e.g., fixed for floating interest rates). Common in currency and interest rate risk management. Not exchange-traded in India.

Market Participants

  • Hedgers: Use derivatives to reduce existing exposure. E.g., a fund manager holding a Nifty portfolio buys Nifty put options to protect against a market fall.
  • Speculators: Take calculated risk positions hoping to profit from price movements. They provide liquidity to the market.
  • Arbitrageurs: Exploit price differences between the spot and futures markets (or between two exchanges) for riskless profit, helping bring prices into alignment.

History of Derivatives in India

  • June 2000: SEBI permitted index futures on Nifty 50 and Sensex
  • June 2001: Index options introduced
  • July 2001: Stock options introduced
  • November 2001: Stock futures introduced
  • 2008 onwards: Currency derivatives, interest rate derivatives added
  • 2014 onwards: Weekly options introduced

Economic Functions of Derivatives

  1. Price Discovery: Futures prices reflect market consensus on future spot prices, providing valuable forward-looking information.
  2. Risk Transfer: Hedgers transfer price risk to speculators who are willing to bear it for a profit opportunity.
  3. Market Completeness: Allow strategies (e.g., going short, leveraged exposure) that are difficult or impossible in spot markets.