Investors put their money into the financial market with the hope that they will make good returns. However, the investment may turn risky due to volatility within the prices of securities such as those of equity, currency, commodities, and others. As a result of these fluctuations, all predictions could go one of two ways. This raises one’s chances of wiping out their entire set of investments. For this reason, the main concern of traders is that of the risk associated with the flow of returns in financial markets, especially when they are trading regularly.
To appeal to varying interests, there are a variety of instruments available on the market that can protect a trader from the volatility and risks of financial markets. Such instruments not only protect traders but also guarantee a potential yield. Such instruments are derivatives. The fact is that it is surprising to learn just how many types of derivatives exist. In this article, we will learn about the concept of derivative securities and the different types of financial derivatives that one can consider investing in. But first, what exactly is meant by derivatives?
What are derivatives?
Financial contracts that earn their value from that of the underlying asset are known as derivatives. The value of derivatives keeps on changing depending upon market conditions. Derivatives can be traded by predicting the underlying asset’s future price movement. Derivatives contracts are often used to make good returns while speculating. Derivative securities can be utilized for a variety of purposes such as access to additional assets, hedging, and more. Now let’s take a look at the different varieties of derivates in India.
Click here to read more about What are Derivatives?
Types of derivatives in India
There are four different types of derivates in India that can conveniently be traded on the Indian stock markets. Each differs from the other while having different contract conditions, risk factors, and more. The different derivative securities types are
- Future Contracts
- Options Contracts
- Forward Contracts
- Swap Contracts
We will take a look at each of these types of currency derivatives contracts in detail.
Similar to a forward contract, a futures contract is an agreement that involves buying or selling an underlying instrument at a future date at some specified price. In the futures contract, both the seller and the buyer choose to enter into an agreement that states as follows. The agreement that is between them via the futures contract is an exchange. As there is a standardized contract in a futures contract, the risk for counterparty is quite low. Additionally, the clearinghouse will serve as the counterparty for both parties of the contract which will further minimize credit risk.
Being a contract that is standardized, a forward contract is fixed and also regulated by the stock exchange, Futures contracts are listed on the stock exchange and are standardized in nature, which is why they cannot be modified in any way. To keep it simple, these contracts have a format that is pre-decided in terms of their expiration date, and size. In a futures derivative securities contract, an initial margin is often required as collateral, while a settlement is carried out on a daily basis.
An options derivatives contract is the second type of derivatives contract out there. This type of derivative is quite different from both the future and forward contracts mentioned earlier, as there it is not mandatory to dispense with the contract on a certain predecided date. Hence, options contracts are those types of contracts that give the trader the right without the obligation to either sell or buy an underlying asset. There are two different types of options: put or call options. In the call option, the buyer receives the right to purchase an asset at a price that is predetermined when they are entering the contract.
Alternatively, with the aid of a put option, the buyer has the opportunity but not the obligation to sell some underlying asset at a predetermined rate when she or he chooses to enter into the contract. In both of these contracts, the buyer receives the option to settle their contract either on or before the expiry period. Hence, anyone that is trading in the options contract can take any one of four positions — either call or put options with long or short positions in either. Options derivates are traded at the stock exchange and over the counter market.
Let’s assume two trading parties enter into an agreement where they either sell or buy an underlying asset at an agreed price at some future date. This is a forward contract. Sounds familiar? A futures contract is very similar to a forward contract. In a forward contract, both parties have the agreement to sell some underlying security at a future date. Forward contracts are customized to possess a decent amount of counterparty risk, which depends upon the term and size of the contract. Unlike futures contracts, however, there is no collateral necessary for a forward derivative securities contract, as they are self-regulated. Forward contracts derivates in India are settled on their maturity date, and they must, hence, be reversed by the time their expiry period approaches.
These are probably the most complicated types of derivates in India. In general, a swap contract is a private agreement between two trading parties. Both parties in the contract choose to exchange their cash flow at some point in the future as per a predetermined formula. The currency derivates underlying a swap contract is either an interest rate or currency itself- both of which are volatile in nature. Hence, swap contracts tend to protect parties from various risks. Such types of derivative securities are not traded on public exchanges. Instead, investment bankers serve as the middlemen for these transactions.
Who Participates in the Derivatives Market?
The participants in the derivative markets are divided into the following categories:
Hedgers participate in the derivative market to lower their risk exposure. They are risk-averse traders in the stock market. They take positions in the derivative market against the current market trend. This way, they transfer the risk to those who are ready to take it.
Let’s understand the situation with an example. You have 100 shares of company ABC that you want to sell after three months. Say the current market price is ₹150. In 3 months, the price can go up following the current trend or down. Hedgers would try to protect themselves by taking the opposite position. In this case, buying a put option to safeguard against a fall in the stock price.
Speculators lie on the opposite pole of hedgers. They are risk-takers. Speculators would take aggressive positions in the market to make large profits. In the above example, the put option seller is a speculator. The speculator bet that the stock price would not fall and the contract would expire worthless. In this case, the speculator makes a profit by keeping the premium.
3. Margin traders
Margin traders leverage their capital to take larger positions, speculating on the future price movements of underlying assets. Margin trading in derivatives can magnify both profits and losses.
Arbitrageurs in the derivative market capitalise on market imperfections. When there is a price difference for the same security in two markets, Arbitrageurs will buy the securities at a low price in one market and sell them at a higher price in another, making a profit in between. Arbitrageurs are low-risk investors who don’t take market positions like speculators.
Why Do Investors Enter Into Derivative Contracts?
Besides making profits, traders would enter the derivatives market for other reasons, such as:
- Hedging Risk
Derivatives are valuable tools for managing risk. Investors use them to hedge against unfavourable price movements in underlying assets. For example, a wheat farmer can use futures contracts to lock in a selling price to protect against potential price declines.
Some investors enter into derivative contracts to speculate on the future price movements of underlying assets. They seek to profit from these price changes without owning the actual asset. Derivatives allow for leveraged positions, potentially magnifying gains or losses.
3. Portfolio Diversification
Derivatives can be used to diversify investment portfolios. By adding assets like options or futures to a portfolio of stocks and bonds, investors can spread risk and reduce the correlation between their holdings.
Derivatives offer the potential for substantial profits with a relatively small upfront investment, thanks to leverage. Traders can control larger positions than they could with the same amount of capital invested directly in the underlying asset. However, leverage also increases the risk of significant losses.
5. Income Generation
Some investors use options strategies like covered calls or cash-secured puts to generate income. They receive premiums for selling options contracts and may benefit from the passage of time or reduced volatility.
6. Arbitrage Opportunities
Arbitrageurs seek to profit from price disparities between related assets in different markets. Derivatives enable them to simultaneously buy and sell these assets to exploit price differences, effectively eliminating risk.
7. Tax Efficiency
In some cases, derivatives can offer tax advantages. For instance, certain types of options may have more favorable tax treatment than direct ownership of the underlying asset.
Some of the best hedging instruments are derivatives contracts like forward contracts, futures, options, and swap contracts. Traders have the opportunity to predict price movements using these derivatives contracts and thereby improve their margin for gains through them.
What are the types of derivatives available in India?
There are 3 major derivative types that trade on the Indian stock exchanges.
- Equity and index derivatives
- Commodity derivatives
- Currency derivatives
What are OTC derivatives?
OTCs are over-the-counter derivatives. It’s a financial contract between two parties with minimum regulations or intermediation. Because of little regulatory intervention, OTCs carry higher counterparty risks.
Where are derivatives traded in India?
Derivatives are traded on the BSE, NSE, United Stock Exchange (USE) and MCX-SX exchanges in India.
What are Nifty derivatives?
Nifty futures are a derivative contract. It has the Nifty50 index as the underlying asset.
Can individuals trade derivatives in India?
Yes, individuals can trade derivatives in India. They can open trading accounts with registered brokers and access derivatives markets through recognised stock exchanges.