Derivative: Concept, Definition and Types
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| TYPES OF DERIVATIVE |
Definitions of Derivatives
The term “Derivative” indicates that it has no independent value, i.e., its value is entirely derived from the value of the underlying asset. The underlying asset can be securities, commodities, bullion currency, livestock or anything else.
The underlying securities for derivatives are:
(a) Commodities (Castor seed, Grain, Coffee Beans, Pepper,
Potatoes)
(b) Precious Metals (Gold, Silver)
(c) Short-term Debt Securities (Treasury Bills)
(d) Interest Rate
(e) Common Shares/Stock
(f) Stock Index Value (NSE Nifty)
In other words, derivative means forward, futures, option or
other hybrid contract of predetermined fixed duration, linked for the purpose
of contract fulfilment to the value of a specified real or financial asset or
to an index of securities. (c) Short-term Debt Securities (Treasury Bills)
(d) Interest Rate
(e) Common Shares/Stock
(f) Stock Index Value (NSE Nifty)
The Securities Contracts (Regulation) Act 1956 defines
“derivative” as under: “Derivative” includes:
1. 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.
The above definition conveys that:
·
The derivatives are financial products. · Derivative is derived from another financial instrument/contract called the underlying. In the case of Nifty futures, Nifty index is the underlying. A derivative derives its value from the underlying assets.
Accounting Standard SFAS 133 defines a derivative as, ‘a
derivative instrument financial derivative or other contract with all three of
the following characteristics:
·
It has one or more underlying, and
· it has one or more notional amount or payments provisions or both. Those terms determine the amount of the settlement or settlements.
· It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contract that would be expected to have a similar response to changes in market factors
· Its terms require or permit net settlement. It can be readily settled net by means Notes outside the contract or it provides for delivery of an asset that puts the recipient
· it has one or more notional amount or payments provisions or both. Those terms determine the amount of the settlement or settlements.
· It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contract that would be expected to have a similar response to changes in market factors
· Its terms require or permit net settlement. It can be readily settled net by means Notes outside the contract or it provides for delivery of an asset that puts the recipient
Types of Derivatives:
In simple form, the derivatives can be classified into different categories which are shown in above figure. One form of classification of derivative instruments is between commodity derivatives and financial derivatives. The basic difference between these is the nature of the underlying instrument or asset.
Financial derivative:
In a financial derivative, the underlying instrument may be treasury bills, stocks, bonds, foreign exchange, stock index, gilt-edged securities, cost of living index, etc.It is observed that financial derivatives are those assets whose values are determined by the value of some other assets, called as the underlying. Presently, there are bewilderingly complex varieties of derivatives already in existence, and the markets are innovating newer and newer ones continuously. For example, various types of financial derivatives based on their different properties like, plain, simple or straightforward, composite, joint or hybrid, synthetic, leveraged, mildly leveraged, customized or OTC traded, standardized or organized exchange traded, etc., are available in the market.
Commodity Derivative:
In a commodity derivative, the underlying instrument is a commodity which may be wheat, cotton, pepper, sugar, jute, turmeric, corn, soybeans, crude oil, natural gas, gold, silver, copper and so on.
It is to be noted that financial derivative is fairly
standard and there are no quality issues whereas in commodity derivative, the
quality may be the underlying matters. However, the distinction between these
two from structure and functioning point of view, both are almost similar in
nature. Another way of classifying the derivatives is into basic and complex
derivatives.
1. Basic derivative
Here we take a brief look at various derivatives contracts
that have come to be used.
1.
Forwards: A forward contract is a
customized contract between two entities, where settlement takes place on a
specific date in the future at today’s pre-agreed price. The rupee-dollar
exchange rates is a big forward contract market in India with banks, financial
institutions, corporate and exporters being the market participants. Forward
contracts are generally traded on Over The Counter Exchange.2. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts. Unlike forward contracts, the counterparty to a futures contract is the clearing corporation on the appropriate exchange. Futures often are settled in cash or cash equivalents, rather than requiring physical delivery of the underlying asset. Parties to a Futures contract may buy or write options on futures.
3. Options: An option represents the right (but not the obligation) to buy or sell a security or other asset during a given time for a specified price (the “strike price”). 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.
4. Swaps: 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. Swaps generally are traded OTC through swap dealers, which generally consist of large financial institution, or other large brokerage houses. There is a recent trend for swap dealers to mark to market the swap to reduce the risk of counterparty default. The two commonly used swaps are:
a. Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.
b. Currency swaps: 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. Swaps may involve cross-currency payments (U.S. Dollars vs. Mexican Pesos) and cross market payments, e.g., U.S. short-term rates vs. U.K. short term rates.
2. Other Types of Derivatives
1. Warrants: Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.2. LEAPS: The acronym LEAPS means Long-term Equity Anticipation Securities. These are options having a maturity of up to three years.
3. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options.
Participants in a Derivative Market
The derivatives market is similar to any other financial market and has following three broad categories of participants:
Hedgers: These are investors with a present or
anticipated exposure to the underlying asset which is subject to price risks.
Hedgers use the derivatives markets primarily for price risk management of
assets and portfolios.
Example: An importer from India has to pay 600/ $ to
buy goods from USA and rupee is expected to fall to `65/$ from ` 60/$, then the
importer can minimize his losses by buying a currency future at ` 62/$.
Speculators: These are individuals who take a view on
the future direction of the markets. They take a view whether prices would rise
or fall in future and accordingly buy or sell futures and options to try and
make a profit from the future price movements of the underlying asset.
Example: If an investor speculate that the stock
price of Infosys is expected to go up to ` 600 in 1 month, then he can hedge
the risk by buying a 1-month future of infosys at ` 500 and make profits.
Arbitragers: These are the third important
participants in the derivatives market. They take positions in financial
markets to earn risk less profits. The arbitragers take short and long
positions in the same or different contracts at the same time to create a
position which can generate a risk less profit
Example: A futures price is simply the current price
plus the interest cost. If there is any change in the interest, it presents an
arbitrage opportunity.RELATED POSTS:
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