Derivatives – Boon or Bane

Before analyzing whether Derivative is a boon or bane. Let us start with the definition of Derivatives. Derivatives are financial instruments which derives its value from the underlying. This underlying can be anything as bullion, commodity, stock, or a stock index. Derivatives can be divided into Forwards, Futures, Options and Swaps broadly based on the purpose for which they are going to be used. Derivatives can either be traded over the Counter (OTC) or on an exchange. OTC’s are the one’s which are customized as per the requirements of the two parties and are not tradable in free market while exchange traded are the standardised one’s and are capable of being traded in an exchange. Now let us take an example and look at a simple derivative forward contract.

In this one party is the seller of the contract and the other is the buyer. Let us say the seller is selling gold at a price of Rupees 600. The seller agrees to buy gold 3 months from now at Rupees 610 and both of them get into an agreement. Essentially all the kind of derivatives contract relates to similar kind of agreements between two parties but with slight variations in terms of contract life, tradability and the purpose of the contract. Looking a bit deeper to the above example one can see that the contract is helping the buyer to first of all book an order for a future date by paying a premium to the seller and not the entire money which he would have to pay if he buys the gold today.

The buyer and the seller in a derivatives contract hold the views that the price of the commodity will rise and fall respectively in the future. Now this seems more like a gamble. But people who buy and sell these kinds of contracts do have their sound logic supported by arithmetic and experience. The derivative contracts are widely used to hedge the risk by different institutions or individuals as well.

Using derivative instruments one can earn a huge amount of profit by investing very less money in a very short span of time. But even though people have their logics behind these, one must not discount the fact that derivative is a zero sum game, wherein one person’s lose is another person’s gain. Now people can earn huge amounts of money in a short span of time but they can loose even bigger sums of money. Some of the example’s which can be cited in this regard are:

a. Nick Lesson leading to the downfall of Baring’s bank

b. Jerome Kerviel leading Societe Generale to a loss of $7.2 Billion in futures contract.

Now seeing these examples one can guess the amount of money which one can loose trading in these instruments.

But on the other hand these instruments can help people and organizations make a lot of money, and hedge their risks against the uncertainties, thus helping them to strengthen their financial positions and their bottom lines.

Derivatives market turnover in India

Derivatives market in India is mainly in two categories: index derivatives & stock derivatives. Index derivatives includes futures and options contracts based on the benchmark index, the most famous of them being Nifty - 50 index. The trading of contracts with Nifty-50 as underlying is done through NSE and the contract size is 50. With a value of Nifty at 6250 this sums to a contract size of 312500 rupees. There are three types of contracts depending on the settlement date: 1 , 2 , 3 month contracts. The contracts expiry date is set on thursday of the last week of each month, and a new contract is initiated on the next trading day.

The derivatives trading in India was started by NSE in June 2000 with the introduction of Nifty Futures. Index options were introduced one year later in June 2001. Since then the turnover in index based derivatives in NSE has grown several times. The following graph shows the turnover trend in NSE index derivatives (futures and options)

NSE launches MINIFTY for retail investors

India's biggest stock exchange National Stock Exchange (NSE) on December 27, 2007, has introduced a new contract, MINIFTY, in with S&P CNX Nifty Index as underlying. The new contract is a small derivatives contract and has a lot size of 20 for fures and options. The main contract NIFTY has lot size of 50. With the value of underlying at about 6250 points the total contract size of MINIFTY can be estimated about 125,000 INR. With the introduction of this contracts NSE, India's biggest derivatives exchange, expects the retail investors' participation to increase significantly. Currently NIFTY futures and options are the highest traded index derivatives in India with an average daily turnover of about INR 20000 crores (200 billion INR). With the introduction of MINIFTY there are arbitrage possibilities between Nifty and mini Nifty derivative contracts.

Nifty 50 is the benchmark index of NSE which captures the Indian stock market movement and is based on 50 highest market capitalization securities.

Thus, the cost of taking a derivative position on the index has reduced from around Rs 3 lakh to a little over Rs 1 lakh.

Bombay Stock Exchange (BSE) has also introduced a mini contract named MSX in the futures segment. The contract is based on BSE's benchmark index SENSEX and has a lot size of 5. The SENSEX is currently at about 20800, making the total contract amount to be just above Rs. 100,000. BSE's main product in the futures segment has a lot size of 25.

Securities and Exchange Board of India (SEBI) has approved the introduction of seven new derivative products for the Indian market. SEBI has put a minimum contract size limit of Rs. 100,000 on the contracts at the time of introduction in the market.