NISM-Series-VIII: Equity Derivatives
Chapter 1: Basics of Derivatives
Authored by Divanshu Kapoor
1.1 What are Derivatives?
A derivative is a financial contract whose value is based on (or derived from) another asset called the underlying.
Underlying assets can be:
- Metals: Gold, Silver, Copper
- Energy: Oil, Coal, Electricity, Natural Gas
- Agriculture: Wheat, Coffee, Cotton
- Financial assets: Stocks, Bonds, Currencies
👉 Think of it like a "side bet" whose outcome depends on how another asset performs.
1.2 History & Evolution of Derivatives
- 12th Century Europe: Merchants signed contracts to deliver goods later.
- 17th Century Japan: Rice futures developed to protect farmers.
- 1630s Holland: "Tulip Mania" – a speculative bubble in tulip bulb futures.
- 1848 USA: Chicago Board of Trade (CBOT) introduced commodity forwards.
- 1865 USA: First standardized futures contract listed.
- 1973 USA: Chicago Board Options Exchange (CBOE) introduced options trading.
Why did derivatives grow so much?
- Increasing price volatility
- Global integration of markets
- Better technology
- Innovations in financial products
1.3 Indian Derivatives Market
- 1996: SEBI formed a committee (L.C. Gupta) to draft regulations.
- 1999: Law amended → derivatives officially recognized as “securities.”
- 2000: NSE & BSE started derivatives trading with Index Futures (Nifty, Sensex).
- 2001: Options introduced on indices & stocks.
- 2001 (Nov): Stock futures started.
- 2013: MSEI (another exchange) began derivatives trading.
Main Derivative Products in India:
- Forwards – Customized OTC contracts to buy/sell later at an agreed price.
- Futures – Exchange-traded standardized forwards.
- Options – Right (not obligation) to buy/sell at a fixed price.
- Swaps – Agreements to exchange cash flows (e.g., interest rate swaps).
1.4 Market Participants
- Hedgers – Reduce risk (e.g., farmers, companies).
- Speculators (Traders) – Take risk to make profits.
- Arbitrageurs – Exploit price differences in different markets for risk-free profit.
1.5 Types of Derivative Markets
- Exchange-Traded: Regulated, standardized, safe, transparent.
- Over-the-Counter (OTC): Customized, private, less regulated, riskier.
1.6 Significance of Derivatives
- Help in price discovery (finding true value).
- Enable risk transfer (from risk-averse hedgers to risk-takers).
- Move speculation from informal/unregulated markets to organized exchanges (safer).
1.7 Risks in Derivatives
- Counterparty Risk → The other party may default.
- Price Risk → Loss due to adverse price movement.
- Liquidity Risk → Can’t exit position easily.
- Regulatory/Legal Risk → Contract enforcement issues.
- Operational Risk → Fraud, errors, poor execution.
⚠️ Derivatives involve leverage → profits & losses can both be magnified.
✅ Key Takeaways:
- Derivatives are financial instruments linked to other assets.
- They evolved globally to manage risk & speculation.
- India introduced them in 2000 (starting with index futures).
- Market players: Hedgers, Speculators, Arbitrageurs.
- Traded on exchanges (safe) or OTC (customized, risky).
- Useful for risk management & price discovery, but carry risks.