Derivative

STUDY MATERIAL ON DERIVATIVES

COMPILED BY:

MS.DEEPIKA,ASSISTANT PROFESSOR,

DEPARTMENT OF COMMERCE

The derivative itself is a contract between two or more parties, and the derivative derives its price from fluctuations in the underlying asset.

Derivatives can trade over-the-counter (OTC) or on an exchange. OTC derivatives constitute a greater proportion of the derivatives market. 

There are many different types of derivatives that can be used for risk management, for speculation, and to leverage a position. Derivatives is a growing marketplace and offer products to fit nearly any need or risk tolerance.

Derivatives are financial instruments whose value is derived from other underlying assets. There are mainly four types of derivative contracts such as futures, forwards, options & swaps. However, Swaps are complex instruments that are not traded in the Indian stock market.

Forms of derivatives contracts

Trading in future and optionsTrading in derivatives like futures, and options were introduced in the Indian stock exchanges in the year 2000. Initially, the only futures, and options were for indices. A couple of years later, futures, and options in

individual stocks followed suit. Since then, futures, and options have become very popular, and account for most of the trading on the stock exchanges.

These instruments are handy for investors, and traders, and learning how to trade in futures and options is very important if you want to make the most of the ups, and downs of the stock market. , and it’s a pretty good idea to invest in the stock market since returns from equity have outperformed most other assets in the past few years. Of course, investing in equity, and its derivatives carry market risk, so it’s always better to proceed with a degree of caution.

Futures contracts enable a buyer or the seller to buy or sell stock at a certain predetermined price on a certain date in the future. This can be best illustrated with the help of an example of an expected increase in the share price of company BZ, which is currently at Rs 80. You then buy 1,000 BZ futures at Rs 80. So if the share price of BZ goes up to Rs 100, you will make 100-80×1000, or Rs 20,000. If the prices fall Rs 60, you make a loss of Rs 20,000

Option trading can be a little daunting if you are a new investor. It can appear to be a little complicated compared to the old, familiar asset classes like stocks, shares, bonds, and mutual funds. However, there are several advantages of options trading, and if you go into it armed with some knowledge and awareness, there are opportunities here that you may want to exploit. Moreover, it could be a good addition to a diversified portfolio.

Before going into topics like option trading tips, let’s first understand what an option is. An option is a derivative whose value derives from an underlying asset. There are two kinds of derivatives – futures and options. A futures contract gives you the right to buy or sell a certain asset at a fixed price at a future date. An options contract gives you the right, but not the obligation to do so.

An example of an options contract will make this clearer. Suppose you expect the share price of ABC company, currently at Rs 100, to fall. You then buy an options contract to sell the share at Rs 100 (this is called the `strike price’). If the ABC price then falls to Rs 90, you would have made Rs

10 on each option. If share prices were to rise to Rs 110, then naturally you wouldn’t want to sell at Rs 100 and incur a loss. In that case, you have the choice of not exercising your right. So, you don’t have to suffer any loss.

Types of OrdersThe most common types of orders are market orders, limit orders, and stop-loss orders.

A market order is an order to buy or sell a security immediately. This type of order guarantees that the order will be executed, but does not guarantee the execution price. A market order generally will execute at or near the current bid (for a sell order) or ask (for a buy order) price. However, it is important for investors to remember that the last-traded price is not necessarily the price at which a market order will be executed.

A limit order is an order to buy or sell a security at a specific price or better. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher. Example: An investor wants to purchase shares of ABC stock for no more than $10. The investor could submit a limit order for this amount and this order will only execute if the price of ABC stock is $10 or lower.

A stop loss order, also referred to as a stop-loss order is an order to buy or sell a stock once the price of the stock reaches the specified price, known as the stop price. When the stop price is reached, a stop order becomes a market order.

A buy stop order is entered at a stop price above the current market price. Investors generally use a buy stop order to limit a loss or protect a profit on a stock that they have sold short. A sell stop order is entered at a stop price below the current market price. Investors generally use a sell stop order to limit a loss or protect a profit on a stock they own.

Commodity derivativesIn commodity derivatives, the underlying asset is a commodity, such as cotton, gold, copper, wheat, or spices. Commodity derivatives were originally designed to protect farmers from the risk of under- or

overproduction of crops. Commodity derivatives are investment tools that allow investors to profit from certain commodities without possessing them. The buyer of a derivatives contract buys the right to exchange a commodity for a certain price at a future date. The buyer may be buying or selling the commodity. The buyer does not have to pay the full value of the amount of the commodity in which investment is made. He only needs to pay a small percentage, known as the margin price. On agreement, the seller gives the owner the ownership of the commodity at the agreed future date along with the physical delivery. Based on the spot price of the commodity the buyer makes profit or loss. Exchanges facilitate the contract settlements and clearing.

TRADING OF COMMODITY DERIVATIVES AT MULTI COMMODITY EXCHANGE OF INDIA

The Multi Commodity Exchange of India Limited (MCX),- India’s first listed exchange, is a state-of-the-art, commodity derivatives exchange that facilitates online trading of commodity derivatives transactions, thereby providing a platform for price discovery and risk management. The Exchange, which started operations in November 2003, operates under the regulatory framework of Securities and Exchange Board of India (SEBI). MCX offers trading in commodity derivative contracts across varied segments including bullion, industrial metals, energy and agricultural commodities. It is India’s first exchange to offer commodity options contracts. The Exchange focuses on providing commodity value chain participants with neutral, secure and transparent trade mechanisms, and formulates quality parameters and trade regulations, in conformity with the regulatory framework. The Exchange has an extensive national reach, with 692 registered members and 54,900 Authorised Persons with its presence in around 1010 cities and towns across India as on 31 March 2020. MCX is India’s leading commodity derivatives exchange with a market share of 94.01% per cent in terms of the value of commodity futures contracts traded in FY20.

The Exchange’s flagship index series, MCX iCOMDEX, is a series of real-time commodity futures price indices, which give information on market movements in key commodities traded on MCX. The iCOMDEX series consists of iCOMDEX Composite, apart from two sectoral indices: iCOMDEX Base Metals and iCOMDEX Bullion, and also four single-commodity indices: iCOMDEX Gold, iCOMDEX Silver, iCOMDEX Copper and iCOMDEX Crude Oil.

Multi Commodity Exchange Clearing Corporation Limited (MCXCCL), a wholly-owned subsidiary of MCX, is the first clearing corporation in the commodity derivatives market. The clearing corporation provides collateral management and risk management services, along with clearing and settlement of trades executed on the Exchange. The European Securities and Markets Authority (ESMA) has granted recognition to MCXCCL as a

third country CCP under European market infrastructure regulation. MCXCCL having state of art risk management system is the central counterparty for all trades executed on MCX’s trading platform. It also provides Electronic Commodity Accounting and Receipts Tracking System through web based portal ‘Commodity Receipts Information Systems’ (COMRIS). Further, it provides a settlement guarantee for all trades executed on MCX via Settlement Guarantee Fund (SGF).

With an aim to seamlessly integrate with the global commodities ecosystem, MCX has forged strategic alliances with leading international exchanges such as CME Group, London Metal Exchange (LME), Dalian Commodity Exchange (DCE), Taiwan Futures Exchange (TAIFEX), etc. The Exchange has also tied-up with various trade bodies, corporates, educational institutions and research centres across the country. These alliances enable the Exchange in improving trade practices, increasing awareness, and facilitating overall improvement of the commodity market.

MCX’s ability to use and apply technology efficiently is a key factor in the development of its business. The exchange’s technology framework is designed to provide high availability for all critical components, which guarantees continuous availability of trading facilities. The robust technology infrastructure of the exchange, along with its with rapid customization and deployment capabilities enables it to operate efficiently with fast order routing, immediate trade execution, trade reporting, real-time risk management, market surveillance and market data dissemination.

MCX has been continuously raising the bar through effective research and product development, intelligent use of information and technology, innovation, thought leadership and ethical business conduct. MCX has been certified with three ISO standards, ISO 9001:2015 Quality Management System, ISO 27001:2013 Information Security Management Standard and ISO 14001:2015 Environment Management Standard.

CURRENCY DERIVATIVES