Understanding Derivative Markets in India

Derivatives trading can be traced back to Mesopotamia in the 2nd century BCE and, more recently, to the Dojima Rice Exchange in eighteenth-century Japan. The trade in derivatives became more common in the modern era when traders needed a system to account for the fluctuation of prices or the different values for various national currencies. Derivative markets are now a cornerstone of modern finance, playing critical economic roles.

Types of Derivatives Markets

Derivatives markets are generally divided into two groups: Exchange Traded Derivatives and Over Counter Derivatives.

Exchange-Traded Derivatives: Exchange-traded derivatives markets involve the trading of regulated and standardised contracts through a stock exchange. These transactions are generally settled with a CCP, a central counterparty.

Over the Counter (OTC) Derivatives: Over-The-Counter derivatives refer to the trading of customised transactions between two parties directly, without the oversight of an exchange. Since such trading involves direct exposure of the parties, OTCs may lead to counterparty risk.

Additional read: How to Manage Risk While Trading in Derivatives

Types of Derivatives

Typical forms of derivatives transactions include the following:

• Future contracts are contracts wherein two parties agree to sell an underlying asset for a fixed price at a set date in the future.
• Forwards are future contracts that are only transacted on OTCs.
• Swaps are instruments used by traders to change from one cash flow to another.
• An option is a contract wherein the buyer is not obligated to fulfil their agreement.

Participants of Derivatives Markets

Participants of derivatives markets can be categorised into three types:

• Hedgers: Hedgers refer to the risk-averse traders who are looking to protect themselves from financial risk by transferring risk to another party. Hedging involves the locking in of a fixed price for derivatives.
• Speculators: Speculators refer to high-risk traders who take risks from hedgers to profit from price speculations. Speculators act as sources of liquidity in a market.
• Arbitrageurs: Arbitrageurs are traders who profit by taking advantage of the price difference of an asset between different markets. They simultaneously put buying and selling transactions to minimise market risk.

Functions of Derivatives Markets in India

Derivatives markets perform the following economic functions:

• Derivatives markets provide the impetus for entrepreneurial activity.
• Derivatives markets provide liquidity to capital markets and contribute to the efficiency of the markets.
• Derivatives trading determines the price of underlying assets through trading of risk between risk-averse and risk-oriented traders.
• Derivatives trading helps in diversification and protection from inflation and deflation.

Requirements for Trading in Derivatives Markets

Trading in derivatives markets require the following:

• Demat Account: A demat account stores financial securities digitally.
• Trading Account: A trading account refers to the account through which trade is conducted. Trading accounts are linked to demat accounts and serve as trader identity in markets.
• Margin Maintenance: Margin maintenance refers to maintaining the initial deposit, which is a percentage of the total value of a trader’s position.

Criticism of Derivatives Markets

• High risk in trading with financial instruments, especially OTCs.
• Financial instruments are susceptible to even small changes to the price due to the volatile nature of the markets.
• The complexity of trading in derivatives is due to their high-risk nature and sensitivity to market fluctuations.
• Derivatives trading has been compared to legalised gambling due to the high-risk speculations involved in such trade.

Conclusion

Derivatives markets thus represent complex financial transactions that can either be used for long-term investments or short-term profits. While high risks and high volatility make them risky endeavours, they can lead to long-term financial stability if managed carefully.