An Overview of Derivatives: Understanding the Basics and the Growth of the Global Market, with a Focus on the Indian Derivative Market.

Derivatives are financial products whose value is derived from the value of some other underlying asset. The underlying assets can be a wide range of things such as metals like gold, silver, aluminum, copper, zinc, nickel, tin, and lead. They can also be energy resources like crude oil, coal, electricity, and natural gas. In addition, derivatives can be based on agricultural commodities such as wheat, sugar, coffee, cotton, and pulses, as well as financial assets like shares, bonds, and foreign exchange. Understanding the basics of derivatives is important for investors who want to diversify their portfolios and potentially earn profits through trading in these financial instruments.

The history of the derivatives market can be traced back several centuries. Below are some significant milestones in the evolution of the derivatives market worldwide:

12th Century: During European trade fairs, sellers signed contracts promising future delivery of the items they sold. 13th Century: English Cistercian monasteries frequently sold their wool up to 20 years in advance to foreign merchants through contracts. 1634-1637: The Tulip Mania in Holland led to fortunes being lost after a speculative boom in tulip futures burst.  Late 17th Century: In Japan, a futures market in rice was developed at Dojima near Osaka to protect rice producers from bad weather or warfare. In 1848, The Chicago Board of Trade (CBOT) facilitated the trading of forward contracts on various commodities. In 1865, the CBOT listed the first "exchange-traded" derivative contract in the US, called "futures contracts." In 1919, the Chicago Butter and Egg Board, a spin-off of the CBOT, was reorganized to allow futures trading. Later, it was renamed the Chicago Mercantile Exchange (CME). In 1972, the CME introduced the International Monetary Market (IMM), which allowed trading in currency futures. In 1973, the Chicago Board Options Exchange (CBOE) became the first marketplace for trading listed options. In 1975, the CBOT introduced the Treasury bill futures contract, which was the first successful pure interest rate futures. In 1977, the CBOT introduced the T-bond futures contract. In 1982, the CME introduced the Eurodollar futures contract, and the Kansas City Board of Trade launched the first stock index futures. In 1983, the CBOE introduced options on stock indexes with the S&P 100® (OEX) and S&P 500® (SPXSM) indexes. 

Over the last four decades, the global derivatives market has experienced significant growth. This growth has been driven by several factors, including:

Increased volatility in underlying asset prices in financial markets, has led to the need for effective risk management strategies. The integration of financial markets globally has created a demand for cross-border risk management tools. The use of advanced technology in communications has helped to reduce transaction costs and make it easier to trade derivatives across borders. The enhanced understanding of market participants on sophisticated risk management tools to manage risk, such as hedging strategies using derivatives. Frequent innovations in the derivatives market and the development of new products and applications to meet the evolving needs of market participants. All of these factors have contributed to the growth of the global derivative market and have made derivatives an important tool for investors and traders around the world to manage risk and generate returns.

Indian Derivative Market

The Indian Derivatives Market was established with the aim of introducing derivatives trading in India. To develop an appropriate regulatory framework for derivatives trading, a 24-member committee was set up under the Chairmanship of Dr. L. C. Gupta in November 1996, which submitted its report on March 17, 1998.  Later, a group was set up in June 1998 under the Chairmanship of Prof. J.R.Verma to recommend measures for risk containment in the derivatives market in India, which submitted its report in October 1998.

In 1999, the Securities Contract Regulation Act (SCRA) was amended to include “derivatives” within the domain of ‘securities,’ and a regulatory framework was developed for governing derivatives trading. In March 2000, the government repealed a three‐decade‐old notification, which prohibited forward trading in securities. The exchange-traded derivatives started in India in June 2000, with SEBI permitting BSE and NSE to introduce the equity derivative segment. Initially, SEBI approved trading in index futures contracts based on Nifty and Sensex, which commenced trading in June 2000. Later, trading in Index options commenced in June 2001, and trading in options on individual stocks commenced in July 2001. Futures contracts on individual stocks started in November 2001. Metropolitan Stock Exchange of India Limited (MSEI) started trading in derivative products in February 2013.

The derivatives market in India offers various products like Forwards, Futures, Options, and Swaps. Forwards are Over-the-counter (OTC) contracts, and both the contracting parties are committed and obliged to honor the transaction irrespective of the price of the underlying asset at the time of delivery. Futures contracts are similar to forwards, except that the deal is made through an organized and regulated exchange. Options give the right, but not an obligation, to buy or sell the underlying on or before a stated date and at a stated price. Swaps are an agreement made between two parties to exchange cash flows in the future according to a prearranged formula.

There are three types of participants in the derivatives market ‐ hedgers, traders, and arbitrageurs. Hedgers use derivatives to reduce the risk associated with the prices of underlying assets. Corporations, investing institutions, and banks all use derivative products to hedge or reduce their exposures to market variables such as interest rates, share values, bond prices, currency exchange rates, and commodity prices. Traders try to predict the future movements in prices of underlying assets and based on their views, take positions in derivative contracts. Arbitrageurs produce a profit by exploiting a price difference in a product in two different markets.

In the modern world, there is a huge variety of derivative products available, either traded on organized exchanges or agreed directly between the contracting counterparties over the telephone or through electronic media. The Over-the-counter (OTC) market is not a physical marketplace but a collection of broker-dealers scattered across the country. The main idea of the market is more a way of doing business than a place. The OTC derivative market is less regulated because these transactions occur in private among qualified counterparties who are supposed to be capable enough to take care of themselves.