Derivative
• Derivative are type of Securities derived from debt instrument, share, loans and contract
which derive their value from underlying assets
• Derivatives are financial Contract that derive their value from underlying asset/value such
as equity shares, treasury bills, commodities, foreign exchange, real estate, etc.
• They are in the form of Futures and Option
• Both RBI and SEBI regulate Derivatives
• § 2 (ac) of SCRA defines “derivative” as: a financial instrument or a contract which derive
its value from underlying securities, risk instruments, index of prices, etc., is treated as
derivative
• Units of Collective Investment Scheme / Mutual Funds Units
o CIS / Mutual Funds are pools which accept contributions or payments from
investors and deploy the same to derive profits out of such investments.
• Difference in terms of their investment objective:
o CIS – makes investment in plantations, Real estate and the like.
o Mutual Fund – Exclusively in securities
• Derivatives, such as options or futures, are financial contracts which derive their value off a
spot price time-series, which is called “the underlying". For examples, wheat farmers may wish
to contract to sell their harvest at a future date to eliminate the risk of a change in prices by
that date.
• Such a transaction would take place through a forward or futures market.
• This market is the “derivative market", and the prices on this market would be driven by the
spot market price of wheat which is the “underlying".
• The terms “contracts" or “products" are often applied to denote the specific traded instrument.
• The world over, derivatives are a key part of the financial system. The most important contract
types are futures and options, and the most important underlying markets are equity, treasury
bills, commodities, foreign exchange and real estate.
• Hedging is an exercise in covering risk.
• Investors operating in the equity market need to cover their risks against price volatility. This
is done by entering into derivatives/ futures contracts.
• The law now permits derivatives transactions based on BSE and NSE.
• When an investor buys an equity, by taking an opposite position in a futures contract the risk
is mitigated. Futures Trading takes place on designated stock exchanges.
• Dynamic hedging is one of the trading strategies. This involves constant changes in futures
position in response to changes in the price of underlying assets and the rate at which the
price of the underlying asset is changing.
• A derivative is defined in SCRA – § 2(ac). A derivative is defined as –
o A Securities derived from a debt instrument, share, loan whether secured or
unsecured, risk instrument or contract for differences or any other forms of security;
o A contract which derives its value from the prices, or index of prices, of underlying
securities.
