SCDL MBA PROJECT - Future markets its impact on economy

SCDL MBA PROJECT -  Future markets its impact on economy 

DERIVATIVES

The word “DERIVATIVES” is derived from the word itself derived of a underlying asset. It is a future image or copy of a underlying asset which may be shares, stocks, commodities, stock indices, etc.

Derivatives is a financial product (shares, bonds) any act which is concerned with lending and borrowing (bank) does not have its value borrow the value from underlying asset/ basic variables.

Derivatives is derived from the following products:

A.    Shares

B.     Debuntures

C.     Mutual funds

D.    Gold

E.     Steel

F.      Interest rate

G.    Currencies.

Derivatives is a type of market where two parties are entered into a contract one is bullish and other is bearish in the market having opposite views regarding the market. There cannot be a derivatives having same views about the market. In short it is like a INSURANCE  market where investors cover their risk for a particular position.

Derivatives are financial contracts of pre-determined fixed duration, whose values are derived from the value of an underlying primary financial instrument, commodity or index, such as: interest rates, exchange rates, commodities, and equities.

Derivatives are risk shifting instruments. Initially, they were used to reduce exposure to changes in foreign exchange rates, interest rates, or stock indexes or commonly known as risk hedging. Hedging is the most important aspect of derivatives and also its basic economic purpose. There has to be counter party to hedgers and they are speculators. Speculators don’t look at derivatives as means of reducing risk but it’s a business for them. Rather he accepts risks from the hedgers in pursuit of profits. Thus for a sound derivatives market, both hedgers and speculators are essential.

Derivatives trading has been a new introduction to the Indian markets. It is, in a sense promotion and acceptance of market economy, that has really contributed towards the growing awareness of risk and hence the gradual introduction of derivatives to hedge such risks.

Initially derivatives was launched in America called Chicago. Then in 1999, RBI introduced derivatives in the local currency Interest Rate markets, which have not really developed, but with the gradual acceptance of the ALM guidelines by banks, there should be an instrumental product in hedging their balance sheet liabilities.

The first product which was launched by BSE and NSE in the derivatives market was index futures

BACKGROUND

Consider a hypothetical situation in which ABC trading company has to import a raw material for manufacturing goods. But this raw material is required only after 3 months. However in 3 months the prices of raw material may go up or go down due to foreign exchange fluctuations and at this point of time it can not be predicted whether the prices would go up or come down. Thus he is exposed to risks with fluctuations in forex rates. If he buys the goods in advance then he will incur heavy interest and storage charges. However, the availability of derivatives solves the problem of importer. He can buy currency derivatives. Now any loss due to rise in raw material prices would be offset by profits on the futures contract and vice versa. Hence the company can hedge its risk through the use of derivatives

DEFINATIONS

According to JOHN C. HUL  “ A derivatives can be defined as a financial instrument whose value depends on (or derives from) the values of other, more basic underlying variables.”

According to ROBERT L. MCDONALD “A derivative is simply a financial instrument (or even more simply an agreement between two people) which has a value determined by the price of something else.

With Securities Laws (Second Amendment) Act,1999, Derivatives has been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act, as:-

A Derivative includes: -

a.       a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;

     b. contract which derives its value from the prices, or index of prices, of      underlying securities.                                                                                            

Derivatives were developed primarily to manage, offset or hedge against risk but some were developed primarily to provide the potential for high returns.

INTRODUCTION TO FUTURE MARKET

Futures markets were designed to  solve the problems that exit in forward markets. A     futures con tract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. There is a multilateral contract between  the buyer  and seller for a underlying asset which may be financial instrument or physical commodities. But unlike forward contracts the future contracts are standardized and exchange traded.

PURPOSE

The  primary  purpose of futures market is to provide an efficient and effective mechanism for management of inherent risks, without counter-party risk.

It is a derivative  instrument and a type of forward contract The future contracts are affected mainly by the prices of the underlying  asset. As  it  is a future contract the buyer and seller has to pay  the margin to trade in the  futures market

It is essential that both the parties compulsorily discharge their respective obligations on the settlement day only, even though the payoffs are on a daily marking to market basis to avoid default risk. Hence, the gains or losses are netted off on a daily basis and each morning starts with a fresh opening value. Here both the parties face an equal amount of risk and are also required to pay upfront margins to the exchange irrespective of whether they are buyers or sellers. Index based financial futures are settled in cash unlike futures on individual stocks which are very rare and yet to be  launched even in the US. Most of the financial futures worldwide are index based and hence the buyer never comes to know who the seller is, both due to the presence of the clearing corporation of the stock exchange in between and also due to secrecy reasons

EXAMPLE

The current market price of INFOSYS COMPANY is Rs.1650.

There are two parties in the contract i.e. Hitesh and Kishore. Hitesh is bullish and kishore is bearish in the market. The initial margin is 10%. paid by the both parties. Here the Hitesh has purchased the one month contract of INFOSYS futures with the price of Rs.1650.The lot size of infosys is 300 shares.