The term “derivatives” is used to refer to
financial instruments which derive their value from some underlying assets. The
underlying assets could be equities (shares), debt (bonds, T-bills, and notes),
currencies, and even indices of these various assets, such as the Nifty 50
Index. Derivatives derive their names from their respective underlying asset.
Thus if a derivative’s underlying asset is equity, it is called equity
derivative and so on.
Derivatives can be traded either on a
regulated exchange, such as the NSE or off the exchanges, i.e., directly
between the different parties, which is called “over-the-counter” (OTC) trading.
(In India only exchange traded equity derivatives are permitted under the law.)
The basic purpose of derivatives is to transfer the price risk (inherent in
fluctuations of the asset prices) from one party to another; they facilitate
the allocation of risk to those who are willing to take it.
Two
important terms
Before discussing derivatives, it would be
useful to be familiar with two terminologies relating to the underlying
markets. These are as follows:
Spot
Market
In the context of securities, the spot market
or cash market is a securities market in which securities are sold for cash and
delivered immediately. The delivery happens after the settlement period. Let us
describe this in the context of India. The NSE’s cash market segment is known
as the Capital Market (CM) Segment. In this market, shares of SBI, Reliance,
Infosys, ICICI Bank, and other public listed companies are traded. The
settlement period in this market is on a T+2 basis i.e., the buyer of the
shares receives the shares two working days after trade date and the seller of
the shares receives the money two working days after the trade date.
Index
Stock prices fluctuate continuously during
any given period. Prices of some stocks might move up while that of others may
move down. In such a situation, what can we say about the stock market as a
whole? Has the market moved up or has it moved down during a given period? Similarly,
have stocks of a particular sector moved up or down? To identify the general
trend in the market (or any given sector of the market such as banking), it is
important to have a reference barometer which can be monitored. Market
participants use various indices for this purpose. An index is a basket of
identified stocks, and its value is computed by taking the weighted average of
the prices of the constituent stocks of the index. A market index for example
consists of a group of top stocks traded in the market and its value changes as
the prices of its constituent stocks change. In India, Nifty Index is the most
popular stock index and it is based on the top 50 stocks traded in the market.
Just as derivatives on stocks are called stock derivatives, derivatives on
indices such as Nifty are called index derivatives.
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