Introduction to Derivatives

Once upon a time in a small Indian village, there was a farmer named Rajesh. Each year, he planted wheat, hoping for good monsoons and a profitable harvest. But the weather was unpredictable, and Rajesh often found himself at the mercy of fluctuating wheat prices. Some years brought abundant rains and profits, while others brought drought and losses.

One year, with the monsoon season looking uncertain, Rajesh learned about derivatives—financial tools that could protect him from unpredictable price changes. Derivatives sounded like a solution to his problem. By using a futures contract, Rajesh could lock in a selling price for his wheat before the harvest, securing a fair price regardless of the weather.

What Are Derivatives?

A derivative is a financial contract whose value is derived from an underlying asset, such as wheat, oil, gold, or even stocks. In simple terms, derivatives help manage risk. They allow individuals or businesses to fix prices or hedge against market uncertainties.

For example, Rajesh used a futures contract to agree on a selling price for his wheat in advance. This ensured that no matter what happened to market prices, he would earn a fair price for his crop.

Derivatives aren’t just for farmers—they are widely used by investors, businesses, and governments to manage risks in their financial portfolios.

Types of Derivatives

1. Futures Contracts

A futures contract is an agreement to buy or sell an asset at a predetermined price on a specific date in the future. It obligates both the buyer and the seller to honour the contract.

2. Options Contracts

An options contract gives the holder the right—but not the obligation—to buy or sell an asset at a specified price within a set time frame. Options provide flexibility, as the holder can decide not to exercise the contract if market conditions are unfavourable.

Historical Background of Derivatives

The concept of derivatives dates back to 17th century Japan, where rice farmers used forward contracts to lock in prices and protect themselves from fluctuations in rice markets. By the 19th century, derivatives trading had spread to Europe and the United States.

India joined the derivatives market in the early 2000s:

• 2000: The National Stock Exchange (NSE) introduced equity futures contracts.
  
• Soon after, the Bombay Stock Exchange (BSE) and multi-commodity exchanges like the MCX and NCDEX followed suit.
  

Today, derivatives trading in India is thriving.

Derivatives in India Today

In 2023, the daily turnover of equity derivatives on the NSE exceeded ₹2.5 lakh crore (approximately $30 billion). The majority of this trading activity comes from equity derivatives like index futures and options, which allow traders to speculate on movements in stock indices like the Nifty 50.

In India, derivatives are regulated by the Securities and Exchange Board of India (SEBI), ensuring fairness and transparency in trading. Exchanges like the NSE and BSE monitor trading activity to prevent market manipulation and protect investors.

Benefits of Derivatives

Derivatives play a critical role in financial markets and offer a wide range of benefits:

1. Risk Management

For farmers like Rajesh, derivatives provide protection against price fluctuations, enabling better financial planning.

2. Portfolio Diversification

Investors use derivatives to hedge against market risks or diversify their portfolios.

3. Speculation Opportunities

Traders can speculate on the price movements of various assets, potentially earning profits in the process.

Rajesh’s Journey with Derivatives

By using a derivative—specifically, a futures contract—Rajesh locked in a selling price for his wheat, shielding himself from unpredictable weather and market prices. This newfound confidence allowed him to focus on growing his crops without worrying about financial uncertainties.

Conclusion

Derivatives have evolved from simple forward contracts for rice farmers in Japan to sophisticated financial tools used globally. In India, derivatives have become integral to the financial markets, empowering individuals and businesses to manage risk effectively. In the next chapter, we’ll explore the different types of derivatives—like futures and options—in greater detail and learn how they can be used to address specific financial needs.