Page 7 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes The word ‘derivatives’ originated in mathematics and refers to a variable that has been derived
from another variable. For example, a measure of distance in kilometres could be derived from
a measure of distance in miles by dividing by 1.61, or similarly a measure of temperature in
Celsius could be derived from a measure of temperature in Fahrenheit. In financial sense, a
derivative is a financial product which had been derived from a market for another product.
The first trade in derivatives was a culmination of legislative and legal efforts which had begun
as early as 1995. In 1995, SEBI appointed a committee for exploring issues in introduction and
creating a regulatory framework for a derivative market. After the committee report was
tabled, the first action taken was to wet nurse the derivatives market by adopting the entire
regulatory framework of securities. This was done simply by defining securities to include
derivatives and removing certain prohibitions on forward and options trading. Thus, the entire
framework of existing securities Regulations including anti-fraud and various disclosure
obligations have become part of the regulations of derivatives in India. This is in sharp contrast
to the introduction of futures on individual stocks in US. Their introduction took 20 years,
endless bickering between the two regulators Securities Exchange Commission (SEC) and
Commodity Futures Trading Commission (CFTC), a new Act which lays down several
requirements for trading which should rightfully be in the bye-laws of the exchange/board of
trade. By that standard, India managed to leapfrog as far as not just technology but also regulations.
The introduction of new products has seen more of changes in the micro regulations like
margining and default.

1.1 Definitions of Derivatives

The term “Derivative” indicates that it has no independent value, i.e., its value is entirely
derived from the value of the underlying asset. The underlying asset can be securities,
commodities, bullion currency, livestock or anything else. In other words, derivative means
forward, futures, option or other hybrid contract of predetermined fixed duration, linked for the
purpose of contract fulfilment to the value of a specified real or financial asset or to an index of
securities.
The Securities Contracts (Regulation) Act 1956 defines “derivative” as under:
“Derivative” includes:

1. Security derived from a debt instrument, share, loan whether secured or unsecured, risk
instrument or contract for differences or any other form of security.
2. A contract which derives its value from the prices, or index of prices of underlying securities.

The above definition conveys that:
1. The derivatives are financial products.
2. Derivative is derived from another financial instrument/contract called the underlying.
In the case of Nifty futures, Nifty index is the underlying. A derivative derives its value
from the underlying assets.
3. Accounting Standard SFAS 133 defines a derivative as, ‘a derivative instrument financial
derivative or other contract with all three of the following characteristics:
(i) It has (1) one or more underlying, and (2) one or more notional amount or payments
provisions or both. Those terms determine the amount of the settlement or
settlements.
(ii) It requires no initial net investment or an initial net investment that is smaller than
would be required for other types of contract that would be expected to have a
similar response to changes in market factors

2 LOVELY PROFESSIONAL UNIVERSITY