BASICS OF EQUITY DERIVATIVES

 BASICS OF EQUITY DERIVATIVES

INTRODUCTION TO DERIVATIVES

The emergence of the market for derivative products, most notably forwards, futures and 

options, can be traced back to the willingness of risk-averse economic agents to guard 

themselves against uncertainties arising out of fluctuations in asset prices. By their very 

nature, the financial markets are marked by a very high degree of volatility. Through the 

use of derivative products, it is possible to partially or fully transfer price risks by locking-

in asset prices. As instruments of risk management, these generally do not influence the 

fluctuations in the underlying asset prices. However, by locking in asset prices, derivative 

products minimize the impact of fluctuations in asset prices on the profitability and cash 

flow situation of risk-averse investors.

DERIVATIVES DEFINED

Derivative is a product whose value is derived from the value of one or more basic 

variables, called bases (underlying asset, index, or reference rate), in a contractual manner. 

The underlying asset can be equity, forex, commodity or any other asset. For example, 

wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a 

change in prices by that date. 

In the Indian context the Securities Contracts (Regulation) Act, 1956 (SCRA) defines 

"derivative" to include-

1. 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. 

2. A contract which derives its value from the prices, or index of prices, of underlying 

securities. 

Derivatives are securities under the SC(R)A and hence the trading of derivatives is 

governed by the regulatory framework under the SC(R)A

FACTORS DRIVING THE GROWTH OF DERIVATIVES

Over the last three decades, the derivatives market has seen a phenomenal growth. A large 
variety of derivative contracts have been launched at exchanges across the world. Some of 
the factors driving the growth of financial derivatives are: 
1. Increased volatility in asset prices in financial markets, 
2. Increased integration of national financial markets with the international markets, 
3. Marked improvement in communication facilities and sharp decline in their costs, 
4. Development of more sophisticated risk management tools, providing economic agents a 
wider choice of risk management strategies, and 
5. Innovations in the derivatives markets, which optimally combine the risks and returns 
over a large number of financial assets leading to higher returns, reduced risk as well as 
transactions costs as compared to individual financial assets.