Derivatives, as the name suggests, are financial instruments that derive their value from an underlying security or asset. The underlying could be equity shares or an index, a commodity, a currency or the exchange rate, bonds, etc. Sounds complicated? In a way, it is. But once you are clear about how a derivative product derives its value from an underlying asset and yet has a price and an identity of its own, it will become just another financial product to you. Then again, derivative products have more variants than any other financial products since they have been created to meet a variety of niche needs.

Dependent on other products, yet a life of their own…
Here’s a little story about a sugarcane contract. There is a farmer who will be harvesting a crop of sugarcane three months down the line. As he is uncertain about how high or low the price of sugarcane will be then, he decides to negotiate a price with his purchase agent right now. They fix a price per quintal, which is suitable to both of them and ink it into a contract that specifies how much the farmer will supply, on what date and at what price.

Now, suppose after one month, the purchase agent decides that he does not want to be a counter party to this contract anymore, he may find another agent who is ready to relieve him of the contract. However, if the price of sugarcane has already begun to fall in the market, the second agent may not be one hundred percent comfortable with the terms printed in the contract. He may feel that the contracted price is too high. So, to compensate him, the first agent may pay him the difference between the original contracted price and the price that he feels is right.
 
If you can imagine that this contract can be traded over and over again, between agents or any intermediaries, replicating the transaction described above, until its expiry date, you have envisaged a derivative product. You have understood how the value of the contract depends upon the price of sugarcane but the actual price that the contract commands could keep changing every time it changes hands, for a variety of other reasons too.

There are various derivative products, which derive their value from equity shares or an index, a commodity, a currency or the exchange rate, bonds, etc. These derivative products vary according to their structure and terms and conditions. The most popular derivative products are Forwards, Futures, Options, Warrants and Swaps. Some of these are short term in nature while others are long term. For example stock and index options that can be traded on stock exchanges are short term in nature, while options like warrants and rights have a longer term.

The first category of people who benefit from such trades are people who wish to mitigate their risk, more specifically, the risk originating from potential future adverse price movements. The ‘sugarcane farmer’ in the story would fall into this category and could be considered a hedger, as he is hoping to avoid risks. The second category of people that participate in this market are people with an appetite for risk. These are speculators who take over the risk from the hedgers in anticipation of good returns. The ‘purchase agents and intermediaries’ who traded on the sugarcane contract typify this class of derivative market participants. The third popular category of people who stand to gain from the market are arbitrageurs. These are participants who try to gain from differences in the price of the derivative product and its underlying asset. Both speculators and arbitrageurs help to improve market liquidity since they buy products with the intention of selling as soon as they see a suitable price.

Since the introduction of futures and options segments on stock exchanges and the setting up of commodity futures markets, even retail investors can participate in these markets. In order to participate in either market, you have to go through a broker who is affiliated with the exchange on which you plan to trade. You will be required to deposit an appropriate amount of token Margin money with your broker and fill in requisite forms, before you begin to trade. However, the most important prerequisite in order to trade in derivative products is, understanding how each one works and the risks and potential returns associated with them.

Globally, the last four decades have seen phenomenal growth in derivative markets. In the process, many new products have been developed and this has also led to a sharp rise in volumes over the years. Today, derivative markets have become an integral feature of financial markets in developed countries and this phenomenon is gaining momentum in developing countries, too. 
 
Since the introduction of futures and options in the Indian equity markets, the turnover in this segment has increased manifold. For instance, in the case of the National Stock Exchange (NSE), the average daily turnover in the futures and options segment stood at Rs 410 crore for the financial year 2001-02. By fiscal 2004-05, it increased 24 times over to more than Rs 10,000 crore!  In the financial year 2005-06, the average daily turnover stood at a whopping Rs 19,000 crore!

Commodity derivatives in India are another active segment of the derivative markets in India. Currently, we have around 25 commodity derivative exchanges with around 100 commodities available for trading.