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A derivative may be defined as an instrument, the value
of which is derived from other underlying asset (s). The
underlying asset can be interest rate, commodity, equity
share, forex or any other asset. Poor understanding and
improper usage of these instruments have led to many institutional
collapses and significant losses but still they hold a key
in today's globalized financial markets. Presently, the
turnover of the derivative segment is more than that of
the cash segment. Though derivatives are complex to understand,
they are used by individual investors, brokers, dealers,
corporate and banks.
When compared to global markets, the forward and future
trading in India is not as popular. However, in the last
few years, there has been substantial improvement in the
functioning of the securities market. For facilitating a
better functioning, margining, establishment of clearing
corporation and adequate capital for market intermediaries
play a major role in the development of this segment of
the capital market. Advanced risk management tools are now
used to reduce the risk. However, after the meltdown of
ICE (Information, Communication and Entertainment) sector,
regulators realized that trading in derivatives was necessary
to strengthen and deepen the capital market. Therefore,
derivative trading in India was introduced initially on
some stocks and later allowed to cover some selected commodities.
Derivatives enable better risk management as they help
to diversify as well as trade the `risk'. They are even
used to transfer risk. Before getting into any contract,
each party trading in derivatives is required to know the
risk involved. Further, since the pricing of a derivative
is derived from the underlying asset, it is important to
remember that any change in the price of the underlying
asset will lead to a change in the value of the asset. Thus,
the risk of trading in derivatives also depends on the change
in the underlying assets. For example, if the settlement
price of a derivative is based on the price of a stock,
say Infosys, whose price frequently changes on a daily basis,
then the derivative risk also changes on a daily basis.
This means that derivative risks and positions must be monitored
constantly.
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