Image source: https://rb.gy/qbkcbu

This article has been written by Samarth Goel, pursuing the Certificate Course in Introduction to Legal Drafting: Contracts, Petitions, Opinions & Articles from LawSikho.

Meaning and Concept of Derivative Contracts

Derivative Contracts are financial instruments in the nature of agreements. These agreements do not possess any intrinsic value, but are totally dependent on the value of the underlying asset. These underlying assets usually include commodities such as crude, precious metals such as gold or silver, shares, bonds or securities of like nature, market index, and currencies of different jurisdictions. Thus, Derivative Contracts or derivatives are financial instruments which derive their value from the underlying assets which are commonly traded and have fluctuating values.  

The underlying assets enumerated above are freely and globally traded, as a result of which, their values are usually influenced by forces of demand and supply. Derivative Contracts allows the parties involved to trade the underlying assets at a future date, without actually paying for their entire quantum or obtaining them physically. It is the value of the underlying assets which determine the value of the Derivative Contracts and finally influences the valuation of rights, claims or benefits of the parties involved. It is necessary to remember that the liquidity or marketability of the Derivative Contracts depend upon various factors such as market participants, regulatory framework, functioning of intermediaries etc. and varies from economy to economy. 

Download Now

Clause (ia) of section 2(h) of Securities Contracts (Regulation) Act, 1956 includes “derivative” within the meaning of “securities” and section 2(ac) defines “derivative” as “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; or a contract which derives its value from the prices, or index of prices, of underlying securities.”

General Categorization of Derivatives

Forwards

Forwards are derivative contracts wherein one party agrees to buy or sell the underlying asset on a future date at a predetermined price with the other party. By entering an agreement the parties involved are obligated to buy or sell the underlying asset as per terms of agreement. These contracts involve two parties namely, forward buyer and forward seller. Forward contracts can be traded in two ways, firstly, by buying the forward, as an implication of which the forward buyer agrees to buy the underlying asset at a predetermined price on a future date. Secondly, by selling the forward, in which the forward seller agrees to sell the underlying asset on a future date at a predetermined price. Forwards generally fall into the category of OTC derivatives.

Example:

Mr. A is an importer of crude oil and Mr. B is the owner of a refinery which purifies and extracts various components from crude oil. Let’s assume that market price of crude oil on May 1, 2020 is Rs.100 per liter, and on same day Mr. B approaches Mr. A for purchasing 1000 liters of crude oil on a future date on today’s price pursuant to his anticipation that the price of the crude will go up in near future. After much negotiations, on May 1, 2020, Mr. B agrees to buy 1000 liters of oil on May 15, 2020 at a price of Rs.120 per liter, from Mr. A. In this case, Mr. A is the forward seller, Mr. B is the forward buyer, crude is the underlying asset and their agreement is the forward derivative contract. It is also necessary to remember that crude oil is a globally traded commodity whose prices fluctuate with forces of demand and supply. Now, on May 15, 2020, either of the three scenarios can exist:

  • The market price of the crude is Rs.125 per liter (above Rs.120 per liter): In this case, the market price of crude is more than the predetermined price as per the agreement. This means that on execution of terms of agreement, Mr. A will bear a loss of Rs.5 per liter because the contract price is less than market price and instead of selling the crude at Rs.125 per liter, he has to sell it at Rs.120 per liter. On the other hand, this is a profitable scenario for Mr. B because he can buy the crude at a price which is lower than the market price. Thus, Mr. A will incur a loss of Rs.5000 (5x1000ltr.) and Mr. B will earn a profit of Rs.5000.
  • The market price of the crude is Rs.120 per liter (unchanged): In this case, market price of crude is equal to the agreed price. This means that upon execution of terms of agreement neither of the parties are going to make any profit or incur any loss.
  • The market price of the crude is Rs.115 per liter (below Rs.120 per liter): In this case, the market price of crude is lower than the predetermined price as per the agreement. This means that on execution of terms of agreement, Mr. A will earn a profit of Rs.5 per liter because the contract price is more than the market price and instead of selling the crude at Rs.120 per liter, he can sell it at Rs.125 per liter. On the other hand, this is a losing scenario for Mr. B because he has to buy the crude at a price which is higher than the market price. Thus, Mr. A will earn a profit of Rs.5000 (5x1000ltr.) and Mr. B will incur a loss of Rs.5000.

From the above example we can easily conclude that in forwards contracts are bilateral contracts negotiated and executed between two parties where the profit of one party is the loss of another. Further, it is favourable to buy a forwards contract if you are expecting the market price of an underlying asset to go up (Scenario 1), and to sell it if you are expecting the market price to go down (Scenario 3). 

Futures

Future contracts are deceptively similar to the forward contracts in terms of their foundational structure. However, in order to enable the trading on a centralized exchange while minimizing the inherent risks, the forward contracts were evolved into futures. Thus, futures are forwards only with the following differential characteristics:

  • Forwards are generally traded on Over the Counter platforms where parties enter transactions on one-to-one basis without the intervention of any exchange or intermediary, on the other hand, futures are generally traded on well-regulated exchanges or markets.
  • The underlying assets in forwards usually include unlisted securities, commodities or other assets which are in physical possession of the party involved or they are capable of delivering their physical possession. Underlying assets in case of futures generally include the securities which are listed and traded on the same exchange which is offering the different future contracts. 
  • Forward contracts are transacted on basis of bilateral negotiations and hence their terms are customized to cater for the needs of the parties involved, whereas, future contracts are transacted in a standardized structure format by the exchange facilitating its trading and settlement irrespective of needs of the parties involved. 
  • Forwards are usually prone to higher counterparty and other risks due to absence of intermediaries and maturing regulatory framework but, futures do not bear any counterparty risk due to intervention of an intermediary such as NSE/BSE which ensure the settlement of trades through a well-developed legal regime.
  • Forward contracts bear lower liquidity because of lack of transferability and the parties involved have to hold them until execution. The future contracts, on the other hand, are highly liquid because of a well-established marketplace which facilitates the transferability of these instruments.
  • Forward contracts have single time ie. their execution is one-time. The futures are offered by the intermediary in a standardized format having distinct multiple time frames offering executions on varied dates.
  • The settlement of forwards are either physical or cash-based. This means the parties have the option to physically obtain the delivery of the underlying asset or can obtain the difference between the market price and agreed price in cash. On the other hand, the settlement of future contracts is on a cash basis only where the party is entitled to receive the difference in market and agreed price only.

Example: 

The future contracts of wherein shares of Reliance Industries are underlying assets are currently trading at Rs.1000. It is necessary to remember that the actual price of shares of Reliance Industries in the spot market will differ from the price of its future contract because of certain calculations.

Mr. A is bearish on the market and decides that if the price of Reliance Industries will touch Rs.950, then it will fall substantially. Thus, he placed an order to short (sell) one lot of Reliance Industries at Rs.950 with an expiry of 15 days. On the other hand, Mr. B is bullish on the market and believes that Rs.950 is the bottom price and after touching it, the price will recover and rise substantially. Thus, Mr. B places an order to long (buy) one lot of future Reliance Industries at Rs.950 with expiry of 15 days. It shall be noted that the lot size of future is 200 shares, Mr. A and Mr. B are the counterparties to each other wherein they deposited margin money at the time of entering the trade. Now, on 15th day, three potential scenarios may prevail:

  • Price of future contract reaches Rs.900: This means that the market price of the share is less than the price at which it was agreed to sell in contract. Squaring of the contract at this stage will enable Mr.A to sell the shares at price of Rs.950 and will obligate Mr. B to buy the same at Rs.950. Thus, it is beneficial for Mr. A to sell a share at price higher than the market price and detrimental for Mr. B to buy a share at price higher than the market price. Thus, Mr. A will earn a profit of Rs.10,000 (50×200) and Mr. B will incur a loss of equal amount.
  • Price of future contract reaches Rs.950: This means that the market price of the share is equal to price at which it was agreed to sell in contract. Squaring the contract at this stage will enable Mr. A to sell the shares at price of Rs.950 and will obligate Mr. B to buy the same at Rs.950. Thus, neither party will incur any loss or earn any profit.
  • Price of future contract remains Rs.1000: This means that the market price of the share is greater than price at which it was agreed to sell in contract. Squaring the contract at this stage will obligate Mr. A to sell the shares at price of Rs.950 and will enable Mr. B to buy the same at Rs.950. Thus, it is detrimental for Mr. A to sell a share at price lower than the market price and beneficial for Mr. B to buy a share at price lower than the market price. Thus, Mr. A will incur a loss of Rs.10,000 (50×200) and Mr. B will earn a profit of equal amount.

From the above example, we can conclude that futures are standardized contracts offered by the exchange which enable traders to buy or sell underlying shares at a future date. It is further advantageous to long (buy) a future if you are bullish on the share and to short (sell) if you are bearish on the share. Further, in future contracts, parties are under obligation to deposit margin money at time of entering the trade for ensuring timely settlement of trade and avoiding default.

Options

Options are derivative contracts which enable the buyer (option buyer) to buy or sell the underlying asset from or to the option seller (option writer) at a particular future date (expiry date) at a particular price (strike price). The option buyer exercises leverage over the option writer by paying a small amount while purchasing the option (premium) for purchasing the right rather than obligation to buy or sell the underlying security as per his own discretion. The option contracts are commonly categorized as Exchange Traded Derivatives. Options are of two types:

  • Call Options: This option vests the option buyer with the right to buy an underlying asset from the option writer at the strike price on the expiry date by paying a premium.
  • Put Options: This option vests the option buyer with the right to sell an underlying asset from the option writer at the strike price on the expiry date by paying a premium.

Example: 

The share of Tata Motors is trading on NSE at Rs.1000. Two persons Mr. A and Mr. B are desirous of trading the options with the underlying asset as the share of Tata Motors. 

Scenario 1: Mr. A is bullish on the market and buys a call option of Rs.1100 (strike price) believing that the price of Tata Motors will rise substantially. Mr. A (option buyer) paid a premium of Rs.50 to Mr. B (option writer) at the time entering the transaction for obtaining the right to buy Tata Motors at Rs.1100 on the expiry date. Now, on the expiry date, three situations may prevail:

  • Price of Tata Motors is Rs.1200 (greater than strike price): In this scenario, the market price is greater than strike price. This means it is beneficial for Mr. A to exercise his right to buy the share at Rs.1100 because he will have to pay Rs.1150 (strike price + premium) for a share which is worth Rs.1200 and will ultimately fetch him a profit of Rs.50. 
  • Price of Tata Motors is Rs.1100 (equal to strike price): In this scenario, the market price is equal to strike price. This means, it is detrimental for Mr. A to exercise his right to buy the share at Rs.1100 because he will have to pay Rs.1150 (strike price + premium) for a share which is worth Rs.1100 and will ultimately cause him a loss of Rs.50.
  • Price of Tata Motors is Rs.1000 (lower than strike price): In this scenario, the market price is lower than strike price. This means, it is detrimental for Mr. A to exercise his right to buy the share at Rs.1000 because he will have to pay Rs.1050 (strike price + premium) for a share which is worth Rs.1000 and will ultimately cause him a loss of Rs.50.

Scenario 2: Mr. A is bearish on the market and buys a put option of Rs.900 (strike price) believing that the price of Tata Motors will fall substantially. Mr. A (option buyer) paid a premium of Rs.50 to Mr. B (option writer) at the time entering the transaction for obtaining the right to sell Tata Motors at Rs.900 on the expiry date. Now, on the expiry date, three situations may prevail:

  • Price of Tata Motors is Rs.1000 (greater than strike price): In this scenario, the market price is greater than strike price. This means it is detrimental for Mr. A to exercise his right to sell the share at Rs.900 because he will get Rs.950 (strike price + premium) for a share which is worth Rs.1000 and will ultimately cause a loss of Rs.50. 
  • Price of Tata Motors is Rs.900 (equal to strike price): In this scenario, the market price is equal to strike price. This means, it is detrimental for Mr. A to exercise his right to sell the share at Rs.900 because he will get Rs.950 (strike price + premium) for a share which is worth Rs.900 and will ultimately cause him a loss of Rs.50.
  • Price of Tata Motors is Rs.800 (lower than strike price): In this scenario, the market price is lower than strike price. This means, it is beneficial for Mr. A to exercise his right to sell the share at Rs.800 because he will get Rs.850 (strike price + premium) for a share which is worth Rs.800 and will ultimately fetch him a profit of Rs.50.

From the above example we can conclude that buying the call option is beneficial in bearish situations and buying the put option is beneficial in bullish situations. The option buyer exercises the right, but not obligation, to buy or sell the underlying asset on a future date at a given price. Further, selling the call option is beneficial in a bullish situation and selling the put option is beneficial in bearish situations which allows him to earn premium. It can also be said that the option buyer has to predict where the price of the underlying share will go, but the option writer has to predict where the price of the share will not go, at the time of entering the trade.

Swaps

Swap is a derivative contract wherein two parties agree to exchange or swap their cash flows whether incoming or outgoing emanating from a financial instrument. Most swaps involve cash flows based on a notional principal amount which usually does not change hands. Each cash flow comprises one leg of the swap. One cash flow is generally fixed, while the other is variable and based on a benchmark interest rate, floating currency exchange rate, or index price. Swaps are traded on OTC platforms because their terms must be customized as per requirements of the parties and the most commonly used swap is Interest Rate Swaps, whose working is explained as under.

Example:

Company A is a medium enterprise which was seeking to obtain a loan from a Bank A. Due to considerable scales of operations and large asset size, Bank A offered a loan to Company A at either of following interest rates: fixed rate of 10% or floating rate of MIBOR + 6%. After much consideration, Company A borrowed a loan of Rs.10,00,000 @ 10% fixed interest rate. On the other hand, Company B is a micro enterprise which was seeking to obtain a loan from a Bank B. Due to low scales of operations and small asset size, Bank B offered a loan to Company B at either of following interest rates: fixed rate of 15% or floating rate of MIBOR + 9%. After much consideration, Company A borrowed a loan of Rs.20,00,000 @ MIBOR + 9% fixed interest rate.

After obtaining the loans, Company A began to believe that the MIBOR was likely to fall and thus, was seeking to switch the interest rates payable to fluctuating rate. Whereas, due to increasing uncertainties in cash flow, Company B began looking forward to switching to a fixed interest rate.

Now, both the Companies approached each other and decided to enter into swap agreement with each other with notional value of Rs.10,00,000, such that Company A will pay fluctuating interest rate of MIBOR + 7% on Rs.10,00,000 to Company B and Company B will pay fixed rate of interest of 12% to Company A. As a result of this agreement, now: 

    • Company A will pay MIBOR + 7% on Rs.10,00,000 to Company B, which will pay MIBOR + 9% to Bank B, as per their terms of loan. Also, Company B will pay interest 7% on Rs.10,00,000 to Company A, which will pay 10% to Bank A, as per their original loan terms.
    • The net interest liability of Company A will become MIBOR + 5% (MIBOR + 7% + 10% – 12%) because he will give MIBOR + 7% to Company B under swap, give 10% to Bank A under terms of agreement and get 12% from Company B under terms of swap. This will ultimately fetch a benefit of 1% (MIBOR + 6% – MIBOR – 5%) fluctuation rate to Company A because the Bank A was originally offering a fluctuating loan of MIBOR + 6%, but got a loan at net interest liability of MIBOR + 5% under swap.
    • The net interest liability of Company B will become  10% (9% + MIBOR + 4% – MIBOR – 3%) because he will give 9% to Company A under swap, give MIBOR + 4% to Bank B under terms of agreement and get MIBOR + 3% from Company B under terms of swap. This will ultimately fetch a benefit of 3% (15% – 12%) fixed rate to Company B because Bank B was originally offering a fixed loan of 15%, but got a loan at net interest liability of 12% under swap.

Derivatives Market in India

A financial system persists in every economy, which involves a set of institutional arrangements that enables the mobilization of funds from units generating surplus income and transferring them to units in need of funds. These financial systems are bifurcated into two markets namely, Money Market and Capital Market. While Money Market involves trading of short term instruments with high liquidity, the Capital Markets involve long term debt and equity based instruments such as scripts, shares, stocks, bonds and other securities of like nature. Capital Markets further subsists in two forms that is, Debt Market and Securities Market. 

The Debt Market involves trading of low risk instruments such as debenture, bonds, whereas, the Securities Market involves trading of shares and stocks of companies. Primary and Secondary Markets are two segments of Securities Market, wherein the issuance of new securities by the issuers to investors are done in Primary Market and trading of previously issued shares amongst the investors is done in Secondary Market. The Derivatives Market is a part of Secondary Markets, which involves trading of Derivative Contracts. 

The two imperative components of Derivatives Market are Exchange Traded Derivatives and Over the Counter Traded Derivatives. These two branches differ from each other in terms of their operations, regulations, participation, nature of instruments, rigidity, negotiability and operate independently from each other.

Over the Counter Derivatives

OTC derivatives is a market form that includes Derivative Contracts which are bilaterally negotiated and directly entered into by the parties involved through a communication network. OTC does not involve any exchange or intermediary and the underlying assets usually include interest rates, currencies and other unlisted securities. The OTC derivatives are customized as per the interpersonal negotiations of the parties involved and thus, the transparency and availability of information is less as compared to exchange traded derivatives. 

In India, OTC derivatives and its market is regulated by the Reserve Bank of India (RBI) which has established the Clearing Corporation of India (CCIL) for the purpose of ensuring guaranteed clearing and settlement of transactions in OTC markets. CCIL is also the central authority vested with power of recording and maintaining the details of derivatives transactions over OTC counters with the motive of enhancing the efficiency, transparency, liquidity and risk management oriented factors prevailing in the OTC markets. 

A general precondition imposed in India based OTC market is that at least one of the parties involved in the transactions must be regulated by RBI. Additionally, the financial institutions are allowed to undertake OTC derivative transactions for management of their own balance sheet and market making, whereas, non-financial institutions are eligible to do the same for hedging their exposures only. The variety of instruments traded on OTC platforms in India are illustrated in the diagram below.

Exchange Traded Derivatives

Exchange Traded Derivatives (ETD) is a market form which involves standardized Derivative Contracts that are traded on formally organized and regulated exchanges or markets. The major characteristic feature of ETD is that the underlying assets in these instruments are listed and traded on the exchange wherein they are being traded. ETDs are traded publicly which helps in generation of market based pricing information resulting in promotion of liquidity and transparency. Pursuant to the systematically structured trading norms, the parties involved in transactions of ETD are obligated to deposit margin money engendering in minimization of risks of default and facilitation of settlements through clearing houses. 

In India, National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) are the two exchanges which foster the trading of ETD in form of Futures and Options and are regulated by Securities Exchange Board of India (SEBI). The most commonly offered derivative contracts on NSE include equity, commodity, currency and interest rate based futures and options.

Conclusion

From the above mentioned facts we can conclude that derivative contracts are financial instruments which help in transferring risk from one party to another. These instruments are useful in making profits or avoiding losses that might arise in future dates due to the price fluctuations of the underlying assets. Derivative contracts are thus, widely used for hedging or speculative purposes.

References

Students of Lawsikho courses regularly produce writing assignments and work on practical exercises as a part of their coursework and develop themselves in real-life practical skill.

LawSikho has created a telegram group for exchanging legal knowledge, referrals and various opportunities. You can click on this link and join:

Follow us on Instagram and subscribe to our YouTube channel for more amazing legal content.

RELATED ARTICLESMORE FROM AUTHOR

LEAVE A REPLY

Please enter your comment!
Please enter your name here