A derivative is a security whose price is dependent on or derived from the value of one or more underlying assets. It itself doesn’t have any value but ‘derives’ its value from some other asset called the ‘underlying’. For example a derivative of the shares of SAIL depends on the price of SAIL’s shares.
Stocks, commodities, bonds, interest rates, currencies and market indexes are some of the common underlyings.
Derivative can be used as insurance or for speculative purposes .For example, amidst 2008 tensions, many US companies started buying European bonds. In such a circumstance, they would have been exposed to exchange-rate risk while holding that stock since the value of the stock decreases with weakening Euro. To hedge this risk, the investors purchased currency futures to fix exchange rates for future sale of stock. A derivative instrument specifies the terms and conditions under which payments are to be made between the participating parties and the maximum expiry time of the contract. The value of the contract depends on the expiry period and on the price of the asset. For example, consider a rice merchant who enters into a contract (derivative) with a dealer to sell his harvest in, let’s say, 3 months time at a price of Rs.5000 per ton, citing risk due to insufficient rains, while the current price stands at Rs.6000 per ton. If, after three months time, the price of rice falls to Rs.3000 as he had feared, then the value of the derivative increases while if the price rises to Rs.7000, then the value of derivative decreases. Hence, at any time, its value depends on the value of the underlying.
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This same concept of derivatives can be extended to large scale businesses with financial assets such as equity shares, currency, debt instruments, etc. For this purpose, derivative contracts are standardized and traded in stock exchanges. Such derivatives are called exchange traded derivatives. In another form, derivatives can be customized as per the needs of the parties which are called Over The Counter (OTC) derivatives. In India, NSE and BSE set up their own individual derivative segments in mid-May 2000. Both the exchanges have a in-house segment for derivatives instead of a separate setting.
In lieu of derivative trading, there are two entities which play a significant role: the trading member and the clearing member. A trading member is a firm which is a member of BSE or NSE and authorized to place orders in the capital market system. It is synonymous to brokerage firms which are financial intermediaries that interface buying and selling operations. For every transaction made, the trading member will be paid a part of the trade by the investor. A clearing member is an entity which is a member of the exchange’s clearing corporation and involves in clearing of trades. Most of the brokerage firms are clearing members. To get the authority to clear trades, a firm has to register itself with the clearing segment of a stock exchange. As per NSE norms, each clearing member should have a net worth of at least Rs 300 lakhs ,along with interest-free security deposits and collateral security deposits of Rs 25 lakhs each. Further, for every trading member which it prefers to clear, the clearing member should pay a deposit of Rs 10 lakhs. Similarly, NSE has setup norms even for trading members: minimum net worth of Rs 100 lakhs, Interest-free security deposits of Rs 25 lakhs and Annual Subscription Fees of Rs 25 lakhs.
NSE’s trading segment for its futures and options is called NEAT F&O which is based on the NEAT system for cash segment. To enforce strict actions against discrepancies, systems for settlement and risk management are required to satisfy the conditions specified by the L.C. Gupta Committee and the J.R. Verma committee. These conditions include those for upfront margins, daily settlement, online surveillance and position monitoring and risk management using the Value-at-risk concept. Further product specifications for S&P CNX Nifty Futures have also been outlined by SEBI: contract size should be 200 times the index, last Thursday of every month will be the expiry day, a contract cycle of minimum 3 months should be maintained and tick size should be 0.05 points or Rs 10.