Derivatives and Its Use

Section 2(ac) of Securities Contract Regulation Act (SCRA) 1956 defines Derivative as “a contract which derives its value from the prices, or index of prices, of underlying securities”
The underlying asset may assume many forms:
• Commodities including grain, coffee beans, orange juice.
• Precious metals like gold and silver.
Foreign exchange rates or currencies.
• Bonds of different types, including medium to long term negotiable debt securities issued by Governments, companies, etc.
• Shares and share warrants of companies traded on recognized stock exchanges and Stock Index
• Short term securities such as T-bills and
• Over- the Counter money market products such as loans or deposits.

Participants in Derivatives Market
• Hedgers: They use derivatives markets to reduce or eliminate the risk associated with price of an asset. Majority of the participants in derivatives market belongs to this category.
• Speculators: They transact futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture.
• Arbitrageurs: Their behavior is guided by the desire to take advantage of a discrepancy between prices of more or less the same assets or competing assets in different markets.

Benefits from the use of derivatives are:

• Management of risk: Effective use of derivatives can save cost, and it can increase returns for the organizations.
• Efficiency in trading: financial derivatives to be a more attractive instrument than the underlying security. This is mainly because of the lower transaction costs associated with trading a financial derivative as compared to the costs of trading the underlying instrument in cash market.
• Price discover: It is used for the price discovery which means revealing information about future cash market prices through the futures market.
• Price stabilization function: derivative reduces both peak and depths and leads to price stabilization effect in the cash market for underlying asset.
• For tax avoidance
• To reduce the cost of debt and increase the debt capacity