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What are Derivatives?The term ‘Derivative’ indicates that it has no independent value, i.e. its value is entirely ‘derived’ from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, livestock or anything else. In other words, derivative means a forward, future, option or any other hybrid contract of pre-determined fixed duration, linked for the purpose of contract fulfilment to the value of a specified real or financial asset or to an index of securities. With Securities Laws (Second Amendment) Act, 1999, derivatives have been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act.
What is a Futures Contract?Futures Contract means a legally binding agreement to buy or sell the underlying security on a future date. Future contracts are the organized/standardized contracts in terms of quantity, quality (in case of commodities), delivery time and place for settlement on any date in future. The contract expires on a pre-specified date which is called the expiry date of the contract. On expiry, futures can be settled by delivery of the underlying asset or cash. Cash settlement enables the settlement of obligations arising out of the future/option contract in cash.
What is an Option Contract?Options Contract is a type of Derivatives Contract which gives the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a predetermined price within or at end of a specified period. The buyer/holder of the option purchases the right from the seller/writer for a consideration which is called ‘Premium’. The seller/writer of an option is obligated to settle the option as per the terms of the contract when the buyer/holder exercises his right. The underlying asset could include securities, an index of prices of securities etc.
What are the types of Options?Call Option: When any option contract grants the buyer the right to purchase the underlying asset from the writer or seller, it is called call optionPut Option: When the option buyer has the right to sell the underlying asset to the writer, then it is called Put Option or putAmerican Option: An option contract can also be categorized on the basis of when the option buyer exercises it. So, a contract with American option entitles buyer to exercise it any time up to expiry dateEuropean Option: When an option can be exercised on only the expiration date, then it is called the European OptionBermuda Option: An Option which can be exercised before the expiry date but only on certain specified dates, then that’s called a Bermuda Option
What are Index Futures and Index Option Contracts?Index Futures Futures contract based on an index i.e. the underlying asset is the index, are known as Index Futures Contracts. For example, futures contract on NIFTY Index and SENSEX Index. These contracts derive their value from the value of the underlying index. Stock portfolio managers who want to hedge risk over a certain period of time often use index futures to do so.Index Options Contract A financial derivative that gives the holder the right, but not the obligation, to buy or sell a basket of stocks, at an agreed-upon price and before a certain date. Options contracts, including index options, allow investors to profit from an expected market move or to reduce the risk of holding the underlying instrument.Unlike Index Futures, the buyer of Index Option Contracts has only the right but not the obligation to buy / sell the underlying index on expiry. Index Option Contracts are generally European Style options i.e. they can be exercised / assigned only on the expiry date.An index in turn derives its value from the prices of securities that constitute the index and is created to represent the sentiments of the market as a whole or of a particular sector of the economy. Indices that represent the whole market are broad based indices and those that represent a particular sector are sectoral indices.In the beginning futures and options were permitted only on S&P Nifty and BSE Sensex. Subsequently, sectoral indices were also permitted for derivatives trading subject to fulfilling the eligibility criteria. Derivative contracts may be permitted on an index only if 80% of the index constituents are individually eligible for derivatives trading. However, no single ineligible stock in the index shall have a weightage of more than 5% in the index. The index is required to fulfill the eligibility criteria even after derivatives trading on the index have begun. If the index does not fulfill the criteria for 3 consecutive months, then derivative contracts on such index would be discontinued.By its very nature, index cannot be delivered on maturity of the Index futures or Index option contracts therefore, these contracts are essentially settled in cash on expiry.
What is the Regulatory Framework of Derivatives Markets in India?With the amendment in the definition of 'securities' under SC(R)A (to include derivative contracts in the definition of securities), derivatives trading takes place under the provisions of the Securities Contracts (Regulation) Act, 1956 and the Securities and Exchange Board of India Act, 1992. Dr. L.C Gupta, Committee constituted by SEBI had laid down the regulatory framework for derivative trading in India. SEBI has also framed suggestive bye-law for Derivative Exchanges/Segments and their Clearing Corporation/House which lay's down the provisions for trading and settlement of derivative contracts. The Rules, Bye-laws & Regulations of the Derivative Segment of the Exchanges and their Clearing Corporation/House have to be framed in line with the suggestive Bye-laws. SEBI has also laid the eligibility conditions for Derivative Exchange/Segment and its Clearing Corporation/House. The eligibility conditions have been framed to ensure that Derivative Exchange/Segment & Clearing Corporation/House provide a transparent trading environment, safety & integrity and provide facilities for redressal of investor grievances. Some of the important eligibility conditions are:Derivative trading to take place through an on-line screen based Trading System.The Derivatives Exchange/Segment shall have on-line surveillance capability to monitor positions, prices, and volumes on a real time basis so as to deter market manipulation.The Derivatives Exchange/ Segment should have arrangements for dissemination of information about trades, quantities and quotes on a real time basis through atleast two information vending networks, which are easily accessible to investors across the country.The Derivatives Exchange/Segment should have arbitration and investor grievances redressal mechanism operative from all the four areas / regions of the country.The Derivatives Exchange/Segment should have satisfactory system of monitoring investor complaints and preventing irregularities in trading.The Derivative Segment of the Exchange would have a separate Investor Protection Fund.The Clearing Corporation/House shall perform full novation, i.e., the Clearing Corporation/House shall interpose itself between both legs of every trade, becoming the legal counterparty to both or alternatively should provide an unconditional guarantee for settlement of all trades.The Clearing Corporation/House shall have the capacity to monitor the overall position of Members across both derivatives market and the underlying securities market for those Members who are participating in both.The level of initial margin on Index Futures Contracts shall be related to the risk of loss on the position. The concept of value-at-risk shall be used in calculating required level of initial margins. The initial margins should be large enough to cover the one-day loss that can be encountered on the position on 99% of the days.The Clearing Corporation/House shall establish facilities for electronic funds transfer (EFT) for swift movement of margin payments.In the event of a Member defaulting in meeting its liabilities, the Clearing Corporation/House shall transfer client positions and assets to another solvent Member or close-out all open positions.The Clearing Corporation/House should have capabilities to segregate initial margins deposited by Clearing Members for trades on their own account and on account of his client. The Clearing Corporation/House shall hold the clients' margin money in trust for the client purposes only and should not allow its diversion for any other purpose.The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the trades executed on Derivative Exchange / Segment. Presently, SEBI has permitted Derivative Trading on the Derivative Segment of BSE and the F & O Segment of NSE.
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