In India, the financial market has grown significantly over the past few decades. Yet, when it comes to financial derivatives, many people still find the concepts difficult to understand.
While derivatives have been in use for centuries, the Indian derivatives market gained substantial traction in the 1990s with the liberalization of the economy and the establishment of exchanges like the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE).
Derivatives played a significant role during the 2008 global financial crisis, leading to concerns about their complexity and potential risks. However, derivatives themselves are not inherently harmful, they are simply financial instruments designed to manage risk or to speculate on future price movements.
This article will explain the three most commonly used types of financial derivatives, forward contracts, futures contracts, and options, in simple terms and through examples.
By the end of this article, you’ll have a better understanding of how derivatives work, their significance, and how they can be used in everyday financial decision-making.
What Are Financial Derivatives?
A derivative is essentially a financial contract whose value is based on the price of an underlying asset. These underlying assets could be stocks, commodities (like gold, oil, or wheat), currencies (such as the Indian rupee to US dollar), or even interest rates.
For example, if the price of crude oil goes up, the value of a futures contract based on crude oil will also rise. This gives traders a way to hedge risk (protect against price fluctuations) or to speculate (bet on price changes).
In India, derivatives trading is highly regulated by the Securities and Exchange Board of India (SEBI) to ensure transparency and fairness in the market.
1. Forward Contracts: Private Agreements with Flexibility
A forward contract is a simple, private agreement between two parties to buy or sell an asset at a future date for a price that is agreed upon today. These contracts are typically customized to meet the specific needs of the buyer and seller, which means they are not traded on exchanges and are often settled over-the-counter (OTC).
Example: Hedging Rice Prices
Let’s say you’re a rice mill owner, and you’re worried about the price of rice changing drastically between now and harvest season, which is 6 months away. Right now, you know you’ll need to buy a significant quantity of rice, but you don’t want to face the uncertainty of fluctuating prices.
You can enter into a forward contract with a local farmer to purchase 10 tonnes of rice at ₹40,000 per tonne in six months. Whether the price of rice goes up or down by the time of delivery, you’ll pay exactly ₹40,000 per tonne.
This agreement helps you plan your finances in advance and protect against price volatility in the future. If the market price goes up to ₹45,000 per tonne, you’ll have saved ₹5,000 per tonne. But if prices drop to ₹35,000 per tonne, you will be paying ₹5,000 more per tonne.
The flexibility of forward contracts makes them useful, but since they are private and not standardized, they carry higher counter-party risk (the risk that the other party may default on the contract).
2. Futures Contracts: Standardized Contracts on Exchanges
Unlike forward contracts, futures contracts are standardized and traded on organized exchanges, such as the National Stock Exchange (NSE) or the Multi Commodity Exchange (MCX) in India. These contracts specify the quantity and price of the asset, and the buyer and seller agree to settle the contract on a specified future date.
Futures contracts help reduce the counter-party risk, as the exchange acts as an intermediary between the buyer and the seller. The key feature of futures is that they can be bought and sold at any time before the contract expires, providing liquidity and flexibility.
Example: Hedging Oil Prices
Suppose you’re the owner of an Indian airline, and you’re concerned about the rising price of aviation fuel (which is linked to global crude oil prices). You can use a futures contract to lock in the price of crude oil in advance, protecting your business against potential price hikes in the future.
For example, you can buy crude oil futures on the MCX at ₹5,000 per barrel for delivery in three months. If the price of oil increases to ₹6,000 per barrel, your futures contract allows you to buy oil at ₹5,000 per barrel, saving ₹1,000 per barrel. If the price falls, you lose out on potential savings, but at least your budget remains stable, and you don’t face the risk of sudden cost increases.
Futures contracts are widely used in India for various commodities, including gold, agriculture products, and stock indices like the Nifty 50 or Sensex.
3. Options Contracts: Right to Buy or Sell, But Not the Obligation
An options contract is a financial derivative that gives the buyer the right (but not the obligation) to buy or sell an asset at a predetermined price, called the strike price, at a specific time or before a certain date.
There are two types of options:
- Call options: Give the holder the right to buy the asset.
- Put options: Give the holder the right to sell the asset.
To acquire an option, the buyer pays a small fee known as the premium. This premium is the price paid for the right to exercise the option.
Example: Stock Options in the Indian Stock Market
Let’s say you’re an investor in the Indian stock market, and you believe the price of XYZ Industries Ltd. will rise in the next month. To profit from this potential rise without buying the stock outright, you buy a call option on XYZ shares.
Suppose you buy a call option that gives you the right to buy 100 XYZ shares at ₹2,500 per share within the next month. If the price of XYZ rises to ₹2,700 per share, you can exercise your option to buy at ₹2,500, making a ₹200 profit per share. If the price falls, you simply let the option expire and lose only the premium you paid for the option.
Options can also be used in India to hedge against potential losses in a portfolio, particularly by institutional investors or those who hold large positions in stocks. The NSE provides a wide range of stock options and index options for this purpose.
Key Differences Between Forwards, Futures, and Options
Here’s a quick comparison of the three main types of derivatives:
| Feature | Forward Contracts | Futures Contracts | Options Contracts |
| Traded On | Private agreement, OTC | Traded on exchanges (e.g., NSE, MCX) | Traded on exchanges (e.g., NSE, BSE) |
| Customization | Highly customizable | Standardized contract terms | Standardized contract terms |
| Settlement | Settled privately between parties | Settled through the exchange clearinghouse | Buyer has the right, but not the obligation, to exercise |
| Risk | Higher counter-party risk | Lower counter-party risk (due to clearinghouse) | Limited to premium paid (for the buyer) |
| Purpose | Hedging, risk management | Hedging, speculation, risk management | Hedging, speculation, limited risk exposure |
Why Do People Use Derivatives in India?
The use of derivatives in India is growing, and they are used primarily for two reasons:
- Hedging Risk: Businesses and investors use derivatives to manage price fluctuations in commodities, currencies, and interest rates. For example, exporters and importers in India use currency futures to protect themselves from fluctuating exchange rates.
- Speculation: Investors can use derivatives to profit from price changes without having to own the underlying asset. Traders in India often use stock options or index futures to speculate on the future direction of the stock market.
Conclusion
Derivatives like forwards, futures, and options play a significant role in the Indian financial market by providing opportunities for hedging and speculation. While the concepts may seem complicated at first, understanding how these instruments work can help individuals and businesses manage risks and make informed financial decisions. Whether you’re in agriculture, manufacturing, or the stock market, derivatives can be powerful tools for navigating price volatility.
By grasping the basics of financial derivatives in India, you’ll be better equipped to understand their practical applications and their potential impact on your investments or business operations.
