Friday, July 29, 2005

Derivates

History of derivatives 
The history of derivatives is surprisingly longer than what most people think. Some texts even find the existence of the characteristics of derivative contracts in incidents of Mahabharata. Traces of derivative contracts can even be found in incidents that date back to the ages before Jesus Christ.

However, the advent of modern day derivative contracts is attributed to the need for farmers to protect themselves from any decline in the price of their crops due to delayed monsoon, or overproduction. The first 'futures' contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650. These were evidently standardised contracts, which made them much like today's futures.

The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was established in 1848 where forward contracts on various commodities were standardised around 1865. From then on, futures contracts have remained more or less in the same form, as we know them today.Derivatives have had a long presence in India. The commodity derivative market has been functioning in India since the nineteenth century with organized trading in cotton through the establishment of Cotton Trade Association in 1875. Since then contracts on various other commodities have been introduced as well.

Exchange traded financial derivatives were introduced in India in June 2000 at the two major stock exchanges, NSE and BSE. There are various contracts currently traded on these exchanges.National Commodity & Derivatives Exchange Limited (NCDEX) started its operations in December 2003, to provide a platform for commodities trading.

The derivatives market in India has grown exponentially, especially at NSE. Stock Futures are the most highly traded contracts on NSE accounting for around 55% of the total turnover of derivatives at NSE, as on April 13, 2005.

Risk Management Tools 
 Derivatives are powerful risk management tools. To illustrate, lets take the example of an investor who holds the stocks of Infosys, which are currently trading at Rs 2,096.

Infosys options are traded on the National Stock Exchange of India, which gives the owner the right to buy (call) shares of Infosys at Rs 2,220 each (exercise price), expiring on 30th June 2005. Now if the share price of Infosys remains less than or equal to Rs 2,200, the contract would be worthless for the owner and he would lose the money he paid to buy the option, known as premium.

However, the premium is the maximum amount that the owner of the contract can lose. Hence he has limited his loss. On the other hand, if the share price of Infosys goes above Rs 2,220, the owner of the call option can exercise the contract, buy the share at Rs 2,220 and make profits by selling the share at the market price of Infosys.

The upward gain can be unlimited. Say the share price of Infosys zooms to Rs .3,000 by June 2005, the owner of the call option can buy the shares at Rs 2,220, the exercise price of the option, and then sell it in the market for Rs 3,000.

Making a profit of Rs 780 less the premium that has been paid. If the premium paid to buy the call option is say Rs 10, the profit would be Rs 770.

 

 

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