Introduction to Derivatives, Types, and Importance
1. Meaning and Definition of Derivatives
The term "derivative" in finance refers to a financial instrument whose value is derived from
the value of an underlying asset. These underlying assets can be stocks, bonds, commodities,
currencies, interest rates, or market indices. Derivatives are primarily used to hedge risk,
speculate on future price movements, or to access otherwise hard-to-trade assets or markets.
Definition (As per Securities Contracts Regulation Act, 1956 – India):
“A derivative includes— (i) a security derived from a debt instrument, share, loan whether
secured or unsecured, risk instrument or contract for differences or any other form of
security; (ii) a contract which derives its value from the prices, or index of prices, of
underlying securities.”
In simple terms, a derivative does not have its own intrinsic value. Instead, its price depends
on the expected future price of the asset it is linked to.
2. Types of Derivative Instruments
There are four primary types of derivative contracts:
a. Forward Contracts
A forward contract is a customized agreement between two parties to buy or sell an asset at a
specified future date at a price agreed upon today. These are private contracts and not traded
on exchanges.
Example:
A wheat farmer agrees in January to sell 1000 kg of wheat to a flour mill at ₹25 per kg in
June. Regardless of the market price in June, both parties are obligated to settle the contract.
b. Futures Contracts
Futures are standardized contracts traded on stock exchanges where parties agree to buy or
sell the underlying asset at a predetermined price and date. These contracts are regulated and
settled daily through margin accounts.
Example (NSE Futures): A trader enters into a futures contract to buy 1 lot (75 shares) of
Nifty 50 Futures at ₹22,000. If the Nifty rises to ₹22,300 before expiry, the trader earns
₹300 × 75 = ₹22,500 profit.
c. Options Contracts
An option gives the buyer the right (but not the obligation) to buy (Call Option) or sell (Put
Option) the underlying asset at a specific price before or on a specific date.
There are two types of options:
Call Option: Right to buy
Put Option: Right to sell
Example (Equity Option - Reliance Industries): A trader buys a Reliance Call Option at a
strike price of ₹2,500, paying a premium of ₹50. If the market price rises to ₹2,600, the
intrinsic value becomes ₹100, and the net gain is ₹100 - ₹50 = ₹50 per share.
d. Swaps
Swaps are agreements between two parties to exchange sequences of cash flows for a set
period. Common types are interest rate swaps and currency swaps.
Example: A company with a floating-rate loan (say linked to LIBOR) might enter into a
swap to convert its exposure into a fixed-rate obligation to avoid interest rate volatility.
3. Practical Importance of Derivatives
a. Risk Management (Hedging)
Derivatives are widely used to hedge against price volatility in the underlying assets. For
instance, an importer may use currency futures to hedge against the depreciation of the Indian
rupee against the US dollar.
Real-Life Data: On July 8, 2025, USD/INR futures on NSE for July contract were trading at
₹83.50. If an importer is expecting to pay USD 1 million in August and fears the rupee may
weaken, he can lock in the rate using futures to prevent losses from currency movement.
b. Price Discovery
Futures and options markets often act as leading indicators of market expectations. They
provide important signals about future price trends and volatility.
Example:
If Nifty Futures are trading significantly higher than the spot price, it indicates bullish
expectations in the market.
c. Speculation
Professional traders and investors use derivatives to speculate on price movements and profit
from volatility. This activity adds liquidity to the market but also increases risk.
Example:
An investor who believes TCS stock will rise may buy a call option. If the stock price
increases sharply, the investor gains multiple times the premium paid.
d. Arbitrage Opportunities
Derivatives help arbitrageurs exploit price differences between the spot and derivatives
markets. This contributes to market efficiency and price alignment.
Example:
If the price of Infosys in the cash market is ₹1,400 and its futures are trading at ₹1,420, an
arbitrageur may buy in the cash market and sell futures to capture the ₹20 difference
(adjusting for cost of carry).
4. Derivatives Market in India
India has a well-developed derivatives market regulated by SEBI. Key derivative products
are traded on exchanges like the National Stock Exchange (NSE) and Bombay Stock
Exchange (BSE).
NSE started index futures trading in June 2000 with Nifty 50.
The derivatives segment includes index futures, stock futures, index options, and
stock options.
Currency derivatives and commodity derivatives are traded on platforms like MCX
and NSE-CDS.
Market Data Snapshot (July 2025 Example):
Nifty 50 Spot: ₹22,200
Nifty Futures (July contract): ₹22,280
Reliance 2500 Call Option Premium (July expiry): ₹45
USDINR July Futures: ₹83.50
5. Summary
Derivatives play a central role in modern finance by enabling efficient risk management,
enhancing market liquidity, aiding in price discovery, and offering trading and investment
opportunities. Whether it's a multinational hedging currency exposure or a retail trader
speculating on stock price movements, derivatives offer the necessary tools for a variety of
financial strategies.
Their proper understanding is essential for financial professionals, as they are integral to
portfolio management, corporate finance, treasury operations, and investment banking.
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