INTRODUCTION

The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, Derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. Derivatives are risk management instruments, which derive their value from an underlying asset. The underlying asset can be bullion, index, share, bonds, currency, interest, etc., Banks, Securities firms, companies and investors to hedge risks, to gain access to cheaper money and to make profit, use derivatives. Derivatives are likely to grow even at a faster rate in future. Derivatives are a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate) in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative.

In the last 20 years derivatives have become notably important in the world of finance. Futures and options are now globally traded on many exchanges. Forward contracts, Swaps and many different types of options are regularly conducted by outside exchanges by financial institutions, fund managers and corporate treasurers in what is termed the over the counter market. Derivatives are also sometimes added to a bond or stock issue. Further, the very nature of volatility in the financial markets, the use of derivative products, it is

possible to partially or fully transfer price risks by locking in asset prices. But these instruments of risk management are generally do not influence the fluctuations in the underlying asset prices. However, by locking asset prices, the derivative products minimize the fluctuations in the asset prices on the profitability and cash flow situations on risk to the investor. The derivatives are becoming increasingly important in world of markets as a tool for risk management. Derivative instruments can be used to minimize risk. Derivatives are used to separate the risks and transfer them to parties willing to bear these risks. The kind of hedging that can be obtained by using derivatives is cheaper and more convenient than what could be obtained by using cash instruments. It is so because, when we use derivatives for hedging, actual delivery of the underlying asset is not at all essential for settlement purposes. The profit or loss on derivative deal alone is adjusted in the derivative market. Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. The following three broad categories of participants hedgers, speculators, and arbitrageurs trade in the derivatives market. Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk. Speculators wish to bet on future movements in the price of an asset. Futures and Options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture. Arbitrageurs and in business to take advantage of a discrepancy between prices in two different markets.

If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit. Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity-linked derivatives remained the sole form for such products for almost three hundred years. Financial derivatives came into spotlight in the post1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products.
In the class of equity derivatives the world over, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use. The lower costs associated with various portfolios and ease of use. The lower costs associated with index derivatives vis--vis derivative products based on individual securities is another reason for their growing use. The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on option in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24member committee under the Chairmanship of Dr. L.C. Gupta. On November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India.

INTRODUCTION TO THE TOPIC

DERIVATIVES:
Derivatives are defined as financial instruments whose value derived from the prices of one or more other assets such as equity securities, fixed-income securities, foreign currencies, or commodities. Derivative is also a kind of contract between two counter parties to exchange payments linked to the prices of underlying assets.

DEFINITION:

In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines derivative to include1. A security derived from a debt instrument, share, and loan whether secured or unsecured, risk instrument or contract for differences or any other from of security. 2. A contract which derives its value from the prices, or index or prices, of underlying securities The above definition conveys that Derivatives are financial products and derive its value from the underlying assets. Derivatives are derived from a matter financial contract called the underlying.

DIFFERENCE BETWEEN DERIVATIVES AND SHARES:

The subtle, but crucial, difference is that while shares are assets, derivatives are usually contracts (the major exception to this are warrants and convertible bonds, which are similar to shares in that they are assets).

INVESTING IN DERIVATIVES:

If one is interested in getting directly involved with futures or options, then the idea to incest is inappropriate they are traded. This implies that one monitors the price more closely, and uses more sophisticated trading techniques (for example, the use if stop orders). There are a number of brokers that specialize in private client futures/options trading; list of these can usually be requested from futures exchanges.
USAGE OF DERIVATIVES:

Any person who has funds invested, (e.g. an insurance policy or a pension fund), are mostly exposed to derivatives in some or other way. Due to its great flexibility, derivatives are used by many different types of investors. From this stand point, derivatives will allow the modern investor the full range of investment strategy: speculation, hedging, arbitrage and all of the possible combinations thereof.
MEASURES OF DERIVATIVES:

The value of a derivatives contract equals the difference between the value of the underlying asset and the cost of financing a purchase of the asset, Further the value also depends on the price of the underlying asset and the level of interest rates.
PARTICIPANTS OF DERIVATIVES:

The following are the three broad categories of participants in the derivative market.

Hedgers:

Hedgers are parties who ate exposed to risk because they have a prior position in the commodity or the financial instrument specified in the futures contract. They use futures or options marked to reduce or eliminate this risk. Since one can take neither a long position nor a short position in the futures contract, there are two basic hedge positions: 1. The short (sell) hedge: A party who has a long cash position, current or potential, may sell (short) the futures. 2. The long (buy) hedge: A party who is not currently in cash but who expects to be in cash in the future may buy a futures contract to eliminate uncertainty about the price.
Speculators:

Speculators are those who do not have any position on which they enter in futures and options market. They only have a particular view on the market, stock, commodity etc. In short speculators put their money a risk in the hope of profiting from an anticipated price change. They consider various factors such as demand supply, market positions, open interests, economic fundamentals and other data to take their positions. They play very important role in the proper functioning of futures market. The futures market offers the following attraction to the speculator: Leverage Ease of transactions Lower transaction costs
ARBITRAGEURS:

An arbitrageur is basically risk averse. To earn risk free profits by exploiting market imperfections. Arbitrageurs make profit from price differential existing in

to markets by simultaneously operating in the two different markets. There are two main kinds of arbitrage transactions. They are A futures-futures arbitrage: It occurs when a dealer exploit the price differential between two future markets. A cash-futures arbitrage: It occurs when a dealer exploits price misalignment between the cash market and the futures market.