Risk is a characteristic feature of all commodity and capital markets. Prices of all commodities both agricultural and non-agricultural commodities are subject to fluctuations overtime keeping with the prevailing supply and demand conditions. Similarly, the price of shares, debentures, and bonds and other securities are also subject to continuous change. Therefore, the sellers and buyers are constantly and continuously exposed to the risk of losses on account of fluctuations in the prices of such assets. Thus, Derivatives came into being primarily to deal with and also to eliminate such price risks prevent in commodity and security market. The objective of an investment decision is to get required rate of return with minimum risk.
Asset of Derivative Market
Derivative contracts exist on a variety of commodities such as corn, pepper, cotton, wheat, silver, etc. besides commodities.
Derivatives contracts also exist on a lot of financial underlying assets like stocks, interest rates, exchange rates, etc. Derivative products initially emerged as hedging devices against fluctuations in commodity prices.
Concept of Derivative Market
In the Indian context the Securities Contracts (Regulation) Act, 1956 SC(R) A, defines “derivative” as 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. A contract which derives its value from the prices, or index of prices, of underlying securities.
"Financial instruments that linked to a specific financial instrument or indicator or commodity and through which specific risks can be traded in financial markets in their own right. The value of a financial derivative derives from the price of an underlying item, such as an asset or index. Unlike debt securities, no principal is advanced to be repaid and no investment income accrues."
-The International Monetary Fund (IMF)-
Need for Derivative Market
- It helps in transferring risk from risk averse to risk takers.
- It helps in predicting future prices based on current prices.
- It catalyses entrepreneurial activity.
- It increases the volume traded in markets because of participation of risk averse people in greater numbers.
Functions of Derivative Market
Like other segments of Financial Markets, Derivatives Market serves the following specific functions:
- Derivatives market helps in improving price discovery based on actual valuations and expectations.
- Derivatives market helps in transfer of various risks from those who are exposed to risk but have low risk appetite to participants with high risk appetite.
- Derivatives market helps shift of speculative trades from unorganised market to organised market. Risk management mechanism and surveillance of activities of various participants in organised space provide stability to the financial system.