FINANCIAL DERIVATIVES – AN INNOVATIVE BUSINESS PRACTICE IN DIGITAL

ERA FOR SUSTAINABLE DEVELOPMENT

Sai Ragini. R - II M.Com(A/F)

Abstract:

This paper briefly explains about the financial derivatives which is an innovative business
practice in digital era for sustainable development. It is a strategy which helps in mitigation of
risks involved in the business. This paper includes the history, present scenario of derivatives in
our country and the benefits of financial derivatives for businesses. It also includes players in the
derivatives market who assist the investors to earn profit. This study is done completely with the
help of secondary data. It is a detailed revision on the financial derivatives in India which is a
boon for capital market.

Introduction:

Financial derivative is a security or contract whose value depends on another contract or asset. In
simpler terms it can be explained as the financial instruments whose prices or values are derived
from the prices of other underlying financial instruments or financial assets. It is a strategy that
businesses and companies enter in order to mitigate the risks involved. The financial derivatives
can also be derived from the combination of cash market instruments or financial market
instruments. In fact, most of the financial derivatives are not revolutionary new market
instruments in nature as they also include various older generation derivatives or cash market
instruments. In 1980s, they were called as off-balance sheet instruments because no assets or
liabilities underlying the contract were put on the balance sheet as such. Since the market prices
of those assets fluctuate continuously, they were treated as contingent in nature.

Basic features of derivatives:

• Underlying - the rates or prices that relate to the asset or liability underlying the
derivative instrument

• Minimal initial investment - a derivative requires little or no initial investment because

it is an investment in a change in value rather than an investment in the actual asset or
liability

• Transaction of contract – the contract is transacted through a recognized exchange or

over the counter exchange.

• No required delivery- generally the parties to the contract, the counterparties, are not
required to actually deliver an asset that is associated with the underlying.

• Prices of the derivatives – the prices of the derivatives depend upon their underlying
assets price movement.
Antiquity and extant of Financial Derivatives:

The full set of equity derivatives was available by November 2011 only. The 9/11 attacks on the
World Trade Centre in the US were the first important event surrounding which index
derivatives trading came to be of interest. From then there was a remarkable growth in number of
contracts that was traded in NSE. In early 2002, the market introduced various techniques such
as options and futures. The knowledge about derivatives percolated within the community and
the shares of derivatives went up to over 80% of the overall equity derivative trading. According
to research in 2014, NSE has the second largest volumes in the derivatives market, second in
index option and third largest in stock index futures.

Benefits of Derivatives for the business:

1. Risk management: It is a process of identifying the desired amount of risk that is involved in
the business. Hedging and speculation strategies, along with derivatives, are useful tools or
techniques that enable companies to more effectively manage risk.

2. Numerous options to execute strategies: Since all the transactions are related to future period,
it provides individual with better opportunities

3. Huge transactions with smaller amount: Another benefit for the investor is that he can transact
huge transactions with smaller amount which gives the benefit of leverage.

4. Liquidity and transaction costs: As we see that in derivatives trading no immediate full amount
of the transaction is required. As a result, large number of traders, speculators, arbitrageurs
operates in such markets. So, derivatives trading enhance liquidity and reduce transaction cost in
the markets of underlying assets.

5. Gearing of value: Special care and attention about financial derivatives provide leverage (or
gearing), such that a small movement in the underlying value can cause a large difference in the
value of the derivative.

Players in derivatives market:

1. Hedgers: They are traders who use derivatives to reduce the risk they face from potential
movements of prices of the assets. Hedging by the means of future contract can also be used to
lock in the acceptable price margin.

2. Speculators: They want to increase their risk and therefore maximize the profits. They buy the
contract at low price and sell at higher price. They don’t own a commodity rather they seek
position in the market to earn maximum profits.
3. Arbitrageurs: They simultaneously buy and sell same asset in the effort to earn profit from
naive price differentials. They concurrently enter into transaction in two or more market in order
to make profit by locking in riskless trading.

Classification of derivatives:

Financial
Derivatives

Forwards Futures Options Swaps

A. Forwards: It is a customized form of contract between two parties whereby the settlement
takes on the specific date in the future at today’s pre agreed price. The biggest forward contract
in India is the rupee-dollar exchange rates with banks and financial institutions.

B. Futures: It is a contract between two parties to buy/sell assets in the future at a certain price. It
is generally settled in the form of cash and cash equivalents rather than requiring physical
delivery of underlying assets.

C. Options: It is the right but not an obligation to buy/sell the asset during a given time for a
specified price. They are of two types – 1. Call option – it is the right to buy securities/assets.
2. Put option – it is the right sell securities/assets.

D. Swaps: It is a private agreement between two parties to exchange cash flows in the future
according to predetermined intervals. They are useful in avoiding the problems of unfavorable
fluctuations in FOREX market. They also reduce borrowing costs and control over interest rate
risk.

Financial derivatives – a gifted business move:

Generally wise business owners analyze their business situation and they don’t jump in to take
risks which are unnecessary in nature. The major role of financial derivatives is to eliminate the
risk or greatly mitigate the risks involved in business. Thus correct use of financial derivatives
can save any business or investment owner a lot of troubles and hassles. If the business enters
into an agreement which ensures smooth operation, then these are gifted option for businesses.

Another intelligent character of a successful business operator is to take up the opportunities of

price movements and trends in the stock market. Mediocre business operator would allow them
to be caught up with the uncertainties of business market and would become the victim when the
market is unfavorable for them. The prudent business operator will take the advantages of ups
and downs in the derivative market.
For example: Business operator sells the asset, if the asset is perceived to be depreciated in the
future period. This move frees the business owner from the non-profitable asset while making
profit from it. One can take advantage of the low cost of an asset and buy it at the current low
price when he sees that it will increase in value in the future. This saves him a lot of money and
allows him to purchase a profitable investment. Good businesses are those that have the ability to
foresee the future trends and performance. Entering into financial derivative contracts entails a
good assessment of financial position

Conclusion:

Businesses of whatever type will always face risks. Any business venture is started with the aim
of gaining profit in mind. Whatever the business, we can find financial derivatives as a very
useful tool. With the help of derivatives, profit can be increased and assets can be purchased that
speculate to have higher financial value in the future. The financial derivative or money that we
will earn through that increase in value is an application of financial derivative concepts.

Bibliography:

Investopedia, books related to financial derivatives, lets learn finance, derivativesinvesting.com

and Various journals.