What is a derivative?
A derivative is an instrument (security or contract) that derives its value from the value of an underlying asset (security or a commodity). For example, in the case of an oil derivative (say oil futures), the underlying asset is a commodity i.e. oil. Derivatives are used primarily as an instrument to hedge the exposure to a certain asset, be it a security or a commodity.
Different types of derivatives:
Forwards 
Futures 
Options 
Complex Derivatives 
Interbank forex forwards 
Commodity 
Commodity 
Swaps 

Financial 
Financial 
Forward rate agreements 



Range forwards 



Exotic options 



Collars 



Synthetic derivatives 



Credit derivative 
Why Derivatives?
We should perhaps explore why should someone take a position in a security which does not exist on its own. If there are no "dividends" or "interest" payments to accrue from a security, and the time horizon is limited to a maximum of one year (as per L. C. Gupta Committee Report on Derivatives), are transactions in Derivatives not mere speculation?
To understand this, let us clear one aspect. Nobody invests in a futures market. One either speculates, hedges or exploits arbitrage opportunities. When a particular person or entity buys or sells a derivative on the expectation that the market will rise or fall without a portfolio to protect, it is a case of speculative trade. However, when a trade has been entered to protect the value of a portfolio in uncertain or bearish market conditions, the particular position so created would be classified as a hedge. As a hedger, you enter into a transaction either  to protect the value of your portfolio in case you are expecting the market to fall, or, to square off an existing open position.
What is an Index future?
Index future is a derivative. Hence, its value is dependent on the value of the underlying asset, in this case the stock market index (BSE or NSE). When you buy an index based mutual fund you are buying the index, any movement in the index will reflect on the value of your investment. Similarly the index future in itself is an instrument whose value is dependent on the index. If your portfolio replicates the index and you hedge using index futures then it guarantees you a risk free rate of return. Therefore, it is of maximum use when markets are volatile.
Index derivatives are of use primarily to the fund managers controlling large portfolios, who wish to hedge their portfolio against any adverse market movements. The popularity of this hedging instrument can also be attributed in part to the very low transaction costs associated with it.
How does a person go about hedging the value of his portfolio?
The first step for any person towards hedging a portfolio would be to evaluate the riskiness of the portfolio. If the portfolio is twice as sensitive as the market, the person would take a suitable exposure in derivatives to protect the portfolio in bearish market conditions.
Example 1
Let us assume a particular fund, XYZ, has a sensitivity of 1.1 times visàvis the market or a suitable representative, say, S&P CNX Nifty. The sensitivity is denoted by Beta, which is the percentage impact on the stock prices for 1% change in the index. Therefore, for a portfolio whose value goes down by 11% when the index goes down by 10%, the beta would be 1.1. As a logical extension of the above example, when the index increases by 10%, the value of the portfolio increases 11%.
Let us assume that the corpus of the fund is Rs 100 m. The person, on 14th February, 2000 feels that the market is highly overvalued and due for a correction. So he sells Nifty futures worth
Rs 100 m * 1.1 (Value of the Beta) = Rs 110 m. (61,265 Nifty Futures) (Rs 110 m / 1795.45)
The value of the Nifty then was 1795.45, and on 25th May it closed at 1247.65. That is, the market had crashed by 30.51%. The NAV of XYZ would have fallen by 30.51* 1.1 = 33.56% had the fund manager not hedged her portfolio. On the other hand, the manager would stand to profit in the futures market (as he would be able to buyback the futures he had earlier shorted at a lower price). Now let us compute the losses / gains for the fund after the hedge:
(Rs) 

Loss in Cash Market 
33,561,502 
Gain in Futures Market 
33,560,967 
Net Effect: Profit / (Loss) 
(535) 
Therefore, with some good use of the futures, the person has protected the value of the portfolio.
Example 2
Mr. Y is expecting the price of Reliance to increase on his projections of sharp growth in profits. He is however, neutral on market expectations, i.e. he is expecting the market to move horizontally. The stock markets are however risky, and within the short span of a fortnight, the expectations could change dramatically. In a bear market, even the best of stocks would lose value.
Therefore, while Mr. Y would be buying shares of Reliance, he will be short selling the futures in proportion to the sensitivity of Reliance to the market. Thus in the normal course of events and expectations, the investor will see appreciation of his portfolio. In case on some adverse news that causes the market to crash, the investors' losses in the cash market would be limited by gains on the futures market. Thus, we see the investor can manage the downside risk of his portfolio reasonably well with the deft use of index futures.
Calculation:
Assume the beta for Reliance as 1.5 times
Number of shares purchased: 1000 @ Rs 325 per share.
Value of portfolio: Rs 325,000.
To create a hedge, Y would look to sell futures worth 325,000 * 1.5 = 487,500. Assuming a value of 1,300 for a Nifty Future, Y would sell 375 Nifty Futures to cover his position completely. Alternatively, he could choose to cover only a part of his portfolio and bear partial market risk.
Example 3
Mr. Z is expecting the price of ITC (Assumed Beta: 1.35 times) to fall in the immediate future. He will therefore short sell the shares or the stock futures. But, if the market takes an upturn, he could be severely affected as the price of ITC prices would also rise in line with the market. Therefore, when he sells 1,000 shares of ITC at Rs 750, he will also go long on the Nifty to the extent of 1.35 * 750,000 = Rs. 1,012,500. Again assuming Nifty Futures price at 1,300, Z would be required to buy 779 Nifty Futures to cover his position completely.
How are margins calculated on Index Futures?
The Clearing Corporation retains some margin for every open position in the exchange. These comprise an initial margin and a daily mark to market margin. The initial margin is the amount deposited with the exchange at the time of entering the contract. The second component, the mark to market margin, is maintained on a day to day basis depending on the movement of the index future.
Currently, NSE has not specified the margin that the clearing corporation would be retaining. However, as per the J. R. Verma Committee Report, it might be at 6%. Assuming the margin rate at 6%, the margins are computed as follows:
Initial margin:
Consider Mr. X having bought into 100 Nifty Futures at a value of 1,500. Therefore, his open position is 1,500 * 100 = Rs 150,000. This makes the initial margin requirement as Rs. 150,000 * 6% = Rs 9000/.
Mark to market margin:
Let us assume that the market goes down by 5% the following day. Then, the Nifty would quote at 1,425. Therefore, the margin requirement would be  1,425 * 100 * 6% = Rs 8,550.
The transactions in his margin account would be as follows:
Losses on investment: 75 * 100 = Rs 7,500
Margin Refund (as the 6% margin has to maintained on a lower value of investment):
7,500 * 6% = Rs 450.
Therefore, net payment to be made: Rs 7,500  Rs 450 = Rs 7,050.
Conclusion
The complicated nature of this instrument is probably evident by now. It would be wise for retail investors to steer clear of this instrument, unless of course, they have taken professional advice. For the funds, however, the introduction of these instruments will come as a boon, especially in view of the increasing volatility in the markets.
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