Model Answer
0 min readIntroduction
Financial derivatives are contracts whose value is derived from the performance of an underlying asset, index, or interest rate. They are crucial tools for risk management, speculation, and arbitrage in modern finance. In recent years, the Indian derivatives market has witnessed substantial growth, driven by increased participation from institutional and retail investors. Options and Futures are two of the most commonly traded derivatives, playing a vital role in enhancing market efficiency and providing hedging opportunities. Understanding their nuances is essential for anyone involved in financial markets.
Futures Contracts
A futures contract is a standardized agreement to buy or sell an asset at a specified future date at a predetermined price. It obligates both parties to fulfill the contract. Key features include:
- Standardization: Exchange-traded, with standardized contract sizes and delivery dates.
- Margin Requirements: Both buyer and seller must deposit an initial margin and maintain a maintenance margin.
- Mark-to-Market: Daily settlement of gains and losses based on price fluctuations.
- Delivery or Cash Settlement: Contracts can be settled by physical delivery of the underlying asset or through cash settlement.
Example: A farmer can use a futures contract to lock in a price for his wheat harvest, protecting him from potential price declines.
Options Contracts
An options contract gives the buyer the right, but not the obligation, to buy (call option) or sell (put option) an asset at a specified price (strike price) on or before a specified date (expiration date). The seller (writer) of the option receives a premium from the buyer.
- Call Option: Gives the buyer the right to buy the underlying asset. Profitable if the asset price rises above the strike price plus the premium.
- Put Option: Gives the buyer the right to sell the underlying asset. Profitable if the asset price falls below the strike price minus the premium.
- European vs. American Options: European options can only be exercised on the expiration date, while American options can be exercised at any time before expiration.
Example: An investor expecting a stock price to increase might buy a call option, limiting their potential loss to the premium paid.
Comparison: Futures vs. Options
| Feature | Futures | Options |
|---|---|---|
| Obligation | Obligatory | Right, not obligation |
| Premium | No premium | Premium paid by buyer |
| Risk/Reward | Unlimited potential gain/loss | Limited loss (premium paid), unlimited potential gain (call option) |
| Margin | Required | Not required for buyers, required for sellers |
Regulatory Framework in India
In India, the trading of futures and options is regulated by the Securities and Exchange Board of India (SEBI). SEBI sets the rules and regulations for trading, clearing, and settlement of derivatives contracts. Major exchanges offering derivatives trading include the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). SEBI’s regulations aim to ensure market integrity, protect investor interests, and promote orderly growth of the derivatives market.
Recent Trends: The introduction of weekly expiry options and the increasing popularity of index options are recent developments in the Indian derivatives market.
Conclusion
Financial derivatives, particularly options and futures, are indispensable tools in modern finance, offering opportunities for risk management, speculation, and arbitrage. The Indian derivatives market has matured significantly under SEBI’s regulation, providing a platform for efficient price discovery and hedging. Continued innovation and investor education are crucial for further developing this market and harnessing its full potential for economic growth. Understanding the nuances of these instruments is vital for both institutional and retail investors navigating the complexities of the financial landscape.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.