Traders in derivatives market

There are three types of traders in the derivatives market:

1. Hedger
2. Speculator
3. Arbitrageur

Hedger: A hedge is a position taken in order to offset the risk associated with some other position. A hedger is someone who faces risk associated with price movement of an asset and who uses derivatives as a means of reducing that risk. A hedger is a trader who enters the futures market to reduce a pre-existing risk.

Speculators: While hedgers are interested in reducing or eliminating risk, speculators buy and sell derivatives to make profit and not to reduce risk. Speculators willingly take increased risks. Speculators wish to take a position in the market by betting on the future price movements of an asset. Futures and options contracts can increase both the potential gains and losses in a speculative venture. Speculators are important to derivatives markets as they facilitate hedging provide liquidity ensure accurate pricing, and help to maintain price stability. It is the speculators who keep the market going because they bear risks which no one else is willing to bear.

Arbitrageur: An arbitrageur is a person who simultaneously enters into transactions in two or more markets to take advantage of discrepancy between prices in these markets For example, if the futures price of an asset is very high relative to the cash price, an arbitrageur will make profit by buying the asset and simultaneously selling futures. Hence, arbitrage involves making profits from relative mispricing. Arbitrageurs also help to make markets liquid, ensure accurate and uniform pricing, and enhance price stability.

All three types of trades and investors are required for a healthy functioning of the derivatives market. Hedgers and investors provide economic substance to this market, and without them the markets would become mere tools of gambling. Speculators provide liquidity and depth to the market. Arbitrageurs help in bringing about price uniformity and price discovery. The presence of Hedgers, speculators and arbitrageurs, not only enables the smooth functioning of the derivatives market but also helps in increasing the liquidity of the market.

Derivatives Market in India:

In India, commodity futures date back to 1875. The government banned futures trading in many of the commodities in the sixties and seventies. Forward trading was banned in the 1960s by the government despite the fact that India had a long tradition of forward markets. Derivatives were not referred to as options and futures but as “tezi-mandi”.

In exercise of the power conferred on it under section 16 of the Securities Contracts (Regulation) Act, the government by its notification issued in 1969 prohibited all forward trading in securities. However, the forward contracts in the rupee dollar exchange rates (foreign exchange market) are allowed by the Reserve Bank and used on a fairly large scale. Futures trading is permitted in 41 commodities. There are 18 commodity exchanges in India. The Forward Markets Commission under the Ministry of Food and Consumer Affairs acts as a regulator.

In the case of capital markets, the indigenous 125 year old badla system was very popular among the broking and investor community. The advent of foreign institutional investors in the nineties and a large number of scams led to a ban on badla. The foreign institutional investors (FIIs) were not comfortable with this system and they insisted on adequate risk-management tools. Hence, the Securities and Exchange Board of India (SEBI) decided to introduce financial derivatives in India. However, there were many legal hurdles which had to be overcome before introducing financial derivatives. The preamble of the Securities Contract (Regulation) Act, states that the Act was to prevent undesirable transactions in Securities by regulating business of dealing therein, by prohibiting options, and by providing for certain other matters connected therewith. Section 20 of the Act explicitly prohibits all options in securities. The first step therefore was to withdraw all these prohibitions and make necessary amendments in the Act. The Securities Laws (Amendment) Ordinance, 1995 promulgated on January 25, 1995 withdrew the prohibitions by repealing section 20 of the SC(R) A, and amending its preamble.