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Derivative market

2021 DEC 21

Preliminary   > Economic Development   >   Miscellaneous   >   Financial market

Why in news?

  • Securities and Exchange Board of India (SEBI) issued directions to stock exchanges in the commodity derivatives segment for immediately suspending trading in derivative contracts in key farm commodities, namely paddy (non-basmati), wheat, chana, mustard seeds and its derivatives, soya bean and its derivatives, crude palm oil and moong for a year.

More about the news:

  • The derivative contracts in these commodities were already suspended, as per a SEBI statement on August 16 and October 8, respectively.

What is derivative market?

  • Derivative is a product whose value is derived from the value of one or more basic variables, called bases, in a contractual manner.
  • The underlying asset can be equity, forex, commodity or any other asset.
  • For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date.
  • Such a transaction is an example of a derivative.
  • The prices of the derivatives are established by the price fluctuations of the underlying assets.
  • Derivatives can be traded on an exchange or over the counter (OTC).
  • Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps.

How the system work and what are derivatives trading?

  • Derivatives trading take place when traders speculate on the future price of an asset through buying or selling of derivative contracts to maximise profit, as compared to buying the underlying asset outright.
  • Traders also use derivatives for hedging to minimise risk against an existing position.
  • With derivatives, traders can go short and make profit from falling asset prices. They also use derivatives to hedge against any existing long positions. The ultimate objective is to profit. This is viewed as a deterrent to bring in price discipline in the market.

What does the SEBI order mean?

  • The imports in such commodities, especially edible oils, would reduce in the short term as traders will not have a hedging platform.
  • Hedging, which is speculative in nature, has been made difficult. This will lead to release of blocked local produce supplies into the market, which should cool the prices. Imports of commodities for speculative gains will be discouraged.

What is the objective of the suspension?

  • It is to rein in rising prices of essential commodities, which are fuelling inflation.
  • India is the world’s biggest importer of vegetable oil and this measure will make it difficult for edible oil importers and traders to transact business since they use Indian exchanges to hedge their risk.
  • It is believed that speculators have a role in jacking up prices and this needed to be discouraged to curb inflation and support growth as the economy is recovering from COVID-19 impact.
  • The suspension of trading in these commodities follows a communication from the Department of Economic Affairs, which is closely monitoring price movements.

PRACTICE QUESTION

Which of the following statements is/are correct?

1.  Derivative market in India is regulated by RBI

2. The prices of the derivatives are established by the price fluctuations of the underlying assets.

Select the correct answer using the code given below:

(a) 1 only

(b) 2 only

(c) Both 1 and 2

(d) Neither 1 nor 2

Answer