Derivatives – Meaning, Type & Taxation

Jayant Makkar

DERIVATIVES

A derivative is nothing but a bet. We in our daily lives enter into a derivative contract (place a bet) without even knowing about it, say while watching a cricket match. To make you familiar with one of the derivative contract let me give you an example. Let’s say you have to buy a cable connection for your televison. As a buyer you select a cable operator and enter into an agreement to subscribe to 100 channels at Rs. 350 per month for year 2018. This contract is similar to a futures contract, in that you have agreed to get a product at a future date and at a specific price. You have secured your benefit at the pre-decided price which is not set to change. Even if the cable operator increases his charges, you’ll still be able to enjoy the channels at Rs. 350 per month. By entering into this agreement with the cable operator, you have reduced your risk of higher prices. This is what a Derivative Contract is.

The term ‘Derivatives’ as its name suggests, means an instrument which derives its value or price from or is dependent upon an underlying asset which can be a financial asset such as currency, stock, market index, commodities etc. Four most common derivative instruments are futures, options, forwards and swaps. According to the Securities Contract Regulation Act, 1956 the term ‘Derivative’ includes:

i. a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security.

ii. a contract which derives its value from the prices or index of prices, of underlying securities.

 Types of Derivative Contracts

The most commonly used derivatives are futures, options, forwards and swaps. These are briefly defined below:

I. Futures Contract: A futures contract is an agreement between two parties to buy or sell an underlying asset at a certain time in future at a certain price. The underlying can be a commodity, stock, currencies etc. These are standardized exchange traded contracts. The buyers of futures contract are said to be in long position whereas the seller in short position. A futures contract may be squared off prior to maturity by entering into an equal and opposite transaction. To trade in futures, one must open a futures trading account with a derivatives broker and simply involves putting in the margin money. With the purchase of a futures contract, the holder legally binds himself to buy the underlying at a specific price and at some specific time in future.

II. Options Contract: An option contract gives the holder of the option the right, not an obligation to do something in future. In contrast, in a forward or futures contract, the two parties are legally bound or are obligated to meet their commitments as specified in the contract. The buyer of the option contract is required to pay an upfront fee called option premium (consider it as the price to be paid to the seller of the option contract for buying the right). There are two types of options:

a) Call option: It gives the holder the right but not the obligation to buy an asset by a certain date for a certain price

b) Put option: It gives the holder the right but not the obligation to sell an asset by a certain date for a certain price.

III. Forward Contracts: A forward contract is a contract between two parties, where settlement takes place on a specified date in future at a price agreed today. Each contract is customized and hence is unique in terms of contract size, expiry and asset type and quality. One of the parties to the contract assumes long position to buy the underlying asset and the other short position to sell the asset. The forward contracts are normally traded outside the exchanges (OTC). Since a forward contract is customized and are traded OTC, these are exposed to counter party risk which arises from the possibility of default by any one party to the transaction.

IV. Swaps: Swaps are private agreement between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:

a) Interest rate swaps: These entail swapping only in the interest related cash flows between parties in the same currency say floating rate with fixed rate of interest.

b) Currency swap: These entail swapping both principal and interest between the parties, with the cash flow in two different currencies.

Having explained the types of derivative contracts, I will now briefly tell how and what type of derivative instruments are traded on the NSE.

Only Futures and Options derivatives instruments are traded on the NSE. The futures and options trading system of NSE, called NEAT F&O trading system, provides a fully automated screen based trading for Index futures & options and stock futures and options on a nationwide basis. It supports an order driven market and provides complete transparency of trading operations. It is similar to that of trading of equities in cash market segment. Since the launch of the Index Derivatives on CNX Nifty index in 2000, the exchange currently provides trading in F&O contracts on 9 major indices and 145 securities.

Taxation of Derivative Transaction in securities

Prior to F.Y. 2005-06, transaction in derivatives were considered as speculative transaction under the Income Tax Act, 1961. Finance Act 2005 amended this provision so as to exclude transactions in derivatives carried out in a “recognized stock exchange” for this purpose. This implies that income or loss on derivative transactions which are carried out in a “recognized stock exchange” is not taxed as speculative income or loss. As per Finance Act 2008, following STT rates are applicable in relation to sale of a derivative transaction on a recognized stock exchange:

 It may also be noted that STT paid on such transactions is eligible as deduction under Income Tax Act,1961.

Not everyone is a fan of using derivatives, including investors as regarded as Mr. Warren Buffett. In a letter to his shareholders in 2002, Buffett describes derivatives as “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” But living in a world where we are surrounded by finance and its technicalities, derivatives form an important part.

To conclude I would say derivatives are complicated yet are great instruments for leveraging your portfolio and to some extent, provide liquidity and flexibility. However, they are risky investments. Before entering into a derivative transaction, keep in mind the expiry, volatility and with a proper strategy.

References:  1. nseindia.com 2. bseindia.com 3. investopedia.com