Context: IndusInd Bank reported derivative losses of Rs 2,100 crore on March 10, which pulled down its share price by 23%.

Background: –

• The bank sought to put the blame on a change of rules by the Reserve Bank of India relating to the derivative portfolio. However, the loss from the derivative book remained unresolved for a long time, leading to the accumulation of losses.

Key points

• Derivatives are financial contracts whose value is derived from the performance of an underlying asset. The underlying asset can be tangible (e.g., gold, oil) or intangible (e.g., stock index, interest rate).
• Purpose: Derivatives are used for:
  • Hedging: Reducing or mitigating risk.
  • Speculation: Betting on the future price movements of assets.
  • Arbitrage: Exploiting price differences in different markets.

Types of Derivatives

• Forward Contracts
  • A customized agreement between two parties to buy or sell an asset at a future date at a predetermined price.
  • Traded over-the-counter (OTC) and not standardized.
  • Example: An oil producer and an airline company agreeing on a fixed price for crude oil delivery in the future.
• Futures Contracts
  • Similar to forwards but standardized and traded on exchanges (e.g., NSE, BSE).
  • Reduces counterparty risk due to clearinghouse settlement.
  • Example: A farmer locking in a price for wheat to be sold at a future date.
• Options Contracts – Gives the right but not the obligation to buy or sell an asset at a set price before or on a specific date.
  • Two types:
    • Call Option: Right to buy at a specified price.
    • Put Option: Right to sell at a specified price.
  • Example: An investor purchasing a call option on a stock, expecting its price to rise.
• Swaps – A contract where two parties exchange cash flows or liabilities based on a financial instrument.
  • Common types:
    • Interest Rate Swaps: Exchange of fixed and floating interest rates.
    • Currency Swaps: Exchange of payments in different currencies.
  • Example: An Indian company exchanging its fixed interest rate loan for a floating rate to reduce costs.

Source: Indian Express