Derivative Market & Instruments
Derivative Instrument
A derivative instrument is one whose value depends on the value of something else.
Derivatives are the Financial instruments that
derive their value from changes in the value of a
related asset or liability.
INSTRUMENTS
Forward Contracts
Futures Contracts
Option Contracts
Swaps
Forward Contracts
Forward market is relatively a simple
derivative . It is an agreement to buy or sell an
asset at a certain future time for a certain price
agreed today.
CHARACTERSTICS
These are bilateral contracts & hence exposed to counter- party risks.
Each contract is custom designed, & hence is unique in terms of contract size, expiration date & the asset type &
quality.
Contract price is generally not available in public domain.
Contract has to be settled by delivery of the asset on expiration date.
CHARACTERSTICS
Contract can be reversed only with the same counter party which being in a monopoly situation can command the prices it wants.
Follow daily settlements .
Over The Counter (OTC) market trading.
FUTURE CONTRACTS
A futures contract is a type of forward contract with highly standardized and closely specified contract terms. Futures contract s is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price.
CHARACTERSTICS
1. Futures contracts always trade on an organized exchange.
2. Futures contracts are always highly standardised with a specified quantity of a good, with a specific delivery date and delivery mechanism.
3. Performance on futures contracts is guaranteed by a clearinghouse.
4) All futures contracts require that traders post margin in order to trade. A margin is a good faith deposit made by a prospective futures trader to indicate his or her willingness and ability to fulfill all financial obligations that may arise from trading futures.
5) Futures markets are regulated by an identifiable government agency.
Differences between Futures and Forwards
A forward contract on the other hand trades
in an unregulated market and does not
require the five points above. However,
futures and forwards are essentially similar
contracts and have similar results.
OPTIONS
An option is a contract which gives the buyer the right to buy or sell an
underlying asset or instrument at a specific strike price on a specified date.
The word “option” means that the holder has the right but not the obligation to
buy/sell underlying assets.
Call Option Example Right to buy 100 Reliance shares at a price of Rs.300 per share after 3 months.
CALL OPTION Strike Price Premium = Rs.25/share Amt to buy Call option =
Rs.2500 Current Price = Rs.250 Suppose after a month, Market price is Rs.400, then the option is exercised i.e. the shares are bought. Net gain = 40,000-30,000- 2500 = Rs.7500
Suppose after a month, market price is Rs.200, then the option is not exercised.
Net Loss = Premium a
CHARACTERSTICS
Buyer has the right to buy or sell the asset.
To acquire the right of an option,
buyer of the option must pay a price to the seller. This is known as
premium.
Strike price is determined at the beginning of the transaction.
It can be traded on both OTC
Types of options: CALL & PUT. Option that gives right to buy is called call option whereas Option that gives right to sell is called put option
Options Terminology
Underlying: Specific security or asset.
Option premium: Price paid.
Strike price: Pre-decided price.
Expiration date: Date on which option expires.
Exercise date: Option is exercised.
Open interest: Total numbers of option contracts that have not yet been expired.
Option holder: One who buys option.
Option writer: One who sells option.
SWAPS
In a swap, two counter parties agree to enter into a contractual agreement wherein they agree to exchange cash flows at periodic intervals.
CHARACTERSTICS
Swaps are an OTC instruments.
At initiation neither party pays any amount to another except currency swap in which the parties exchange amounts denominated in two different currencies but equal in value.
The payment between the parties is based on net owed amount.
Types of Swaps
There are 2 main types of swaps:
Simply interest rate swaps.
Simply currency swaps.
Traders in Derivatives Market
There are 3 types of traders in the Derivatives Market : HEDGER:
A hedger is someone who faces risk associated with price movement of an
asset and who uses derivatives as means of reducing risk. They provide economic balance to the market.
SPECULATOR :
A trader who enters the futures market for pursuit of profits, accepting risk in the
endeavor. They provide liquidity and depth to the market.
ARBITRAGEUR:
A person who simultaneously enters into
transactions in two or more markets to take advantage of the discrepancies between
prices in these markets.
