DERIVATIVES
A derivative
is a financial contract that derives its value from another financial
product/commodity (say spot rate) called underlying (that may be a stock, stock index, a foreign
currency, a commodity). Forward contract in foreign exchange transaction, is a simple form of a
derivative.
Objectives and instruments of derivates: The major purpose that is served by derivatives is to
hedge the risk. Futures, forwards, options, swaps etc. are the common instruments of
derivatives. The derivatives do not have any independent existent and are based on the
underlying assets that could be a stock index, a foreign currency, a commodity or an individual
stocks.
Operators in the derivative market : There are various kinds of operators in the derivative
market such as hedgers (which manage the risk), the speculators (who undertake risk for
realization of profit) and the arbitrageurs (who make purchase and sales simultaneously but in
different market to take benefit of price differentials). The players in option market include
development finance institutions, mutual funds, institutional investors, brokers, retail investors.
Components: The derivatives have components such as Options, Futures-forwards and Swaps.
Option It is contract that provides a right but does not impose any obligation to buy or sell a
financial instrument, say a share or security. It can be exercised by the owner. Options offer the
buyers, profits from favourable movement of prices say of shares or foreign exchange.
Variants of option: There are two variants of options i.e. European (where the holder can
exercise his right on the expiry date) and American (where the holder can exercise the right,
anytime between purchase date and the expiry date). It is important to note that option can be
exercised by the owner (the buyer, who has the right to buy or sell), who has limited liability but
possibility of realization of profits from favourable movement in the rates. Option writers on the
other hand have high risk and they cover their risk through counter buying.
product/commodity (say spot rate) called underlying (that may be a stock, stock index, a foreign
currency, a commodity). Forward contract in foreign exchange transaction, is a simple form of a
derivative.
Objectives and instruments of derivates: The major purpose that is served by derivatives is to
hedge the risk. Futures, forwards, options, swaps etc. are the common instruments of
derivatives. The derivatives do not have any independent existent and are based on the
underlying assets that could be a stock index, a foreign currency, a commodity or an individual
stocks.
Operators in the derivative market : There are various kinds of operators in the derivative
market such as hedgers (which manage the risk), the speculators (who undertake risk for
realization of profit) and the arbitrageurs (who make purchase and sales simultaneously but in
different market to take benefit of price differentials). The players in option market include
development finance institutions, mutual funds, institutional investors, brokers, retail investors.
Components: The derivatives have components such as Options, Futures-forwards and Swaps.
Option It is contract that provides a right but does not impose any obligation to buy or sell a
financial instrument, say a share or security. It can be exercised by the owner. Options offer the
buyers, profits from favourable movement of prices say of shares or foreign exchange.
Variants of option: There are two variants of options i.e. European (where the holder can
exercise his right on the expiry date) and American (where the holder can exercise the right,
anytime between purchase date and the expiry date). It is important to note that option can be
exercised by the owner (the buyer, who has the right to buy or sell), who has limited liability but
possibility of realization of profits from favourable movement in the rates. Option writers on the
other hand have high risk and they cover their risk through counter buying.
Components
of options: Options have two components i.e. call option and put option. The
owner’s liability is restricted to the premium he is to pay.
Call option : The owner i.e. the buyer, has the right to purchase and the seller has to obligation
to sell, a specified no. of instruments say shares at a specified price during the time prior to
expiry date.
Put option : Owner or the buyer has the right to sell and the seller has the obligation to buy
during a particular period.
Futures and forwards
The futures are the contracts between sellers and buyers under which the sellers (termed ‘short’) have to deliver, a pre-fixed quantity, at a pre-fixed time in future, at a pre-fixed price, to the buyers (known as ‘long’). It is a legally binding obligation between two parties to give/take delivery at a certain point of time in future. The main features of a futures contract are that these are traded in organised exchanges, regulated by institutions such as SEBI, they need only margin payment on a daily basis. The future positions can be closed easily. Futures contract are made primarily for hedging, speculation, price determination and allocation of resources.
The forward on the other hand is a contract that is traded off-the-stock exchange, is self regulatory and has certain flexibility unlike future which are traded at stock exchange only, do not have flexibility of quantity and quality of commodity to be delivered and these are regulated by SEBI, RBI or other agencies.
Futures
and options.owner’s liability is restricted to the premium he is to pay.
Call option : The owner i.e. the buyer, has the right to purchase and the seller has to obligation
to sell, a specified no. of instruments say shares at a specified price during the time prior to
expiry date.
Put option : Owner or the buyer has the right to sell and the seller has the obligation to buy
during a particular period.
Futures and forwards
The futures are the contracts between sellers and buyers under which the sellers (termed ‘short’) have to deliver, a pre-fixed quantity, at a pre-fixed time in future, at a pre-fixed price, to the buyers (known as ‘long’). It is a legally binding obligation between two parties to give/take delivery at a certain point of time in future. The main features of a futures contract are that these are traded in organised exchanges, regulated by institutions such as SEBI, they need only margin payment on a daily basis. The future positions can be closed easily. Futures contract are made primarily for hedging, speculation, price determination and allocation of resources.
The forward on the other hand is a contract that is traded off-the-stock exchange, is self regulatory and has certain flexibility unlike future which are traded at stock exchange only, do not have flexibility of quantity and quality of commodity to be delivered and these are regulated by SEBI, RBI or other agencies.
Futures can also be distinguished from options because in futures, both the parties have to
perform the contract and no premium is required to be paid by either party, where as in case of
option, only the writer has to perform while the buyers makes payment of the premium to the
seller in consideration for his performance. In addition, in futures the contract is to be performed
on the settlement date and not before that whereas in case of option the buyer can exercise the
option any time prior to the expiry date.
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