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Derivatives Market Basic


Derivatives Market


Meaning of Derivatives


A financial instrument whose price is dependent upon or derived from one or more underlying assets is called Derivatives. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and Market indices. Most Derivatives are characterized by high leverage.


Types of Derivatives



Forward


Forward Contract is a contract between two parties to buy or sell an Asset on a pre specified future date at a pre specified price. Forward contract is different from Spot Contract as in spot contract settlement comes at the time of contract while in Forward Contract Settlement comes on a pre specified future date.



Forward contracts are traded only in Over the Counter (OTC) Market and not in stock exchanges. OTC Market is a private Market where individuals/institutions can trade through negotiations on a one to one basis. Forwards are private contracts and their terms are determined by the parties involved


Features of forward contracts:

  • Custom tailored
  • Traded over the counter ( not on exchanges )
  • Counterparty risk..

Futures


A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts.



As far as Indian Equity Market is Concern, NSE is having the most developed Equity Derivatives Market. They have launched 3 Month series for Future Contracts i.e. Current Month (1 month Expiry), Next Month (2-month Expiry) and Far Month (3-month Expiry).


Options


An Option is a contract between two party, where one party gives to the other the right, but not the obligation, to buy from (or sell to) the First Party the underlying asset on or before a specific day at an agreed price. In return for giving the right, the party giving the right collects a payment from the other party. This payment collected is called the “premium” or price of the Option.


Types of Options


Call Options


Call Option is an Option where buyer gets the right to purchase the underlying but not any obligation. Buyer of the Call option expects the price to go up and hence purchase right to buy at a specified rate by paying premium. Call Option buyer is getting the right to purchase from Call Option seller and pays the premium to Call Option seller. The Maximum loss to the buyer of the Option is limited up to premium paid. If price rises than Call buyer earns unlimited profit. The maximum profit to the Call seller is up to premium received when Market falls and he may make unlimited loss if Market rises.


Put Options


Put Option is an Option where buyer gets the right to sell the Underlying but not any obligation. Buyer of the Put Option expects the price to go down. The Maximum loss to the buyer of the Option is limited up to premium paid. If prices falls than Put buyer earns unlimited profit. Let us look at one example to make it clear.


Swaps


Swaps are private agreements between two parties to exchange cash flows in the future according to a pre-agreed price. The two main types of swaps are:


Interest Rate Swaps


This swaps only the interest related cash flows between the parties in the same currency.


Currency Swaps


This swaps both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.





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