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Derivate Products
Derivate products initially emerged as hedging devices against fluctuations in commodity prices . Derivate is a product whose value is derived from the value of one or more basic variables , called bases ( underlying asset , index , or refrence rate ) , in a contractual manner . The under lying asset can be equity , forex , commodity or any other asset .For example when wheat farmers may wish to sell their harvest at a future date to eliminate the risk of change in prices by that date . Such a transaction is an example of derivative . The price of this derivative is driven by spot price of wheat which is the "underlying".
Applications of Derivatives
Some of the benefits that financial derivatives bring to its users are :-
Risk Management
Risk management is not about the elimination of risk rather it is about the management of risk. Financial derivatives provide a powerful tool for limiting risks that individuals and organizations face in the ordinary conduct of their businesses. Successful risk management with derivatives requires a thorough understanding of the principles that govern the pricing of financial derivatives . Used correctly , derivatives can save costs and increase returns .
Trading efficiency
Derivatives allow for the free trading of individual risk components , thereby improving market efficiency . Traders can use a position in one or more financial derivatives as a substitute for a position in the underlying instruments . In many instances traders find financial derivatives to be a more attractive instrument than the underlying security .Reason being , the greater amount of liquidity in the market offered by the financial derivatives and lower transaction costs associated with trading a financial derivative as compared to the costs of trading the underlying instrument.
Forward Contracts
These are the simplest form of derivative contracts. A cash market transcation in which delivery of the commodity is deferred until after the contract has been made. Although the delivery is made in the future, the price is determined on the initial trade date. Most forward contracts don'ts have standards and aren't traded on exchanges. A farmer would use a forward contract to "lock-in" a price for his grain for the upcoming fall harvest.
A forward contract is an agreement between parties to buy/sell a specified quantity of an assest at a certain future date for a certain price. One of the parites to a forward contract assumes a ling position and agrees to buy the underlying assest at a certain future for a certain price.
The other party to the contract assumes a short postion and agrees to sell the asset on the same date for the same price. The specified price is referred to as the delivery price. The parties to the contract mutally agree upon the contract terms like delivery price and quantity. No margins are generally payable by any of the parties to the other.
Salient features
- Each contract is custom designed, and hence is unique in terms of contract size, maturity date and the asset type and quality.
- On the expiration date, the contract is normally settled by the delivery of the asset.
- Forward contracts being bilateral contracts are exposed to counter party risk, and
- If the party wishes to cancel the contract or change any of its terms, it has necessarily to go to the same counter party.
Futures contracts
Futures contract is one by which one party agrees to buy from / sell to the other party at a specified future time a specified asset at a price agreed at the timeof the contract and payable on maturity date. The agreed price is known as the strike price. The underlying asset can be a commodity, currency, debt or equity security ctc.
The exchange specifies certain standardized features of the contract. As the two parties do not necessarily know each other, the exchange also provides a mechanism that give the two parties a guarantee that the contract will be honored. Unlike forward contracts, futures are usually perfermed by the payment of difference between the strike price and the market price on the fixed future date, and not by the physical delivery and the payment in full on that date.
Salient Features
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An organized exchange.
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Standardized contract terms viz. the underlying asset, the time of maturity and the manner of maturity etc.
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Associated clearing house to ensure smooth functioning of the market.
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Margin requirements and daily settlement to act as further safeguard. and
Existence of a regulatory authority.
Futures contracts being traded on organized exchanges impart liquidity to a transaction. The clearing house, being the counter party to both sides oi a transaction. provides a mechanism that guarantees the honoring of the contract and ensuring very low level of default.
Types of Futures
- Currency Futures
- Interest Futures
- Stock Index Futures
Option contracts
The literal meaning of the word 'option' is choice or we can say 'an alternative for choice'. In derivatives market also the idea remains the same. An opyion a right (but not the obligation) to buy/sell the underlying asset at a specified price on or before a specified future date.
As compared to forwards and futures, the option holder is not under an obligation to exercise the right. Another distinguishing feature is that, while it does not cost anything to enter into a forward contract or a futures contract, an investor must pay to the iption writer to purchase an option contract.
The amount paid by the buyer of the option to the seller of the option is referred to as the premium. For this reward i.e. the option premium, the option seller is under an obligation to sell/buy the underlying asset at the specified price whenever the buyer of the option chooses to exercise the right.
Option contracts having simple standard features are usually called plain vanilla contracts. Contracts having non-standard features are also available that have been created by financial engineers. These are called exotic derivative contracts.These are generally not traded on exchanges and are structured between parties on their own.
American Option and European Option
It is essential to be aware of the distinction between an American Option and European Option. American Option can be exercised at any time upto the expiration date, a European Option can be exercised only on the expiration date itself. Most of the option contracts traded on exchanges are of the type of American option.
Call Option and Put Option
Basically there are two types of options- Call option and Put Option. A call option gives the buyer of the option the right (but not the obligation) to buy underlying asset on or before a certain future date for a specified price whereas a put option gives the buyer of the option the right (but not the obligation) to sell the underlying asset on or before a certain future date for a specified price.
As stated earlier, the option writer is under an obligation to sell/nuy the underlying asset at the specified price whenever the buyer of the option chooses to exercise the right. The specified price is known as the strike price or the exercise price and the specified date is known as the exercise date, maturity date or the expiration date.
Call options are a way of leveraging your money. You are able to participate in any upward moves of a stock without having to put up all the money to buy the stock.However if the stock does not go up in price, the option buyer may lose 100% of the investment. For this reason options are considered to be risky investments.
On the other hand, options can be used to considerably reduce risk. Most of the time this involves selling rather than buying the options. Since most stock markets go up over time andmost people invest in stock because they hope prices will rise, there is more interest and activity in call options than there is in put options.
