What is a Derivative ?

The term Derivative stands for a contract whose price is derived from or is dependent upon an underlying asset. The underlying asset could be a financial asset such as currency, stock and market index, an interest bearing security or a physical commodity. As Derivatives are merely contracts between two or more parties, anything like weather data or amount of rain can be used as underlying assets.

Need for Derivatives The derivatives market performs a number of economic functions. They help in : Transferring risks Discovery of future as well as current prices Catalyzing entrepreneurial activity Increasing saving and investments in long run.

Participants in Derivative markets Hedgers use futures or options markets to reduce or eliminate the risk associated with price of an asset. Speculators use futures and options contracts to get extra leverage in betting on future movements in the price of an asset. Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets.

Classification of Derivatives OTC (over the counter) trading Exchange Traded Derivatives

Future contracts Options

Forward contracts Swaps

What is OTC (Over the counter) ? Over the Counter (OTC) derivatives are those which are privately traded between two parties and involves no exchange or intermediary. Non-standard products are traded in the so-called over-the-counter (OTC) derivatives markets. The Over the counter derivative market consists of the investment banks and include clients like hedge funds, commercial banks, government sponsored enterprises etc. Futures Contract Futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today (the futures price or the strike price) with delivery occurring at a specified future date, the delivery date. Since such contract is traded through exchange, the purpose of the futures exchange institution is to act as intermediary and minimize the risk of default by either party. Thus the exchange requires both parties to put up an initial amount of cash, the margin.

Concept of Margin Since the futures price will generally change daily, the difference in the prior agreed-upon price and the daily futures price is settled daily also. The exchange will draw money out of one party's margin account and put it into the other's so that each party has the appropriate daily loss or profit. Thus on the delivery date, the amount exchanged is not the specified price on the contract but the spot value.

Options An option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to fulfill the transaction.

Option Styles European option an option that may only be exercised on expiration. American option an option that may be exercised on any trading day on or before expiry. Bermudan option an option that may be exercised only on specified dates on or before expiration.

Exchange Traded Derivatives Market A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange. A derivatives exchange acts as an intermediary to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee. Forward Contract Forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. For Example: If A has to buy a share 6 months from now. and B has to sell a share worth Rs.100. So they both agree to enter in a forward contract of Rs. 104. A is at Long Position and B is at Short Position Suppose after 6 months the price of share is Rs.110. so, A overall gained Rs. 4 but lost Rs. 6 while B made an overall profit of Rs. 6. Swap Contract The derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. The Types of Swaps are: Interest rate swaps Currency swaps Commodity swaps Equity Swap Credit default swaps