DEFINITION 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 cont
ract between two or more parties. Its value is determined by fluctuations in the
underlying asset. The most common underlying assets include
1. stocks,
2. bonds,
3. commodities,
4. currencies,
5. interest rates and
6. market indices. Most derivatives are characterized by high leverage.
Derivatives Market is the market where the financial instrument like derivatives
are traded.
Primarily, Derivatives Market has been divided in two parts:
1. Over-the-counter (OTC) Market and
2. Exchange-traded Market : where derivatives like Forwards, Futures, Swaps
and Options are traded.
Normally, these derivatives are tool to manage risk attached to asset, but one n
eeds to have lot of expertise to use them in their trading strategy due to their
complexity. Below is the detailed explanation of the various derivative contrac
ts.

Forwards: A forward contract is the customized contract between two parties(enti
ties), where settlement takes place on a specific date in future at today's pre-
agreed price. Forwards represent the obligation to make a transaction at a set p
oint in time in the future. Once you enter into a forward-based contract, you ar
e obligated to make the transaction unless both parties agree to cancel or other
wise modify the agreement.
Forward contracts trade over the counter (OTC), thus the terms of the deal can b
e customized to fit the needs of both the buyer and the seller. They are unique
in terms of contract size, expiry date, asset type and quality.
Forward contracts draw in counter-party risk i.e. the counter-party defaults and
is unable to pay the cash difference or deliver the asset.
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 differen
t from Spot Contract as in spot contract settlement comes at the time of contrac
t 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 st
ock exchanges. OTC market is a private market where individuals/institutions can
trade through negotiations on a one to one basis. Forwards are private contract
s 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 a
n asset at a certain time in the future at a certain price. Futures contracts ar
e special types of forward contracts in the sense that the former are standardiz
ed exchange-traded contracts.
Futures: A futures contract is an agreement between two parties to buy or sell a
n asset at a certain time in the future at a certain price. Futures contracts ar
e special types of forward contracts in the sense that the former are standardiz
ed exchange-traded contracts. When a forward contract is traded on a recognized
exchange, it is referred to as a futures contract". Examples of futures include c
ommodities, interest rates, currencies, and stock market indices.
Futures can be used either to hedge or to speculate on the price movement of the
underlying asset. For example, an airline uses crude oil futures for hedging pu
rpose to lock in a certain price and reduce risk. Similarly, anybody could specu
late on the price movement of crude oil by going long or short using futures. So
me future contracts may call for physical delivery of the asset, while others ar
e settled in cash.
Futures
A futures contract is an agreement between two parties to buy or sell an asset a
t 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 exchan
ge-traded contracts.
As far as Indian Equity market is Concern, NSE is having the most developed Equi
ty 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).
How Futures Contract work?
The futures market is a centralized market place for buyers and sellers from aro
und the world who meet and enter into futures contracts. Pricing can be based on
an open cry system, or bids and offers can be matched electronically. The futur
es contract will state the price that will be paid and the date of delivery, als
o known as the expiry date.
Options: Options are of two types - calls and puts. Calls give the buyer the rig
ht but not the obligation to buy a given quantity of the underlying asset, at a
given price on or before a given future date. Puts give the buyer the right, but
not the obligation to sell a given quantity of the underlying asset at a given
price on or before a given date.
Options: An option gives the contract holder the right to buy or sell on a speci
fied date in the future - but they are under no obligation. Options are of two t
ypes - calls and puts. Calls give the buyer the right but not the obligation to
buy a given quantity of the underlying asset, at a given price on or before a gi
ven future date. Puts give the buyer the right, but not the obligation to sell a
given quantity of the underlying asset at a given price on or before a given da
te.
Options
An option is a contract between two party, where one party gives to the other th
e right, but not the obligation, to buy from (or sell to) the First Party the un
derlying asset on or before a specific day at an agreed price. In return for giv
ing the right, the party giving the right collects a payment from the other part
y. This payment collected is called the premium or price of the option.
Players in the Options Market:
Developmental institutions, Mutual Funds, Financial Institutions, FIIs, Brokers,
Retail Participants are the likely players in the Options Market.
Some of the examples of Options are Index Options, Options on individual stocks,
Bond options, Interest Rate Futures Options, etc.
Swaps: Swaps are private agreements between two parties to exchange cash flows i
n the future according to a prearranged formula. They can be regarded as portfol
ios of forward contracts. The two commonly used swaps are:
Swaps: Swaps are the types of Forward contracts and they occupy an important rol
e in International Finance. They are private agreements between two parties to e
xchange cash flows in the future according to a prearranged formula. They are ge
nerally an agreement to exchange one stream of cashflows to another.
Swaps
Swaps are private agreements between two parties to exchange cash flows in the f
uture 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.
Swaps have been categorised into four parts:
Interest rate swaps
Currency swaps
Commodity swaps
Equity swaps
Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.
Currency swaps: These entail swapping both principal and interest between the p
arties, with the cash flows in one direction being in a different currency than
those in the opposite direction.
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.
Warrants: Options generally have lives of upto one year, the majority of options
traded on options exchanges having a maximum maturity of nine months. Longer-da
ted options are called warrants and are generally traded over-the-counter.
LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These a
re options having a maturity of upto three years.
Baskets: Basket options are options on portfolios of underlying assets. The unde
rlying asset is usually a moving average or a basket of assets. Equity index opt
ions are a form of basket options.
Swaptions: Swaptions are options to buy or sell a swap that will become operativ
e at the expiry of the options. Thus a swaption is an option on a forward swap.
Rather than have calls and puts, the swaptions market has receiver swaptions and
payer swaptions. A receiver swaption is an option to receive fixed and pay floa
ting. A payer swaption is an option to pay fixed and receive floating.
Hedging
To Be cautious or to protect against loss.
In financial parlance, hedging is the act of reducing uncertainty about
future price movements in a commodity, financial security or foreign currency .
Thus a hedge is a way of insuring an investment against risk.