Derivatives

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.
Today, around the world, derivative contracts are traded on electricity, weather,
temperature and even volatility.
According to the Securities Contract Regulation Act, (1956) the term derivative
includes:
a security derived from a debt instrument, share, loan, whether secured or
unsecured, risk instrument or contract for differences or any other form of
security
a contract which derives its value from the prices, or index of prices, of
underlying securities.
FEATURES
Have a maturity or expiration date after which they become worthless or
actually terminate.
Value of the derivative can move exponentially relative to the value of its
underlying.
Types- future or forward contracts, options and swaps.
Transactions take place in future specific date.
TRADERS IN DERIVATIVES MARKET
There are 3 types of traders in derivatives market:1) HEDGER
A hedger is someone who faces risk associated with price movement of an asset
and who uses derivatives as means of reducing risk. They provide economic balance
to the market.
Or
These are investors with a present or anticipated exposure to the underlying asset
which is subject to price risks. Hedgers use the derivatives markets primarily for
price risk management of assets and portfolios.

2) SPECULATOR
A trader who enters the futures market for pursuit of profits, accepting risk in the
endeavor. They provide liquidity and depth to the market.
Or
These are individuals who take a view on the future direction of the markets. They
take a view whether prices would rise or fall in future and accordingly buy or sell
futures and options to try and make a profit from the future price movements of the
underlying asset.
3) ARBITRAGEUR
A person who simultaneously enters into transactions in two or more markets to
take advantage of the discrepancies between prices in these markets.

Arbitrageurs also help to make markets liquid, ensure accurate and uniform
pricing, and enhance price stability.

They help in bringing about price uniformity and discovery.

or

They take positions in financial markets to earn riskless profits. The

arbitrageurs take short and long positions in the same or different contracts
at the same time to create a position which can generate a riskless profit.

Classification of derivatives contract1) On the basis of nature of contracta) Forward Contracts

b) Future Contracts
c) Options Contracts
d) Swaps
a) Forward Contracts
A forward contract is an agreement between two parties a buyer and a seller to
purchase or sell something at a later date at a price agreed upon today. Any type

of contractual agreement that calls for the future purchase of a good or service
at a price agreed upon today and without the right of cancellation is a forward
contract.

b) Future Contracts
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.
c) Options Contracts
Options are of two types 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
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
future date.

d) Swaps
Swaps are private agreements between two parties to exchange cash
flows in the future according to a prearranged formula. They can be
regarded as portfolios of forward contracts. The two commonly used
swaps are interest rate swaps and currency swaps.

Interest rate swaps: These involve 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 parties, with the cash flows in one direction being in a
different currency than those in the opposite direction.

2) On the basis of market mechanisma) OTC ( Over-the-counter)

Over-the-counter (OTC) or off-exchange trading is to trade financial
instruments such as stocks, bonds, commodities or derivatives directly
between two parties without going through an exchange or other
intermediary.

The contract between the two parties are privately negotiated.

Over-the-counter markets are uncontrolled, unregulated and have

very few laws.

b) Exchange-traded Derivatives
Exchange traded derivatives contract (ETD) are those derivatives
instruments that are traded via specialized Derivatives exchange or
other exchanges. A derivatives exchange is a market where individuals
trade standardized contracts that have been defined by the exchange.
The worlds largest derivatives exchanges (by number of
transactions) are the Korea Exchange.
There is a very visible and transparent market price for the
derivatives.