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A derivative is an instrument whose value is derived from the value of one or more underlying asset,
which can be stocks, bonds, currency, commodities, metals, intangible pseudo assets like stock indices
etc. When we say a Tata Steel future or a Tata Steel option, these carry a value only because of the value
of Tata Steel. Below given are the four most common types of derivative instruments.
Forwards
Futures
Options
Swaps
Financial Derivatives
Financial derivatives are instruments, which derive their value from financial assets. These derivatives can
be forward rate agreements, futures, options swaps etc. As mentioned earlier, the most traded
instruments are futures and options. Assets under financial derivatives can be the following;
• Stocks
• Bonds
• Currency etc.
Pricing of Derivatives
Derivative is priced based on a future price of the underlying asset i.e.; perceived value of the asset. In
the case of an option to buy an asset at some future date, the expectation is that it will be priced higher
than the derivative price plus the strike price (the price you agree to pay), allowing for a gain. For
example, Lets consider the underlying asset as a stock, if Stock XYZ is trading at Rs. 500 and you buy an
option for Rs.100, allowing you to purchase XYZ at Rs. 1000 at some future date, your expectation is that
XYZ will be at Rs. 1100 or higher by that future date.
Speculators
Speculators are those people who buy or sell in the market to make profits. For instance, if you will the
stock price of Reliance is expected to go upto Rs.400 in 1 month, one can buy a 1 month future of
Reliance at Rs 350 and make profits.
Hedgers
Hedgers are those people who buy or sell to minimize their losses. For instance, an importer has to pay
US $ to buy goods and rupee is expected to fall to Rs 48/$ from Rs 45/$, then the importer can minimize
his losses by buying a currency future at Rs 46/$•
Arbitrageurs
Arbitrageurs are those people who buy or sell to make money on price differentials in different markets. In
other words arbitraging helps us to take advantage of a price difference between two or more markets.
Difference between the market prices is the profit. For instance, a futures price is simply the current price
plus the interest cost. If there is any change in the interest, it shows an arbitrage opportunity.
Forward contracts
A forward contract is a customized contract between two parties, where settlement takes place on a
specific date in future at a price agreed today. The main features of forward contracts are;
• They are bilateral contracts and hence exposed to counter party risk.
• Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the
asset type and quality.
• The contract price is generally not available in public domain.
• The contract has to be settled by delivery of the asset on expiration date.
• In case, the party wishes to reverse the contract, it has to compulsorily go to the same counter party,
which being in a monopoly situation can command the price it wants.
Futures
Futures are exchange-traded contracts to sell or buy the underlying asset; it can be financial instruments
or physical commodities for Future delivery at an agreed price. There is an agreement to buy or sell a
specified quantity of financial instrument/ commodity in a designated future month at a price agreed upon
by the buyer and seller. To make trading possible, the exchange specifies certain standardized features of
the contract.
• Future contracts are standardised contracts, which are traded on the exchanges.
• These contracts, being standardised and traded on the exchanges are very liquid
• In futures market, clearing corporation/ house provides the settlement guarantee.
Options
Options contracts are those which give only the right to buy or sell the underlying asset, whereas futures
contract have the obligation to buy or sell the underlying asset. The buyer of the options contract has the
right to choose whether or not to exercise their right, and if they do, the seller of a matching options
contract will be obligated to complete the transaction. There are two main types of options;
• Call Option
• Puts Option
Calls Option
Calls Option gives you the right to buy the underlying asset in a future date. You can buy a call option
when you believe the underlying futures price will move higher. For example, if you expect Nifty futures to
move higher, you should buy a Nifty call option.
Puts Option
Put Option gives you the right to sell the underlying asset in a future date. It is better to buy a put option
if you believe the underlying futures price will move lower. For example, if you expect Nifty futures to
move lower, you should buy a Nifty put option.
Swaps
Swap is a financial derivative contract where a set of future cash flows are agreed to be exchanged
between two counterparties at set dates in the future. In other words swap is a derivative instrument in
which counterparties exchange certain benefits of one party's financial instrument for those of the other
party's financial instrument. The swap agreement defines the dates when the cash flows are to be paid
and the way they are calculated. Following are the major kinds of swaps;
• Interest rate swaps
• Currency swaps
• Commodity swaps
• Equity Swap
• Credit default swap