ABC OF DERIVATIVES

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1) What are Derivatives
Derivatives, such as futures or options, are financial contracts which derive their value from a spot price, which is called the “underlying”. Such a transaction would take place through a forward or futures market. This market is the “derivatives market”, and the prices of this market would be driven by the spot market price of wheat which is the “underlying”.

2) What are the various kinds of derivatives
In India primarily there are 3 kinds of derivatives.
a) forward contract?
In a forward contract, two parties agree to do a trade at some future date, at a stated price and quantity. No money changes hands at the time the deal is signed. Forward contracting is very valuable in hedging and speculation. The classic hedging application would be that of a wheat farmer forward -selling his harvest at a known price in order to eliminate price risk. Conversely, a bread factory may want to buy bread forward in order to assist production planning without the risk of price fluctuations.

b) Futures markets are exactly like forward markets in terms of basic economics. However, contracts are standardised and trading is centralized (on a stock exchange). There is no counter party risk (thanks to the institution of a clearing corporation which becomes counter party to both sides of each transaction and guarantees the trade). In futures markets, unlike in forward markets, increasing the time to expiration does not increase the counter party risk. Futures markets are highly liquid as compared to the forward markets.

c) An Option is a contract which gives the right, but not an obligation, to buy or sell the underlying at a stated date and at a stated price. While a buyer of an option pays the premium and buys the right to exercise his option, the writer of an option is the one who receives the option premium and therefore obliged to sell/buy the asset if the buyer exercises it on him. Options are of two types – Calls and Puts options : “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 underlying asset at a given price on or before a given future date. All the options contracts are settled in cash. Further the Options are classified based on type of exercise. At present the Exercise style can be European or American. American Option – American options are options contracts that can be exercised at any time up to the expiration date. Options on individual securities available at NSE are American type of options. European Options – European options are options that can be exercised only on the expiration date. All index options traded at NSE are European Options.

3) What are the Risks associated with trading in Derivatives?

Investors must understand that investment in derivatives has an element of risk and is generally not an appropriate avenue for someone of limited resources/ limited investment and / or trading experience and low risk tolerance. An investor should therefore carefully consider whether such trading is suitable for him or her in the light of his or her financial condition. An investor must accept that there can be no guarantee of profit ts or no exception from losses while executing orders for purchase and / or sale of derivative contracts, Investors who trade in derivatives at the Exchange are advised to carefully read the Model Risk Disclosure Document and the details contained therein.

Posted: October 2017