Derivatives market

By- Ambika Garg

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.

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-thecounter (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.

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.

Classification of Derivatives

Future Contracts
Forward Contracts
Options
Swaps

OTC (Over the

counter ) trading
Exchange Traded
Derivatives
OTC

Exchange Traded

Rupee Interest Rate

Derivatives

Forward Rate agreements,

Interest rate Swaps

Interest Rate futures

Foreign Currency
Derivatives

Forwards, Swaps, Options

Currency Futures

Equity Derivatives

Index Futures, Index

Options, Stock futures,
Stock options

Basic Terminologies
Spot Contract: An agreement to buy or sell an asset today.
Spot Price: The price at which the asset changes hands on
the spot date.
Spot date: The normal settlement day for a transaction
done today.
Long position: The party agreeing to buy the underlying
asset in the future assumes a long position.
Short position: The party agreeing to sell the asset in the
future assumes a short position
Delivery Price: The price agreed upon at the time the
contract is entered into.

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

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.

Some Terminologies
Call Option: Right but not the obligation to buy
Put Option: Right but not the obligation to sell
Option Price: The amount per share that an option buyer
pays to the seller
Expiration Date: The day on which an option is no longer
valid
Strike Price: The reference price at which the underlying
may be traded
Long Position: Buyer of an option assumes long position
Short Position: Seller of an option assumes short position

Option Pay Off

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.

Thank You !!