Derivatives

 

Derivatives Simplified Today, the derivative form of investing has become a trend, especially in stocks. Now, derivatives are being used to shift risk and act as a form of insurance. The difference between a share and a derivative is that while the former is an asset, a derivative instrument is a contract. So, a shift of risk means that each party involved in the contract should be able to identify all the risks involved before the contract is agreed upon. Also, derivatives are derived from an underlying asset. It means that risks in trading derivatives may change depending on what happens to that asset. Future and options are two derivative contracts
   
FUTURES A future or a forward contract is the simplest mode of a derivative transaction. It is an agreement to buy or sell an asset of a specified quantity at a future time for a certain price. No cash is exchanged when the contract is entered into. For example, A is an importer who has to make a payment for his consignment in six months. To meet his payment obligation he has to buy dollars in six months from today. But he is not sure what the rupee-dollar rate will be then. So, he will enter into a contract with a bank to buy dollars six months later at a decided rate. This is a forward contract and the underlying security is foreign currency.
   
OPTIONS Options are contracts which give the buyer the right, but not the obligation, to buy or sell shares of the underlying security at a specific price on or before a specific date. They are of two types—‘call’ and ‘put’. In call, you can buy a stock at a specific price on or before a certain date. So, they are like security deposits and increase in value as the value of the underlying instrument rises. Put options are options to sell a stock at a specific price on or before a certain date. So, they are ‘insurance’ policies. Say, if you buy a new car and then buy an auto insurance, you can use your policy to regain the insured value of the car for an accident. A put option gains in value as the value of the underlying instrument decreases. 
   
USING CALLS When you buy a call, you expect the price of the underlying stock or index to go up. With a call option, the price you pay for it (option premium) gives you the right to buy that certain stock at a specified price called the strike price. If you decide not to buy the stock, your only cost is the option premium
   
USING PUTS When you buy a put, you expect the price of the underlying stock or index to go down. With a put option, you can “insure” a stock by fixing a selling price. If the stock price falls and “damages” your asset, you can sell it at its “insured” price. If the price goes up and there is no “damage”, you do not need to use the insurance, and your only cost is the premium. Technically, in an option, the buyer receives a privilege for which he pays a premium and the seller accepts an obligation for which he receives a fee.
   
ONLINE TRADING All brokerages offer online usage of such derivatives. Once online, you can trade in index, stock futures and options. At present, only selected stocks, which meet the criteria on liquidity and volume can be traded for futures trading. The interest of investors in this area is picking up. But there are risks. One must get educated on these instruments before setting out for actual trading.
   
  Derivatives are nothing but a kind of security whose price or value is determined by the value of the underlying variables. It is more like a contract of future date in which two or more parties are involved to alleviate future risk. Usually, derivatives enjoy high leverage. Its value is affected by the volatility in the rates of the underlying asset. Some of the widely known underlying assets are:
   
  Indexes (consumer price index (CPI), stock market index, weather conditions or inflation)
  Bonds
  Currencies
  Interest rates
  Exchange rates
  Commodities
  Stocks (equities)
   
Types of Derivatives The range of derivatives is really wide. But some of the most commonly known derivatives are:
   
  Forwards-This is a tailor-made contract between two parties. In case of this contract, a settlement is done on a scheduled future date at today's pre-decided rate.
   
  Futures-When two entities decide to purchase or sell an asset at a given time in the future at a given price, it is called futures contract. Futures contracts can be said to be a special kind of forward contracts, as they are customized exchange-traded agreements.
   
  Options-It is of two different kinds such as calls and puts. Those who take calls option, they are not obligated to purchase given quantity of the underlying variable, at a mentioned price on or prior to a scheduled future date. On the other hand, buyers in case of puts option may not necessarily sell a mentioned quantity of the underlying variable at a mentioned price on or prior to a given date.
   
  Swaps-These are private contracts between two entities to deal in cash flows in the future following a pre-decided formula. They are somewhat like forward contracts' portfolios. Swaps are also of two types such as interest rate swaps and currency swaps.
   
  Interest rate swaps-in this case, only interest related cash flows can be exchanged between the entities in one currency.
   
  Currency swaps-in this case of swapping, principal and interest can be exchanged in one currency for the same in other form of currency. 
   
Importance of Derivatives Financial transactions are fraught with several risk factors. Derivatives are instrumental in alienating those risk factors from traditional instruments and shifting risks to those entities that are ready to take them. Some of the basic risk components in derivatives business are:
   
  Credit Risk: When one of the two parties fails to perform its role as per the agreement, this is called the credit risk. It can also be referred to as default or counterparty risk. It varies with different sources.
   
   
  Market Risk: This is a kind of financial loss that takes place due to the adverse price movements of the underlying variable or instrument.
   
   
  Liquidity Risk: When a firm is unable to devise a transaction at current market rates, it can be referred to as liquidity risk. There are two kinds of liquidity risks involved in the scenario. First is concerned with the liquidity of separate items and second is related to supporting the activities of the organization with funds comprising derivatives.
   
  Legal Risk:Legal issues related with the agreement need to be scrutinized well, as one can deal in derivatives across the different judicial boundaries
   
Derivatives Markets in India India had started with a controlled economic system and from there it moved on to become a destination that witnesses constant fluctuation in prices on a daily basis now. Persistent efforts of Reserve Bank of India (RBI) in building currency forward market and liberalization process provided the risk management agencies their much needed momentum. Derivatives are the indispensable components of liberalization process to handle risk. With National Stock Exchange (NSE) measuring the market demands, the process of launching derivative markets in India got started. In the year 1999, derivatives trading took place in India.
   
  Indian derivatives markets can be divided into two types including 1) the transaction which depends on the exchange, and 2) the transaction which takes place 'over the counter' in one-to-one scenario. They can thus be referred to as:
   
  Exchange Traded Derivatives 
  Over the Counter (OTC) Derivatives
  Over the Counter (OTC) Equity Derivatives 
  Operators in the Derivatives Market
  There are different kinds of traders in the derivatives market. These include:
   
  Hedgers-traders who are interested in transferring a risk element of their portfolio. 
  Speculators-traders who deliberately go for risk components from hedgers in look out for profit.
  Arbitrators-traders who work in various markets at the same time in order to gain profit and do away with mis-pricing

 

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