BASICS OF DERIVATIVES MARKET | EXPLAINED.

INTRODUCTION TO DERIVATIVES:

Derivatives is defined as “a financial contract whose value is derived from the value of an
underlying asset or simply underlying”
Derivatives have no direct value in and of themselves -- their value is based on the expected
future price movements of their underlying asset.
The most common types of derivatives are futures, options, forwards and swaps.


(DERIVATIVES IN HINDI)



FUNCTIONS OF DERIVATIVES MARKET.

  1. Management of risk

Management of different types of risk through various strategies like hedging, arbitraging, spreading etc is one of the important services provided by the derivatives to control, avoid and manage such risk.


  1. Price discovery

Price discovery means revealing information about future cash market prices through future market. Derivatives provide such mechanism.


  1. Liquidity and reduce transaction cost

In derivatives trading no immediate full amount of the transaction is required because of margin trading. Hence it enhances liquidity and reduces transaction cost in the markets of underlying assets.


  1. Measurement of market:

Derivatives serve as barometers, of the future trends in price which result in the discovery of new prices both in spot and futures markets. They help in getting information regarding trading to the society which enable to discover tue equilibrium price in the market.


  1. Efficiency in trading

Financial derivatives allow for free trading of risk components and that leads to improving market efficiency. Traders can use a position in one or more financial derivatives as a substitute for a position in underlying security.


  1. Speculation and arbitrage

Derivatives can be used o acquire risk rather than to hedge against risk. Thus some individuals will enter into the contract to speculate on the value of the underlying asset. Likewise the individuals will also look for arbitrage opportunities and make profit.


  1. Hedging 

Hedge or mitigate risk occurs in the underlying by entering into a derivative contract whose value moves in the opposite direction to their underlying position. Hedging also occurs when an individual buys an asset and sells it using futures contract.


  1. Price stabilization function

Derivatives market helps to keep a stabilization influence on spot prices  by reducing the short term fluctuations.

 

  1. Gearing of value:

Special care and attention about financial derivatives provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivatives.

 

  1. Encourage competition

The derivatives trading encourage the competitive trading in the market, different risk taking preferences at market operators like, speculators, hedgers, traders, arbitrageurs etc, resulting in increase and trading volume in the country.


Types of Derivatives:

1. Forwards: 

  • Forwards are over the counter (OTC) derivatives that enable buying or selling an underlying on a future date, at an agreed price. 

  • The terms of a forward contract are as agreed between counterparties and is not stock exchange regulated.

  • It is also an OTC contract. 

  • It can be settled in cash or result in actual delivery of wheat. 

  • The settlement terms such as quantity and quality of wheat to be delivered, the price and payment terms are as decided by the counterparties. 

  • As there is no official regulator, It carries counterparty risk. 

  • It is therefore mostly entered into between known parties, and depends on informal protection mechanisms to ensure that the contract is honored. 

2. Futures: 

  • Futures are exchange-traded forwards. 

  • A future is a contract for buying or selling a specific underlying, on a future date, at a price specified today, and entered into through a formal mechanism on an exchange. 

  • The fundamental principle of forward and futures contract is the same, since both specifies the price today for the delivery of an asset at a future date. The only difference is, Future contracts work as per the stock exchange and hence there is no counter party default risk. The terms of the contract such as quality and quantity of asset, date of delivery etc are specified by the exchange.

  • Futures are thus forward contracts defined and traded on an exchange. Since Buyers and sellers don’t know each other in futures contract the counterparty here is the clearing house or clearing corporation, with whom buyers and sellers need to maintain a margin amount.

  • This is done to ensure that there is no default in payment by either buyer or seller.

3. Options:

  • Options are contracts that grant the right, but not the obligation to buy or sell an underlying asset at a set price on or before a certain date. 

  • This means if one opts for an options contract either call or put one is not obliged to buy/sell. 

  • Options are of two types.

Call Option: 

A “call” option represents a right to buy a specific underlying on a later date, at a specific price decided today.
Put Option: 

A “put” option represents a right to sell a specific underlying on a later date, at a specific price decided today.


4. Swaps: 

  • A swap is a contract in which two parties agree to a specified exchange on a future date. 

  • Swaps are common in interest rate and currency markets. 

  • Swaps are very common in currency and interest rate markets. 

  • Though swap transactions are OTC, they are governed by rules and regulations accepted by swap dealer associations.

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