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Introduction to Derivatives
DERIVATIVES
Derivatives, such as futures or options, are financial contracts which derive their value from a spot price, which is called the “underlying”. For example, wheat farmers may wish to enter into a contract to sell their harvest at a future date to eliminate the risk of a change in prices by that date. 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”. The term “contracts” is often applied to denote the specific traded instrument, whether it is a derivative contract in wheat, gold or equity shares. The world over, derivatives are a key part of the financial system. The most important contract types are futures and options, and the most important underlying markets are equity, treasury bills, commodities, foreign exchange, real estate etc.
TYPES OF DERIVATIVE CONTRACTS:
Derivatives comprise four basic contracts namely Forwards, Futures, Options and Swaps.
1 . FORWARD CONTRACTS
These are promises to deliver an asset at a pre- determined date in future at a predetermined price. The contracts are traded over the counter (i.e. outside the stock exchanges, directly between the two parties) and are customized according to the needs of the parties
2 . FUTURES CONTRACTS
A futures contract is an agreement between two parties to buy or sell an asset at a certain time in future at a certain price. These are basically exchange traded, standardized contracts.
3 . OPTIONS CONTRACTS
Options give the buyer (holder) a right but not an obligation to buy or sell an asset in future.
TWO TYPES OF OPTIONS
(i) 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.
(ii) PUTS
Give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.
4 . SWAPS
Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula.
Participants
The derivatives market is similar to any other financial market and has following three broad categories of participa6nts:
HEDGERS
These are investors with a present or anticipated exposure to the underlying asset which is subject to price risks. Hedgers use the derivatives markets primarily for price risk management of assets and portfolios.
SPECULATORS
These are individuals who take a view on the future direction of the markets. They take a view whether prices would rise or fall in future and accordingly buy or sell futures and options to try and make a profit from the future price movements of the underlying asset.
ARBITRAGEURS
They take positions in financial markets to earn riskless profits. The arbitrageurs take short and long positions in the same or different contracts at the same time to create a position which can generate a riskless profit.
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