Financial Derivatives

What are Derivatives?

• A derivative is a financial instrument whose value is derived from the value of another asset, which is known as the  underlying.

• When the price of the underlying changes, the value of the derivative also changes.

• A Derivative is not a product. It is a contract that derives its value from changes in the price of the underlying.

Example:

• The value of a gold futures contract is derived from the value of the underlying asset i.e. Gold.

Underlying Assets:

• Crude Oil.

• Precious Metals.

• Interest Rates.

• Agricultural  Commodities.

• Bonds.

• Currency.

• T-Bill.

• Interest Rates.

Features of Derivatives:

• Traded on Exchange.

• All Transaction in derivatives take place in future  specific date.

• Hedging Device-Reduces Risk.

• Derivatives are often leveraged, such that a small  movement in the underlying value can cause a  Large difference in the value of the derivative.

Types of Derivatives Contract:

1. Forwards:

• A forward contract is a customized contract between  two entities, where settlement takes place as a specific  date in the future at Predetermined price

•  Forwards are also known as Private Contracts Normally traded outside exchange

Features of forward contracts:

• They are bilateral contracts and hence, exposed to counterparty risk.

• Each contract is customer designed, and hence is unique in terms of contract sixe, expiration date and the asset type and quality.

• Each contract is customer designed, and hence is unique in terms of contract sixe, expiration date and the asset type and quality.

• The contract price is generally not available in public domain.

• On the expiration date, the contract has to be settled by delivery of the asset and if party wishes to reverse the contract.

Limitations of Forward contract:

Forward markets are facing many problems. They are:

• Lack of centralization of trading,

• Liquidity and Counterparty risk.

• The basic problem in the first two is that they have too much flexibility and generality.

• Counterparty risk arises from the possibility of default by any one party to the transaction. When one of the two sides to the transaction declares bankruptcy, the other suffers

2. Futures:

• Future contract is an agreement between two parties to buy or sell an asset at a certain time in the future, at a certain price. But unlike forward contract, futures contract are standardized and stock ex-changed traded.

• A Financial contract obligating the buyer to purchase an  asset, (or the seller to sell an Asset), such as a physical  commodity or a financial instrument, at a predetermined  Future date and price.

• Some of the most popular assets on which futures  Contracts are available are equity stocks, indices,  Commodities and Currency.

For example:

• Sugar cane or wheat or cotton farmers may wish to have contracts to sell their harvest at a future date to eliminate the risk of change in price by that date.

• There are commodity futures and financial futures.

The standardized items in a futures contract are:

• Quantity of the underlying,

• Quality of the underlying,

• The date/month of delivery,

• The units of price quotation and minimum price change and,

• Location of settlement.

Important terms in future contract:

• Spot price: The price at which an instrument/asset trades in the spot market.

• Future Price: The price at which the futures Contract trade in the future market.

• Contract cycle: The period over which a contract trades. The index futures contract typically have one month, two months and three months expiry cycles that expire on the last Thursday of the month.

• Expiry Date: It is date specified in future Contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist.

• Contract Size: The amount of the asset that has to be delivered under one contract.

• Basis: Basis is defined as the future price minus spot price. There will be difference basis for each delivery month for each contract. In the normal market, basis will be positive. This reflects that futures price normally exceeds spot price.

Distinction between Forward and Future Contract:

3. Options:

• American options can be exercised at any time up to the expiration date.

• European options can be exercised only on the expiration date itself.

Types of Options:

i. Call option gives the holder the right to buy the underlying asset by a certain date for a certain price but not the obligation to buy the underlying asset.

ii. Put option gives the holder the right to sell the underlying asset by a certain date for a certain price but not the obligation to sell the underlying asset.

• The price in the contract is known as the exercise price or strike price.

• The date in the contract is known as the expiration date or maturity.

Participants in options markets:

1. Buyers of calls option: Those who buy Call option 

2. Seller of calls option: Those who sell Call option

3. Buyer of puts option: Those who Buy Put Option

4. Seller of puts option: Those who sell Put Option

Market Players:

• Hedgers: Transfer of Risk component of their portfolio

• Speculators: Intentionally taking the risk from the  Hedgers in pursuit of profit

• Arbitrageurs: Operating in different markets  Simultaneously, in pursuit of profit and eliminate  mis-pricing

In India, three type of derivatives are available in exchanges: