Basics of Derivative Market

Derivatives are totally different from securities. They are financial instruments that are
mainly used to protect against and manage risks, and very often also serve arbitrage or
investment purposes, providing various advantages compared to securities. Derivatives
come in many varieties and can be differentiated by how they are traded, the underlying
they refer to, and the product type.
Definition-A derivative is a contract between a buyer and a seller entered into today
regarding a transaction to be fulfilled at a future point in time
Meaning derivative are financial instrument whose value depend on the value of some
underlying assets. Such assets could be tangible such as wheat, cotton , real state , or
financial instrument like equity, or it could be tangible such as interest rates or index etc.
The returns on derivatives are derived from those of the assets. In way , the performance
of derivative depend on how the underlying assets perform. A derivative does not have
any physical existence but emerges out of a contract between two parties . it does not
have any value of its own but its value in turn, depend on the value of other assets which
are called underlying assets.
For example
Bombay stock exchange share index, called Sensex, is a derivative whose value (index
for a particular day) depends upon the prices of underlying 30 shares. The weighted
average of the closing prices of 30 shares in the Sensex. If the prices of all these share
increase or decrease , the Sensex also increase or decrease. So the sensex derived its
value from the market prices of these 30 shares
Derivatives have a valuable purpose in providing a means of managing financial risk. By
using Derivatives companies and investors can transfer any undesired risk , for a price
,to other parties who either want to assume that risk or have that offset that risk
Traders in derivative market - There are 3 types of traders in the Derivatives
market:

SPECULATOR
HEDGER
ARBITRAGEUR

OTC
Over-the-counter (OTC) or off-exchange trading is to trade financial instruments such
as stocks, bonds, commodities or derivatives directly between two parties without
going through an exchange or other intermediary.

The contract between the two parties are privately negotiated.

The contract can be tailor-made to the two parties liking.
Over-the-counter markets are uncontrolled, unregulated and have very few laws.
Its more like a freefall.

. Exchange-traded Derivatives
Exchange traded derivatives contract (ETD) are those derivatives instruments that are
traded via specialized Derivatives exchange or other exchanges. A derivatives exchange
is a market where individuals trade standardized contracts that have been defined by
the exchange.
There are two types of derivatives
1. Commodity derivative :- Commodity derivatives the underlying instruments are a
commodity which may be sugar, cotton, copper, gold, silver
2. Financial derivative:- :- Financial Derivatives the underlying instruments is stock,
bond, foreign exchange.
Financial Derivatives further divided
1.
2.
3.
4.
5.

Forward
Future
Option
Swap
Exotics

Forward Contract
A forward is a contract in which one party commits to buy and the other party commits
to sell a specified quantity of an agreed upon asset for a pre-determined price at a
specific date in the future.
It is a customized contract, in the sense that the terms of the contract are agreed upon
by the individual parties.
Hence, it is traded OTC
Forward Contract Example

Farm

I agree
to sell
500kgs
wheat at
Rs.40/kg

Bread
Maker

500kgs wheat

Bread
Maker

Farmer

Rs. 20,000

Future

Contract

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.
Futures Contract Example
The
Short
(seller)

Sell oil

Clearing
House

Buy oil

The
Long
(buyer)

Buy oil

Sell oil

Futures prices /barrel on day 1

$45

Futures prices /barrel on day 2

$46

Gain in value of contract

$1
OPTIONS CONTRACT

An option is the right, but not the obligation to buy or sell something on a specified date
at a specified price. In the securities market, an option is a contract between two parties
to buy or sell specified number of shares at a later date for an agreed price.
Types of Options
Options are of two types call and put.
Call option 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 particular date by paying a
premium.
Puts give the buyer the right, but not obligation to sell a given quantity of the
underlying asset at a given price on or before a particular date by paying a
premium.

Call Option Example

CALL OPTION

current

price=Rs.250

Right to buy 100

Reliance shares at
Premium=Rs25/share
a price of Rs.300
per share after 3
Amount to by Call option
months.

=Rs. 2500
Suppose after a month,
Market price is Rs.400,
then the option is
exercised i.e. the shares
are bought.
Net gain = 40,00030,000-

Strike price

Expiry Date
Suppose after a month,
market price is Rs.200,
then the option is not
exercised.
Net Loss = Premium amt
= Rs.2500

There are three parties involved in the option trading, the option seller, buyer and
the broker.
1. The option seller or writer is a person who grants someone else the option to buy
or sell. He receives premium on its price.
2. The option buyer pays a price to the option writer to induce him to write the
option.
3. The securities broker acts as an agent to find the option buyer and the seller, and
receives a commission or fee for it.

1. Types of Options-Call option: A call option is a contract giving the right to buy the
shares.
2. Put option is a contract giving the right to sell the shares.

SWAPS-. An agreement between two parties to exchange one set of cash flows for
another. In essence it is a portfolio of forward contracts. While a forward contract
involves one exchange at a specific future date, a swap contract entitles multiple
exchanges over a period of time.
: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of
forward contracts

Commonly two kinds of swaps- Interest rate swaps: These entail swapping only the
interest related cash flows between the parties in the same currency.

Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than
those in the opposite direction.

Types of Swaps
(1).Interest Rate Swaps.

(2).Currency Swaps.
(3).Commodity Swaps.
(4).Equity Swaps.

Interest Rate Swap Example

Bank
Counter-

Pays a variable rate

Issuer Of

Receives 8% fixed

$10
Million

Party

Pays 8%
fixed

Debt

If variable rate is 7.5%, Debtor:

Pays to creditors.

$ (800,000)

Pays to bank counterparty.. (750,000)

Receives from bank counterparty..

800,000

Net interest expense... $ 750,000

Creditors