Characteristics of Derivatives

Derivatives:
Dervatives are those assets whose values are determined from the value of
underlying assets. The underlying assets may be equity, commodity or
currency.
The derivatives are most modern financial instrument in hedging risk. The
individual and the firms who wish to avoid or reduce risk can deal with others
who are willing to accept for a price. A common place where such transactions
take place is called the derivative market. As the financial products commonly
traded in the derivative market are themselves not primarily loans or securities
but can be used to change the risk characteristics of underlying asset or
liability position, they are referred to as ‘derivative financial instruments’. These
instruments are called financial derivative instruments because they derive there
value from underlying instrument and have no intrinsic value of their own.
Some commonly used derivatives are: Spot, Forward, Futures, Swap, Options
Characteristics of derivatives:
 Derivatives possess a combination of novel characteristics not found in

any other form of assets.
 Dervatives are traded globally having strong popularity in financial
markets.
 Derivatives maintain a close relationship between their values and values
of underlying assets.
 It is comfortable to take a short position in derivatives than in other
assets. An investor is said to have a short position in derivatives
products if he is obliged to deliver the underlying assets in specified
future dates.
 Derivatives traded on exchange are liquid and involves the lowest
possible transaction costs
 Derivatives can be closely matched with specific portfolio requirements.
 The margin requirements for exchange traded derivatives are relatively
low, reflecting the relatively low level of credit risk associated with
derivatives.
SPOT CONTRACT:
The spot market is also called ‘cash market’ where sale and purchase
of commodity takes place for immediate delivery.
The price at which exchange takes place is called ‘cash’ or ‘spot’ price.
The spot market involves both the transfer of ownership and delivery of
commodity or instrument on the spot or immediately.
FORWARD CONTRACT:
A forward contract is an agreement made today between buyer and
seller to exchange the commodity or instrument for cash at a
predetermined at future date at a price agreed upon today. The agreed
upon price is called the ‘forward price’ with a forward market the transfer
of ownership occurs on the spot, but the delivery of commodity or
instrument does not occur until some future date.
In forward contract, two parties agree to do a trade at some future date ,
at a stated price and quantity. No money changes hands at the time the
deal is signed.
For example, a wheat farmer may wish to sell their harvest at a future
date to eliminate the risk of change in prices by that date. Such
transaction would take place through a forward market. Forward contracts
are not traded on an exchange, they are said to trade over the counter.
Features of the forward contract:

a) They are bilateral contracts and hence exposed to counter party
risk.
b) Each contract is custom designed, and hence is unique in terms
of contract size, expiration date and the asset type and quality.
c) The contract price is generally not available in public domain.
d) The contract has to be settled by delivery of the asset on
expiration date.
e) In case , the party wishes to reverse the contract, it has to
compulsorily go to the same counterparty, which being monopoly
situation can command the price it wants.
Problems in forward contracting:
The forward contracts are affected by the problems like:
a) Lack of centralization of trading

b) Illiquidity
c) Counterparty risk
In the first two of these, the basic problem is that of too much
flexibility and generality. Counterparty risk in forward market arises when
one of the two parties of the transaction chooses to declare bankruptcy,
the other suffers. Forward markets have one basic property; the larger
the time period over which the forward contract is open, the larger are
the potential price movements, and hence the larger is the counterparty
risk.
FUTURES CONTRACT:
The futures contract is traded on futures exchange as a standardized

contract, subject to the rules and regulation of exchange.It is the
standardization of the futures contract facilitates the second market
trading. The future contracts relates to a given quantity of the underlying
assets and only whole contracts can be traded ,and trading of fractional
contracts are not allowed in future contracting. The terms of future
contracts are not negotiable. A futures contracts is a financial security,
issued by an organized exchange to buy or sell a commodity, security
or currency at a predetermined future date at a price agreed upon
today. The agreed upon price is called the ‘futures price’. Futures are
exchange traded contracts to sell or buy financial instrument or physical
commodities for future delivery at an agreed price. There is an
agreement to buy or sell a specified quantitity of financial
instrument/commodity in a designated future month at aprice agreed
upon by the buyer and seller. The contracts have certain standardized
specifications.
Futures markets are exactly like forward markets in terms of basic

economics. However, contracts are standardized and trading is
centralized, so that future markets are highly liquid. There is no
counterparty risk. In futures market increasing the time to expiration does
not increase the counterparty risk. A futures contract provides both right
and an obligation to buy or sell a standard amount of commodity,
security or currency on a specified future date at a price agreed when
the contract is entered into.
Types of futures contract:
1. Commodity futures
2. Financial futures
The

Characteristics of Derivatives

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Characteristics of Derivatives

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Derivatives:

 Derivatives possess a combination of novel characteristics not found in

Features of the forward contract:

Problems in forward contracting:

The forward contracts are affected by the problems like:

a) Lack of centralization of trading

The futures contract is traded on futures exchange as a standardized

Futures markets are exactly like forward markets in terms of basic

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