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    Derivatives

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    Shruti Mhatre
    Derivatives are financial contracts whose value is derived from an underlying asset such as stocks, bonds, currencies or commodities. There are several types of derivative contracts including options, futures, forwards, and swaps. Participants in the derivatives market include hedgers who aim to reduce risk, speculators who take on risk to earn profits, and arbitrageurs who exploit temporary price differences between markets. To trade derivatives, an investor needs an account that allows derivatives trading, must understand how the derivatives market works, and needs to deposit an initial margin amount.

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    Derivatives

    Uploaded by

    Shruti Mhatre
    24 views20 pages
    Derivatives are financial contracts whose value is derived from an underlying asset such as stocks, bonds, currencies or commodities. There are several types of derivative contracts including options, futures, forwards, and swaps. Participants in the derivatives market include hedgers who aim to reduce risk, speculators who take on risk to earn profits, and arbitrageurs who exploit temporary price differences between markets. To trade derivatives, an investor needs an account that allows derivatives trading, must understand how the derivatives market works, and needs to deposit an initial margin amount.

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    Derivatives are financial contracts whose value is derived from an underlying asset such as stocks, bonds, currencies or commodities. There are several types of derivative contracts including options, futures, forwards, and swaps. Participants in the derivatives market include hedgers who aim to reduce risk, speculators who take on risk to earn profits, and arbitrageurs who exploit temporary price differences between markets. To trade derivatives, an investor needs an account that allows derivatives trading, must understand how the derivatives market works, and needs to deposit an initial margin amount.

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    © All Rights Reserved
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    Download as docx, pdf, or txt
    24 views20 pages

    Derivatives

    Uploaded by

    Shruti Mhatre
    Derivatives are financial contracts whose value is derived from an underlying asset such as stocks, bonds, currencies or commodities. There are several types of derivative contracts including options, futures, forwards, and swaps. Participants in the derivatives market include hedgers who aim to reduce risk, speculators who take on risk to earn profits, and arbitrageurs who exploit temporary price differences between markets. To trade derivatives, an investor needs an account that allows derivatives trading, must understand how the derivatives market works, and needs to deposit an initial margin amount.

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    Derivatives : Meaning, participants, types and more

    Derivatives are contracts that derive their value from the underlying asset.
    These are widely used to speculate and make money. Some use them as risk
    transfer vehicle as well. This article covers the following:

    What are derivatives

    Derivatives are financial contracts whose value is dependent on an underlying


    asset or group of assets. The commonly used assets are stocks, bonds,
    currencies, commodities and market indices. The value of the underlying assets
    keeps changing according to market conditions. The basic principle behind
    entering into derivative contracts is to earn profits by speculating on the value
    of the underlying asset in future.

    Imagine that the market price of an equity share may go up or down. You may
    suffer a loss owing to a fall in the stock value. In this situation, you may enter a
    derivative contract either to make gains by placing an accurate bet. Or simply
    cushion yourself from the losses in the spot market where the stock is being
    traded.

    Why do investors enter derivative contracts?

    Apart from making profits, there are various other reasons behind the use of
    derivative contracts. Some of them are as follows:
     Arbitrage advantage:Arbitrage trading involves buying a commodity or
    security at a low price in one market and selling it at a high price in the other
    market. In this way, you are benefited by the differences in prices of the
    commodity in the two different markets.

     Protection against market volatility: A price fluctuation of an asset may


    increase your probability of losses. You can look for products in the
    derivatives market which will help you to shield yourself against a reduction in
    the price of stocks that you own. Additionally, you may buy products to
    safeguard against a price rise in the case of stocks that you are planning to buy.

     Park surplus funds: Some individuals use derivatives as a means of


    transferring risk. However, others use it for speculation and making profits.
    Here, you can take advantage of the price fluctuations without actually selling
    the underlying shares.

    Who participates in derivatives market

    Each type of individual will have an objective to participate in the derivative


    market. You can divide them into the following categories based on their
    trading motives:

     Hedgers: These are risk-averse traders in stock markets. They aim at


    derivative markets to secure their investment portfolio against the market risk
    and price movements. They do this by assuming an opposite position in the
    derivatives market. In this manner, they transfer the risk of loss to those others
    who are ready to take it. In return for the hedging available, they need to pay a
    premium to the risk-taker. Imagine that you hold 100 shares of XYZ company
    which are currently priced at Rs. 120. Your aim is to sell these shares after
    three months. However, you don’t want to make losses due to a fall in market
    price. At the same time, you don’t want to lose an opportunity to earn profits
    by selling them at a higher price in future. In this situation, you can buy a put
    option by paying a nominal premium that will take care of both the above
    requirements.

     Speculators: These are risk-takers of the derivative market. They want to


    embrace risk in order to earn profits. They have a completely opposite point of
    view as compared to the hedgers. This difference of opinion helps them to
    make huge profits if the bets turn correct. In the above example, you bought a
    put option to secure yourself from a fall in stock prices. Your counterparty i.e.
    the speculator will bet that the stock price won’t fall. If the stock prices don’t
    fall, then you won’t exercise your put option. Hence, the speculator keeps the
    premium and makes a profit.

     Margin traders: A margin refers to the minimum amount that you need to
    deposit with the broker to participate in the derivative market. It is used to
    reflect your losses and gains on a daily basis as per market movements. It
    enables to get leverage in derivative trades and maintain a large outstanding
    position. Imagine that with a sum of Rs. 2 lakh you buy 200 shares of ABC
    Ltd. of Rs 1000 each in the stock market. However, in the derivative market,
    you can own a three times bigger position i.e. Rs 6 lakh with the same amount.
    A slight price change will lead to bigger gains/losses in the derivative market
    as compared to the stock market.

     Arbitrageurs: These utilize the low-risk market imperfections to make


    profits. They simultaneously buy low-priced securities in one market and sell
    them at a higher price in another market. This can happen only when the same
    security is quoted at different prices in different markets. Suppose an equity
    share is quoted at Rs 1000 in the stock market and at Rs 105 in the futures
    market. An arbitrageur would buy the stock at Rs 1000 in the stock market and
    sell it at Rs 1050 in the futures market. In this process, he/she earns a low-risk
    profit of Rs 50.

    What Are The Different Types Of Derivative Contracts

    The four major types of derivative contracts are options, forwards, futures and
    swaps.

     Options: Options are derivative contracts that give the buyer a right to


    buy/sell the underlying asset at the specified price during a certain period of
    time. The buyer is not under any obligation to exercise the option. The option
    seller is known as the option writer. The specified price is known as the strike
    price. You can exercise American options at any time before the expiry of the
    option period. European options, however, can be exercised only on the date of
    the expiration date.

     Futures: Futures are standardised contracts that allow the holder to buy/sell


    the asset at an agreed price at the specified date. The parties to the futures
    contract are under an obligation to perform the contract. These contracts are
    traded on the stock exchange. The value of future contracts is marked to
    market every day. It means that the contract value is adjusted according to
    market movements till the expiration date.

     Forwards:Forwards are like futures contracts wherein the holder is under an


    obligation to perform the contract. But forwards are unstandardised and not
    traded on stock exchanges. These are available over-the-counter and are not
    marked-to-market. These can be customised to suit the requirements of the
    parties to the contract.
     Swaps: Swaps are derivative contracts wherein two parties exchange their
    financial obligations. The cash flows are based on a notional principal amount
    agreed between both parties without exchange of principal. The amount of
    cash flows is based on a rate of interest. One cash flow is generally fixed and
    the other changes on the basis of a benchmark interest rate. Interest rate swaps
    are the most commonly used category. Swaps are not traded on stock
    exchanges and are over-the-counter contracts between businesses or financial
    institutions.

    How To Trade In Derivatives Market

     You need to understand the functioning of derivatives markets before trading.


    The strategies applicable in derivatives are completely different from that of
    the stock market.

     The derivative market requires you to deposit a margin amount before starting
    trading. The margin amount cannot be withdrawn until the trade is settled.
    Moreover, you need to replenish the amount when it falls below the minimum
    level.

     You should have an active trading account that permits derivative trading. If


    you are using the services of a broker, then you can place orders online or on
    the phone.

     For the selection of stocks, you have to consider factors like cash in hand, the
    margin requirements, the price of the contract and that of the underlying
    shares. Make sure that everything is as per your budget.
    You can choose to stay invested till the expiry to settle the trade. In this
    scenario, either pay the entire outstanding amount or enter into an opposing
    trade.

    Inter
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