Introduction to Derivatives

Introduction to Derivatives

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Derivative is a product whose value is derived from the value of one or more basic underlying variables.

The underlying asset can be equity, commodity, or any other asset. For example, paddy farmers may wish to sell their harvest at a future date to eliminate the risk of change in prices by that date. Such a transaction is an example of a derivative. The spot price of paddy, which is the "underlying", drives the price of this derivative.

What are Derivatives?

Derivatives

In the Indian context the Securities Contracts (Regulation) Act, 1956 (SCRA) defines

"Derivative" to include -

1. A security derived from a debt instrument, share, loan (whether secured or unsecured), risk instrument, contract for differences, or any other form of security.

2. A contract that derives its value from the prices, or index of prices, of the underlying

securities.

Derivatives are securities under the SCRA. The SCRA through its regulatory framework governs the trading of derivatives.

What are various Derivative variants available?

The most common variants are forwards, futures, options, and swaps.

1. Forwards: A forward contract or simply a forward is a non-standardized contract between two parties to buy or to sell an asset at a specified future time at a price agreed upon today. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position.

2. Futures: A futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed upon today with delivery and payment occurring at a specified future date, called the delivery date. The contracts are negotiated at a futures exchange, which acts as an intermediary between the two parties.


3. Options: Options are of two types - calls and puts. 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.

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. Warrants: Options generally have life of up to one year, majority of options traded on options exchanges have a maximum maturity of nine months. Warrants are longer-dated options, generally traded over-the-counter.


5. LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities.These are options having a maturity of up to three years.

6. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options.


7. Swaptions:

A swaption is an option granting its owner the right, but not the obligation to enter into an underlying swap. Although options can be traded on a variety of swaps, the term "swaption" typically refers to options on interest rate swaps

There are two types of swaption contracts:

A payer swaption gives the owner of the swaption, the right to enter into a swap where he/she pays the fixed leg and receives the floating leg.

A receiver swaption gives the owner of the swaption the right to enter into a swap in which he/she will receive the fixed leg and pay the floating leg


7. Swaps: Swaps are private agreements between two parties to exchange cash flows in the

future according to a prearranged formula. The two commonly used swaps are:

• Interest rate swaps: An agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount.

• Currency swaps: A swap that involves the exchange of principal and interest in one currency for the same in another currency.

For example, suppose an Indian company needs to acquire US Dollars and a US-based company needs to acquire Indian Rupee. These two companies could arrange to swap currencies by establishing an interest rate, an agreed upon amount, and a common maturity date for the exchange.

Participants in Derivative Markets Hedgers: face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk. Hedging involves taking an offsetting position in a derivative in order to balance any gains and losses to the underlying asset.

Speculators: wish to bet on future movements in the price of an asset. Speculators make bets or guesses on where they believe the market is headed. For example, if a speculator believes that a stock is overpriced, he/she may short sell the stock and wait for the price of the stock to decline, at which point he or she will buy back the stock and receive a profit.

Arbitrageurs: are in the business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

Contact Us:

Asit C Mehta Investment Interrmediates Ltd.

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Maharashtra. India.

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