What are Derivative Instruments?

A derivative is an instrument whose value is derived from the value of one or more underlying, which can be
commodities, precious metals, currency, bonds, stocks, stocks indices, etc. Four most common examples of derivative
instruments are Forwards, Futures, Options and Swaps.
2. What are Forward Contracts?
A forward contract is a customized contract between two parties, where settlement takes place on a specific date in
future at a price agreed today. The main features of forward contracts are

They are bilateral contracts and hence exposed to counter-party risk.

Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset
type and quality.
The contract price is generally not available in public domain.
The contract has to be settled by delivery of the asset on expiration date.
In case the party wishes to reverse the contract, it has to compulsorily go to the same counter party, which
being in a monopoly situation can command the price it wants.

3. What are Futures?

Futures are exchange-traded contracts to sell or buy financial instruments or physical commodities for a future
delivery at an agreed price. There is an agreement to buy or sell a specified quantity of financial instrument
commodity in a designated future month at a price agreed upon by the buyer and seller.To make trading possible, BSE
specifies certain standardized features of the contract.
4. What is the difference between Forward Contracts and Futures Contracts?
Sr.No
1

Basis
Nature

Contract
Terms
Liquidity
Margin
Payments
Settlement

Squaring off

2
3
4

Futures

Forwards

Traded on organized
exchange

Over the Counter

Standardized

Customised

More liquid
Requires margin
payments
Follows daily settlement

Less liquid

Can be reversed with any

member of the Exchange.

Not required
At the end of the period.
Contract can be reversed only with
the same counter-party with whom it
was entered into.

Over-The-Counter (or OTC) is a security traded in some context other than on a formal
exchange such as the NYSE, TSX, AMEX, etc. The phrase "over-the-counter" can be used to
refer to stocks that trade via a dealer network as opposed to on a centralized exchange. It
also refers to debt securities and other financial instruments such as derivatives, which are
traded through a dealer network.
DEFINITION of 'Capital Markets'
Capital markets are markets for buying and selling equity and debt instruments. Capital markets channel savings and
investment between suppliers of capital such as retail investors and institutional investors, and users of capital like
businesses, government and individuals. Capital markets are vital to the functioning of an economy, since capital is a
critical component for generating economic output. Capital markets include primary markets, where
new stock and bond issues are sold to investors, and secondary markets, which trade existing securities.
A bond is a debt investment in which an investor loans money to an entity (typically corporate
or governmental) which borrows the funds for a defined period of time at a variable or fixed

interest rate. Bonds are used by companies, municipalities, states and sovereign governments
to raise money and finance a variety of projects and activities. Owners of bonds are
debtholders, or creditors, of the issuer.

PRIMARY MARKET
A market that issues new securities on an exchange. Companies, governments and other groups
obtain financing through debt or equity based securities. Primary markets are facilitated by underwriting groups,
which consist of investment banks that will set a beginning price range for a given security and then oversee its sale
directly to investors.Also known as "new issue market" (NIM).
SECONDARY MARKET
A market where investors purchase securities or assets from other investors, rather than from issuing companies
themselves. The national exchanges - such as the New York Stock Exchange and the NASDAQ are secondary
markets.Secondary markets exist for other securities as well, such as when funds, investment banks, or entities such
as Fannie Mae purchase mortgages from issuing lenders. In any secondary market trade, the cash proceeds go to an
investor rather than to the underlying company/entity directly.
Delta is the amount of change in the price of an option for every one-point increase in the underlying asset, or the
percentage of the change in the price of the underlying asset that is reflected in the price of an option. Delta is positive
for calls and negative for puts.
MONEY MARKET
A segment of the financial market in which financial instruments with high liquidity and very
short maturities are traded. The money market is used by participants as a means for
borrowing and lending in the short term, from several days to just under a year. Money market
securities consist of negotiable certificates of deposit (CDs), bankersacceptances,
U.S. Treasury bills, commercial paper, municipal notes, federal funds and repurchase
agreements (repos).
Initial Public Offering - IPO'
The first sale of stock by a private company to the public. IPOs are often issued by smaller, younger companies
seeking the capital to expand, but can also be done by large privately owned companies looking to become publicly
traded.In an IPO, the issuer obtains the assistance of an underwriting firm, which helps it determine what type of
security to issue (common or preferred), the best offering price and the time to bring it to market.Also referred to as a
"public offering."
Collateralized debt obligations
Not all collateralized debt obligations (CDOs) are credit derivatives. For example a CDO made up of loans is merely a
securitizing of loans that is then tranched based on its credit rating. This particular securitization is known as a
collateralized loan obligation (CLO) and the investor receives the cash flow that accompanies the paying of the debtor
to the creditor. Essentially, a CDO is held up by a pool of assets that generate cash. A CDO only becomes a derivative
when it is used in conjunction with credit default swaps (CDS), in which case it becomes a Synthetic CDO. The main
difference between CDOs and derivatives is that a derivative is essentially a bilateral agreement in which the payout
occurs during a specific event which is tied to the underlying asset.Other more complicated CDOs have been
developed where each underlying credit risk is itself a CDO tranche. These CDOs are commonly known as CDOssquared.
Repo rate is the rate at which the central bank of a country (RBI in case of India) lends money to commercial banks
in the event of any shortfall of funds.

Reverse repo rate is the rate at which the central bank of a country (RBI in case of India) borrows money from
commercial banks within the country.
Options and futures
The main fundamental difference between options and futures lies in the obligations they put on their buyers and
sellers. An option gives the buyer the right, but not the obligation to buy (or sell) a certain asset at a specific price at
any time during the life of the contract. A futures contract gives the buyer the obligation to purchase a specific asset,
and the seller to sell and deliver that asset at a specific future date, unless the holder's position is closed prior to
expiration.
MF
An investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in
securities such as stocks, bonds, money market instruments and similar assets. Mutual funds are operated by money
managers, who invest the fund's capital and attempt to produce capital gains and income for the fund's investors.
Amutual fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus.
Hedge funds are alternative investments using pooled funds that may use a number of different strategies in order to
earn active return, or alpha, for their investors. Hedge funds may be aggressively managed or make use
of derivatives and leverage in both domestic and international markets with the goal of generating high returns (either
in an absolute sense or over a specified market benchmark). Because hedge funds may have low correlations with a
traditional portfolio of stocks and bonds, allocating an exposure to hedge funds can be a good diversifier.
Corporate actions are typically agreed upon by a company's board of directors and authorized by the shareholders.
Some examples are stock splits, dividends, mergers and acquisitions, rights issues and spin offs.
A stock split is a decision by the company's board of directors to increase the number of shares that are outstanding
by issuing more shares to current shareholders. For example, in a 2-for-1 stock split, every shareholder with
one stock is given an additional share.
An options contract offers the buyer the right to buy, not the obligation to buy at the specified price or
date. Options are a type of derivative product. The right to sell a security is called a 'Put Option', while the right to
buy is called the 'Call Option'.
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