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What is a Derivative?
The term Derivative stands for a contract whose price is
derived from or is dependent upon an underlying asset.
The underlying asset could be a financial asset such as
currency, stock and market index, an interest bearing
security or a physical commodity.
As Derivatives are merely contracts between two or more
parties, anything like weather data or amount of rain can be
used as underlying assets.
Classification of Derivatives
Future Contracts
Forward Contracts
Options
Swaps
Exchange Traded
Foreign Currency
Derivatives
Currency Futures
Equity Derivatives
Basic Terminologies
Spot Contract: An agreement to buy or sell an asset today.
Spot Price: The price at which the asset changes hands on
the spot date.
Spot date: The normal settlement day for a transaction
done today.
Long position: The party agreeing to buy the underlying
asset in the future assumes a long position.
Short position: The party agreeing to sell the asset in the
future assumes a short position
Delivery Price: The price agreed upon at the time the
contract is entered into.
Forward Contract
Forward is a non-standardized contract between two
parties to buy or sell an asset at a specified future time at a
price agreed today.
For Example: If A has to buy a share 6 months from now.
and B has to sell a share worth Rs.100. So they both agree
to enter in a forward contract of Rs. 104. A is at Long
Position and B is at Short Position Suppose after 6
months the price of share is Rs.110. so, A overall gained
Rs. 4 but lost Rs. 6 while B made an overall profit of Rs. 6.
Swap Contract
Futures Contract
Futures contract is a standardized contract between two
parties to exchange a specified asset of standardized
quantity and quality for a price agreed today (the futures
price or the strike price) with delivery occurring at a
specified future date, the delivery date.
Since such contract is traded through exchange, the
purpose of the futures exchange institution is to act as
intermediary and minimize the risk of default by either party.
Thus the exchange requires both parties to put up an initial
amount of cash, the margin.
Concept of Margin
Since the futures price will generally change daily, the
difference in the prior agreed-upon price and the daily
futures price is settled daily also.
The exchange will draw money out of one party's margin
account and put it into the other's so that each party has the
appropriate daily loss or profit.
Thus on the delivery date, the amount exchanged is not the
specified price on the contract but the spot value.
Options
An option is a derivative financial instrument that specifies
a contract between two parties for a future transaction on an
asset at a reference price.
The buyer of the option gains the right, but not the
obligation, to engage in that transaction, while the seller
incurs the corresponding obligation to fulfill the transaction.
Some Terminologies
Call Option: Right but not the obligation to buy
Put Option: Right but not the obligation to sell
Option Price: The amount per share that an option buyer
pays to the seller
Expiration Date: The day on which an option is no longer
valid
Strike Price: The reference price at which the underlying
may be traded
Long Position: Buyer of an option assumes long position
Short Position: Seller of an option assumes short position
Option Styles
European option an option that may only be exercised on
expiration.
American option an option that may be exercised on any
trading day on or before expiry.
Bermudan option an option that may be exercised only on
specified dates on or before expiration.
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