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Introduction to Derivatives
Derivative is a product/contract which does
not have any value on its own i.e. it derives its value from some underlying.
Forward contracts
- A forward contract is one to one bi-partite
contract, to be performed in the future, at the terms decided today.
(E.g. forward currency market in India).
- Forward contracts offer tremendous
flexibility to the parties to design the contract in terms of the price, quantity, quality
(in case of commodities), delivery time and place.
- Forward contracts suffer from poor liquidity
and default risk.
Future contracts
- Future contracts are organised/ standardised
contracts, which are traded on the exchanges.
- These contracts, being standardised and
traded on the exchanges are very liquid in nature.
- In futures market, clearing corporation/
house provides the settlement guarantee.
Every futures contract is a forward
contract. They :
- are entered into through exchange, traded on
exchange and clearing corporation/house provides the settlement guarantee for trades.
- are of standard quantity; standard quality
(in case of commodities).
- have standard delivery time and place.
Forward / Future Contracts
|
Features
|
Forward Contract |
Future Contract |
|
Operational Mechanism
|
Not
traded on exchange |
Traded
on exchange |
|
Contract Specifications
|
Differs
from trade to trade. |
Contracts
are standardised contracts. |
|
Counterparty Risk
|
Exists |
Exists,
but assumed by Clearing Corporation/ house. |
|
Liquidation Profile
|
Poor
Liquidity as contracts are tailor maid contracts. |
Very
high Liquidity as contracts are standardised contracts. |
|
Price Discovery
|
Poor;
as markets are fragmented. |
Better;
as fragmented markets are brought to the common platform. |
Options
Options are instruments whereby the right is given by the option
seller to the option buyer to buy or sell a specific asset at a specific price on or
before a specific date.
- Option Seller - One who gives/writes the
option. He has an obligation to perform, in case option buyer desires to exercise his
option.
- Option Buyer - One who buys the option. He
has the right to exercise the option but no obligation.
- Call Option - Option to buy.
- Put Option - Option to sell.
- American Option - An option which can be
exercised anytime on or before the expiry date.
- European Option - An option which can be
exercised only on expiry date.
- Strike Price/ Exercise Price - Price at
which the option is to be exercised.
- Expiration Date - Date on which the option
expires.
- Exercise Date - Date on which the option
gets exercised by the option holder/buyer.
- Option Premium - The price paid by the
option buyer to the option seller for granting the option.
Introduction of futures in India
- The first derivative product to be introduced in
the Indian securities market is going to be "INDEX FUTURES".
- In the world, first index futures were
traded in U.S. on Kansas City Board of Trade (KCBT) on Value Line Arithmetic Index (VLAI)
in 1982.
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