What is a Derivative?
The
word 'Derivative' originates from mathematics and refers to a variable, which
has been derived from another variable. In other words it is a security which
doesn’t have its own value but it derives its value from one or more
underlying assets. The derivative itself is merely a contract between two
or more parties and its value is determined by fluctuations in
the value of the underlying asset. The most common underlying assets
include stocks, bonds, commodities, currencies, interest rates
and market indexes and further it also includes derivatives based on weather data
like the amount of rainfall, etc. The main reason why derivatives are common
are they can be used both as a hedging and speculative purposes.
For example, a derivative
contract on Sugar depends upon the price of Sugar. And in same way, a
derivative of the shares of L&T (underlying) will derive its value from the
share price (value) of L&T.
Derivatives
are specialised contracts which signify an agreement or an option to buy or
sell the underlying asset of the derivate up to a certain time in the future at
a prearranged price, the exercise price.
Let us understand
the concept of Derivatives with a very basic example:
A farmer has sown wheat but he hasn’t harvested
it yet. He fears that price of wheat (underlying) when harvested and ready for delivery,
will be less than his production cost. Thus in order to overcome this risk, he
enters into a “Contract” to sell his standing crop on some date in the future
at a predetermined price.
Let’s say the production cost is 23,000 Rs per
ton. Farmer is doing a contact with a merchant on 1st January to sell his
standing crop on 1st March for a set price of 24,000 Rs per ton. By doing so,
he can avoid the risk of fall in price of his crop in future. If selling price
of wheat on 1st march is 21,000 Rs per ton than the derivative
contract is said to be more valuable for farmer because farmer can sell his
wheat at 24,000 Rs per ton even though market price is much less (21,000 Rs per
ton).
Participants in a Derivative
Market
The derivatives market is similar
to any other financial market and has following three broad categories of
participants:
• Hedgers:
T These are investors with a
present or anticipated exposure to the underlying asset which is subject to
price risks. Hedgers use the derivatives markets primarily for price risk
management of assets and portfolios. The farmer mentioned in the above example
can be a typical hedger.
• Speculators:
These are individuals who take a
view on the future direction of the markets. They take a view whether prices
would rise or fall in future and accordingly buy or sell futures and options to
try and make a profit from the future price movements of the underlying asset.
• Arbitrageurs:
They take positions in financial
markets to earn riskless profits. The arbitrageurs take short and long
positions in the same or different contracts at the same time to create a
position which can generate a riskless profit.
Derivatives
Derivatives
can be classified into:
EXCHANGE
TRADED
1) Futures
2) Options
OVER
THE COUNTER
1) Financial Swaps
2) Forward Rate Agreements (FRA)
3) Forward Contracts
The
knowledge of the following terms is necessary to comprehend the concept of
Derivatives- :
·
Spot prices: The price of the underlying asset at the time
the contract is entered.
·
Forward/ future/ options price: the price for which the contract is entered
into in the present time.
·
The difference
between the spot and the forward price is the forward premium or forward discount, generally considered
in the form of a profit, or loss, by the purchasing party.
What are futures contracts?
A futures contract is an agreement
between two parties to buy or sell an asset at a certain time in future for a
certain price. These are basically exchange
traded, and are in the form of standardized contracts. The exchange stands
guarantee to all transactions and hence, the counterparty risk (the risk that
one of the parties to the contract may not fulfil his or her obligation) is
largely eliminated. The buyers
of futures contracts are considered having a long position whereas the sellers
are considered to be having a short position. It should be noted that this is
similar to any asset market where anybody who buys is long and the one who
sells in short. (The concept of long and short position is explained below)
What are forwards Contracts?
These are generally in the form of
promises to deliver an asset at a pre-determined date in future at a pre-agreed
price. The contracts are traded over the
counter (OTC) (i.e. outside the
stock exchanges, directly between the two parties) and can be customized
according to the needs of the parties. Since these contracts do not fall under
the purview of rules and regulations of an exchange, they generally suffer from
counterparty risk.
What are Options?
Options give the buyer (holder) a right but
not an obligation to buy or sell an asset in future. 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.
One can buy and sell each of the
contracts. When one buys an option he is said to be having a long position and
when one sells he is said to be having a short position. It should be noted
that, in the first two types of derivative contracts (forwards and futures)
both the parties (buyer and seller) have an obligation; i.e. the buyer needs to
pay for the asset to the seller and the seller needs to deliver the asset to
the buyer on the settlement date.
In case of Options only the seller (also
called option writer) is under an obligation and not the buyer (also called
option purchaser). The buyer has a right to buy (call options) or sell (put
options) the asset from / to the seller of the option but he may or may not exercise
this right. In case the buyer of the option does exercise his right, the seller
of the option must fulfil his all obligation (for a call option the seller has
to deliver the asset to the buyer of the option and for a put option the seller
has to receive the asset from the buyer of the option).
