DERIVATIVES

A financial instrument whose characteristics and value depend upon the characteristics and value of an underlier, typically a commodity, bond, equity or currency. Examples of derivatives include futures and options etc Advanced investors sometimes purchase or sell derivatives to manage the risk associated with the underlying security, to protect against fluctuations in value, or to profit from periods of inactivity or decline. These techniques can be quite complicated and quite risky.

The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. They are known to be the most complicated instruments in the entire financial market. Some of the investors find them right instruments for risk management, which increases liquidity. However, they are extremely important and have huge effects on financial markets and the economy . Now , we make the comparison between forwards , futures & options. DIFFERENCE BETWEEN FORWARDS & FUTURES & OPTIONS

FORWARDS

FUTURES

OPTIONS

Meaning

A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time.

The meaning of futures is summarized as the contract made by two different parties either to purchase or sell products at a future period where the prices are pre-determined.

The meaning of options is the right without the obligation to purchase and sell underlining assets. Call option stands for the right without obligation to only buy the underlining asset and the purchaser may refuse the contract prior to its maturity. Put option means the opposite of call option.

Contract parties

with In Forwards, there is still an agreement with later date between the parties, where the company/individual will buy at a specific price. The key difference between the contracts, is that a forwards contract cannot be traded on the basis of an exchange. This means that cash amounts are not settled for accounts on a daily basis

In the future contract, both the parties are engaged in a contract with obligation to purchase or sell the asset at a particular price on the day of settlement. This is a risky proposition for both the parties.

In case of the option contract, the buyer has the right without any obligation to purchase or sell the underlying asset. With this kind of trading, the purchaser’s risk becomes limited to the payment of premium but the prospective profit is unlimited.

Payment

Payment is predetermined amount, at a predetermined rate or date. It does not involve CASH FLOW during the contract between the parties.

The investor is able to engage in future contract without any advance expenditure. Futures need no advance payment.

In the options case, it requires the payment of a premium to be made. This additional charge is paid to get relief from the obligations to purchase underlying assets in case of negative shift in prices of assets. The only loss would be in the shape of premium when the transaction is made though option and hence the risk remains limited within the payment of premium. Options have the advance payment system of premiums.

Concept of gain

The gain in the option trading can be obtained in certain different manners.

The gain in the future trading is automatically linked to the daily fluctuations in the market.

The gain in the option trading can be obtained in certain different manners.

Price determination

Price is pre- A future is a contract determined which is governed by a between the two pre-determined price for parties. selling and buying at a future period.

In options, there is the right to sell or purchase of underlying assets without any obligation.

Risk

High risk

A future trading has The risk in option is open risk. limited. Standardized

Contract Size

Depending on the Standardized transaction and the requirements of the contracting parties.

Expiry Date

Depending on the Standardized transaction

Transaction Method Institutional Guarantee Market Regulation Settlement

Standardized. American style options can be exercised at any time. European style options can only be exercised at expiry. Negotiated directly Quoted and traded on Quoted and traded on by the buyer and the Exchange the Exchange seller. The contracting Clearing House Clearing House parties Not regulated Government market regulated Government market regulated

Cash settled.

Contracts are usually closed prior to expiry by taking a compensating position. At expiry contracts can be cash settled or settled by delivery of the underlying.

When a long position is exercised it may be settled by delivery or cash settled. A long position which is out-ofthe-money is usually cancelled prior to expiry.

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