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Derivatives

Derivatives
• Instruments whose value is derived from one
or more underlying financial asset
• Underlying asset: financial security,
securities index, indexes and commodities
• They have no intrinsic value
The underlying basis can be…
• Commodities including grain, coffee beans,
orange juice etc.
• Precious metals like gold, silver
• Foreign exchange rate
• Bonds
• Short term debt securities
• Loans and deposits
Derivative instruments
1. Forwards:
A customized contract between two entities,
where settlement takes place on a date in the
future at today’s pre-agreed price

1. Features of Forward contracts
1. Bilateral contracts
2. Customized contract
3. Long and short position
4. Delivery price
5. Synthetic assets
6. Settlement by delivery on expiration date
7. Popular contracts
Advantages of forward contracts
• Flexibility of price, quantity and date
• The trader knows the results
• Payment is not required until the contract is
settled
Disadvantages of Forward
contracts
• The user may not be able to negotiate good
terms
• Users have to bear the spread
• Deals can only be reversed by going back to the
original party and offsetting the original trade
• The creditworthiness of the other party may be a
problem
2. Futures
• A futures contract is a standardized contract
between two parties to buy or sell a stipulated
quantity (and quality) of a commodity, currency,
security, index or some other specified item at a
certain time in future at a certain price
Futures contracts
• Standardized in terms of
• Quantity
• Quality
• Date and month of delivery
• The units of price quotation
• The minimum price by which the price would change

Trading in futures
1. Long position
2. Short position
• No risk of default
Illustration
• If a futures contract maturing on December 23
rd

2013 and involving 500 shares of company X at
Rs. 375 is bought by investor A and sold by
another investor B, then each of these investors
has their rights and obligations to the clearing
corporations.
Marking to the market
• The parties in the contract are required to keep
margins

Advantages of futures
• Discovery of prices
• Reduction of risk
• High leverage
• Profit in both bull and bear market
• Lower transaction cost
• High liquidity
Disadvantages of futures
• Customer’s risk may not be fully covered
• May not be available in the required currency
• Procedure for conversion may be complex
• During volatile trading conditions the potential
loss can be high
Difference between forward and
futures
• Standardization
• Liquidity
• Conclusion of contract
• Margins
• Profit or loss settlement