DERIVATIVES

A derivative is an instrument whose value is

derived from the value of one or more
underlying, which can be commodities, precious
metals, currency, bonds, stocks, stocks indices,
etc. Four most common examples of derivative
instruments are Forwards, Futures, Options and
Swaps

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 Derivatives involve payment/receipt of income
generated by the underlying asset on a
notional principal.
Derivatives are a special type of off-balance
sheet instrument in which no principal is ever
paid.
Transactions are carried out on a notional
principal, transferring only the income
generated by the underlying asset.

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 Characteristics of derivatives
Their origin is from some other security,
commodity or a reference point (such as
indexes)
They help in hedging against risk of undue
volatility.
They are leveraged instruments for risk
management based on original security or
instrument.

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 Derivatives are of two types 
exchange traded and over the counter

Exchange traded- It is trading done throughout the

world through exchanges. It's more like the stock market.
The most common are future and option derivatives.

Over the counter- These are derivatives that are not

traded through any exchange process. Some of the
popular OTC instruments are forwards, swaps etc.
(popularly known as OTC)

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 What Does Over-The-Counter - OTC
Mean?
A security traded in some context other than on a
formal exchange such as the NYSE, BSE, NSE, etc.
The phrase "over-the-counter" can be used to
refer to stocks that trade via a dealer network as
opposed to on a centralized exchange. It also
refers to debt securities and other financial
instruments such as derivatives, which are traded
through a dealer network.

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 Forwards
A forward contract refers to an agreement
between 2 parties to exchange an agreed quantity
of an asset for cash at a certain date in future at a
predetermined price specified in that agreement.
The asset may be currency, commodity or
instrument.
The long position and short position take the
form of buy and sell respectively in a forward
contrast.

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 Features of FORWARDS
Over the counter trading (OTC) they are privately
arranged agreements, not standardized ones and are traded
OTC and not in exchange.
No down payment.
Settlement at maturity.
Linearity: there are symmetrical gains or losses due to
price fluctuations of the underlying asset. The loss of the
forward buyer is the gain of the forward seller and vice-
versa.
No secondary market. It is a private contract which is
customized and cannot be traded on an organized stock
exchange.
Necessity of a third party (intermediary) to enable the
parties to enter into a forward rate contract.
Delivery is essential on maturity of the contract
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 Futures
Futures contract is a standardized forward
contract. It is legally enforceable and is always
traded on an organized exchange.
Definition: A futures contract is one where
there is an agreement between two parties to
exchange any asset or currency or commodity
for cash at a certain future date, at an agreed
price.
It takes place only in organized futures markets
and according to well established standards.
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 Features of FUTURES
Highly standardized.
Down payment- Down payment need not be paid at the time of
the agreement but the contracting parties deposit a percentage of
the contract price with the exchange. This is initial margin and it
gives a guarantee that the contract will be honoured.
Hedging of price risks
Linearity: The parties to the contract get symmetrical losses or
gains due to price fluctuations of the underlying asset in either
direction.
Secondary market is available
Delivery of asset not essential on the maturity date of the
contract. The difference between future and spot prices may be
exchanged instead.
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 Features of FUTURES Cond.
Settlements
Though future contracts can be held till maturity they are not so
in actual practice. Futures are ‘marked to the market’ and the
exchange records profit and loss (Difference between futures
price and the spot price on that day) on them on daily basis for
both parties. Generally these profits or losses are accumulated in
the margin accounts of the parties. But, if there are continuous
losses and if the initial margin falls below a minimum level called
“maintenance margin”, then the exchange authorities will
interfere and the contract automatically lapses.

The default risk due to such a lapse is limited to the profit or loss
booked during that day and it is borne by the exchange since it
guarantees performance by both the parties.

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 Forwards Vs Futures Contract
Nature of the Contract: A forward contract is not
standardized. It is tailor made contract in terms of
quantity, price, period, date, delivery conditions,
etc. according to the convenience of the parties. A
futures contract is standardized.
Existence of Secondary Market: A forward
contract is customized and is not standardized so it
cannot be traded on an organized exchange. Thus it
does not have a secondary market. A futures
contract is traded on organized exchange and
therefore has a secondary market.
Settlement: A forward contract is settled only on
the maturity date. A futures contract is settled daily,
irrespective of the maturity date.
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 Forwards Vs Futures Contract cond.
Modus operandi: Forward contract is entered
into with the help of some financial intermediary
like a bank while a futures contract is entered into
through an organized exchange and a third party is
not required.
Down payment: In forward contract no down
payment is made at the time of agreement while in
a futures contract margin money is deposited with
the exchange by the contracting parties.
Delivery of the Asset: In forward contract
delivery of the asset is essential on the date of
maturity whereas a futures contract does not end
with the delivery of the asset.

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 OPTIONS
An option is a special contract under which the
option owner enjoys the right to buy/sell an
underlying asset (stock, bond, currency, commodity,
etc) at a predetermined price on or before a
specified date in future without the obligation to do
so.
The option holder is the buyer of the option and
option writer is the seller of the option.
The act of buying or selling the underlying asset as
per the option contract is called exercising the
option.
The fixed price at which the option holder/writer
can buy/sell the underlying asset is called the
exercise price or striking price.
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