INSIGHT TO DERIVATIVES: AN INVESTMENT OPTION

The three main categories of financial instruments are:

• Equities(i.e. stocks)
• Debt (i.e. bonds and mortgages)
• Derivatives.

Derivatives are one of the three main categories of financial instruments.It is a financial contract between two parties whose value is measured as the value of the underlying assets. In actual an underlying corpus is made which consists of one security or a combination of different securities. The value of the derivative is the value of the created corpus and keeps on changing as the value of the underlying assets change. The term securities may confuse you but it is nothing but just a term used for all tradable assets. All the tradable assets are securities example: bonds, shares, stocks, futures, forwards etc.

Lets understand some more about this financial instrument. What is it actually?

Derivative came into existence in 12^th century. It is a contract between two parties. But what this contract actually comprises of?

The contract has the following information clearly described:

1. Important dates.
2. Description of the underlying assets i.e. the securities involved. The most common underlying assets include stocks, bonds, currencies etc.
3. Parties’ contractual obligations.
4. The notional amount.

What do derivatives include?

Here the, Forwards, futures and the swaps are commonly known as “lock products”.

And the options are known as an “option product".

What are these lock and option products?

Lock products obligates the parties to certain terms over the life of the contract. On the other hand, options are not held with any obligations but with rights that are provided to the buyer under the terms specified.

Let’s study in brief about the various derivatives and how they differ from each other.

1.   1. FUTURES:

    Futures are categorized under the lock products and hence obligate the buyer to purchase and seller to sell an asset such as a physical commodity or financial instrument at a predetermined future date and price.                                                                                                                                    As the name itself is self explanatory and can be easily remembered as a product that is locked for future transaction, the future contract may call for physical delivery or can also be settled in cash. Future contracts detail the quantity and quality of the underlying asset, they are standardized to facilitate trading on a futures exchange.

Future markets are known for its high leverage capacity as compared to stock markets.

For example: a farmer can use futures and lock his crops in certain price and reduce risk(hedge) but at the same time the price of the crop may float in a reverse direction and may land the farmer with a loss.

2. FORWARDS: 
With futures as a lock product with a future predetermined date and price, forwards are similar but a bit different from futures. The price of the future transaction under forwards are decided at the time of contract itself and is not a future based parameter.

Forwards are customized contracts between two parties to sell or purchase an asset on a specified price but on a future date. It is of non- standardized nature. Unlike standard future contracts, a forward contract can be customized to any commodity, amount and delivery date. A forward contract can also be settled either in cash or on a physical delivery basis.

Example: A farmer who has sowed the seeds today would be getting his crops after 3 months enters into a forward contract to sell the 10 tons of wheat after 3 months at a price of Rs 50/kg and settlement on the cash basis. Here the price is fixed today but the delivery of a fixed quantity or cash settlement is set on a future date based on the difference in price at that point in time between the two parties with an obligation to sell and purchase.

Now suppose in this case the price after three months can be the following:

• More than Rs50/kg: then the farmer owes the difference between the contracted rate and current spot rate.
• Less than Rs50/kg: the farmer will pay the difference to the other party as per the difference in the current spot rate and the contracted rate.
• Remains Rs50/kg: no money is owned by anyone to each other and the contract is closed.

3. SWAPS: 

Swap is a type of derivative in which the two involved parties exchange their financial instruments so as to gain mutual benefits. The benefits depend upon the type of financial instruments involved. The swaps agreement clearly mentions the dates when the cash flows are to be paid and the way they will be calculated and accrued.

There are different types of Swaps:

1. Interest rate swaps.
2. Currency swaps.
3. Credit default swaps
4. Commodity swaps.
5. Subordinated risk swaps.

4. OPTIONS:

Options are the second type of category other than lock products under the major categories of derivatives.

The options carry with them certain rights rather than obligations as we have seen in lock products.

Options are contracts that give the involved parties the right, but not the obligation to buy (in case of call option) or sell (in case of put option) a specified amount of commodity, currency index or any other financial instrument or to sell or buy the underlying futures at a specified price on or before the specified future dates.

Call option gives the right to buy.

Put option gives the right to sell.

EXCHANGES THAT OFFER DERIVATIVE TRADING IN INDIA

• NSE (NATIONAL STOCK EXCHANGE)
• BSE (BOMBAY STOCK EXCHANGE)
• NCDEX (NATIONAL COMMODITY AND DERIVATIVES EXCHANGE)
• MCX (MULTI COMMODITY EXCHANGE)