Introduction to Derivatives

Introduction to Derivatives
Derivative is a product/contract which does not have any value on its own i.e. it derives its value from some underlying.


Forward contracts
A forward contract is one to one bi-partite contract, to be performed in the future, at the terms decided today. (E.g. forward currency market in India).
Forward contracts offer tremendous flexibility to the parties to design the contract in terms of the price, quantity, quality (in case of commodities), delivery time and place.
Forward contracts suffer from poor liquidity and default risk.


Future contracts
Future contracts are organised/ standardised contracts, which are traded on the exchanges.
These contracts, being standardised and traded on the exchanges are very liquid in nature.
In futures market, clearing corporation/ house provides the settlement guarantee.
Every futures contract is a forward contract. They :
are entered into through exchange, traded on exchange and clearing corporation/house provides the settlement guarantee for trades.
are of standard quantity; standard quality (in case of commodities).
have standard delivery time and place.


Forward / Future Contracts
Features Forward Contract Future Contract
Operational Mechanism Not traded on exchange Traded on exchange
Contract Specifications Differs from trade to trade. Contracts are standardised contracts.
Counterparty Risk Exists Exists, but assumed byClearing Corporation/ house.
Liquidation Profile Poor Liquidity Very high Liquidity
contracts Type contracts are tailor maid. contracts are standardised .
Price Discovery Poor. Better.


Options
Options are instruments whereby the right is given by the option seller to the option buyer to buy or sell a specific asset at a specific price on or before a specific date.
Option Seller - One who gives/writes the option. He has an obligation to perform, in case option buyer desires to exercise his option.
Option Buyer - One who buys the option. He has the right to exercise the option but no obligation.
Call Option - Option to buy.
Put Option - Option to sell.
American Option - An option which can be exercised anytime on or before the expiry date.
European Option - An option which can be exercised only on expiry date.
Strike Price/ Exercise Price - Price at which the option is to be exercised.
Expiration Date - Date on which the option expires.
Exercise Date - Date on which the option gets exercised by the option holder/buyer.
Option Premium - The price paid by the option buyer to the option seller for granting the option.


Introduction of futures in India
The first derivative product to be introduced in the Indian securities market is going to be "INDEX FUTURES".
In the world, first index futures were traded in U.S. on Kansas City Board of Trade (KCBT) on Value Line Arithmetic Index (VLAI) in 1982.