What are derivatives according to you?
I’m sure you’re aware. I’ll start with my point of view.
According to my research and perception, derivatives are financial contracts that derive their value from an underlying asset, such as stocks, commodities, or currencies, and are contracted by two or more parties, with the derivative’s value determined from the price or value variations of the underlying assets. Derivatives can be used to hedge a position, speculate on an underlying asset’s directional movement, or leverage holdings.
As an example, You expect share prices to fall soon, therefore instead of selling your security, you can purchase the put option on that particular share. When the price of a security drops. You will gain from the option while also being protected from a drop in the stock price.
The four most common examples of derivative instruments are Forwards, Futures, Options, and Swaps.
Forwards– It is a contract between two parties to buy or sell an underlying asset at a specific price at a future date that is pre-determined on the contract’s date. Irrespective of the price of the underlying asset at the time of delivery, both contracting parties are committed and obliged to honor the transaction. The terms and circumstances of contracts for forwards are personalized because they are negotiated between two parties. These are OTC contracts, which means they can be bought and sold over the counter.
For example, if the oil price is trading at $10,000 per barrel and you anticipate it will rise in the near future, you may execute a forward contract with the supplier at $10,000 per barrel for the next six months.
Futures– A futures contract is similar to a forward contract, except that instead of being negotiated directly between two parties, it is arranged through an organized and controlled exchange. Futures are, in fact, exchange-traded forward contracts.
As an example, Forwards can be compared to future contracts, but the only difference is that futures contracts are standardized and traded on an exchange. Such as purchasing gold futures for the following month at the exchange’s specified price.
Options– For example, the Nifty is currently trading at 6143.40 on October 1, 2010. You pay Rs. 118.35 for a call option with a strike price of 6200 and an expiration date of October 28, 2010. The buyer of a Call option has the choice, but not the duty, to buy the underlying at the market price. In this case, you have the option to purchase Nifty at 6200. You have the option to buy or not buy, and there is no obligation to do so. You will exercise the option if the Nifty closes over 6200 at expiration, otherwise, you will let it expire.
Swaps-A swap is an agreement between two parties to exchange future cash flows according to a predetermined formula. Swaps are, in general, a collection of forwarding contracts. Swaps assist market participants in mitigating the chances of fluctuations in interest rates, currency exchange rates, and commodity prices.
Participants in derivatives markets:
Hedgers: They are exposed to various risks linked with underlying asset prices and employ derivatives to mitigate those risks. Derivative products are used by corporations, investing institutions, and banks to hedge or reduce their exposure to market factors such as stock prices, bond prices, currency exchange rates, and commodity prices. They must pay a premium to the risk-taker in exchange for the available hedging. For example, we believe the market will rise shortly and are willing to take the risk of purchasing stocks at a higher price. We can hedge today by buying index futures.
Speculators/Traders: A speculator employs strategies for a shorter period to outperform long-term investors. A speculator will make assumptions, particularly when anticipating price volatility in the future, in the hopes of making profits that will compensate for the anticipated risk. such as Technical analysis traders.
Arbitrageurs: Arbitrage is a deal that produces profit by exploiting a price difference in a product in two different markets. Arbitrage originates when a trader purchases an asset cheaply in one location and simultaneously arranges to sell it at a higher price in another location. Such opportunities are unlikely to persist for very long, since arbitrageurs would rush into these transactions, thus closing the price gap at different locations. For example, there can be a price difference in security at BSE & NSE, arbitrageurs are the ones who fill this price gap.
Types of Derivatives market:
Exchange-traded derivatives: In the modern world, there are a huge variety of derivative products available. They are either traded on organized exchanges like NSE, BSE, etc. Are standardized, and traded on organized exchanges with prices determined by the interaction of buyers and sellers through the auction platform. A clearing corporation like SEBI guarantees contract performance (settlement of transactions).
Over-the-counter (OTC): The over-the-counter market is a collection of broker-dealers scattered across the country. The market’s principal concept is more of a business model than a physical location. Contracts are bought and sold through a negotiated bidding procedure that connects thousands of intermediaries over a network of telephone or electronic media. Because these transactions take place in private between qualified counterparts, the OTC derivative market is less regulated, and contracts are often tailored to meet the needs of both parties involved.
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