What are Derivatives

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Table of Contents

Derivatives

A Derivative is a product whose value is derived from some other assets known as underlying assets. These underlying assets can be a lot of things ranging from :

Metals (Gold, Silver, Aluminium),

Energy resources (Oil, Coal, Electricity),

Agricultural commodities (Wheat, Sugar, Coffee),

Financial assets(Bonds, Shares, Foreign Exchange).

Now say a product is launched which has its value derived (linked) from the aforementioned assets then the product will be called a Derivative. 

Types Of Derivative

FORWARDS

Forwards are customized over-the-counter contractual agreements between two parties to buy/sell an underlying asset at a certain future date at a particular price which is pre-decided on the date of the contract. Both parties are obliged to honor the transaction irrespective of the price of the underlying asset at the time of delivery.

Let’s understand it with a simple example.

Party 1 (Ram) draws a contract without involving an Organized/Regulated Exchange on August 23 to buy Gold (Underlying Asset) from Party 2 (Shyam) at a future date of December 23 for the price of Rs 20000 per 10 gram.

Scene 1:

On the date of delivery even if the price of gold shoots up to Rs. 25000 per 10 gram Mr. Shyam will be still obliged to sell the gold at the price mentioned in the contract i.e Here Ram gets the asset at a discounted rate from the current market price.

Scene 2:

On the date of delivery even if the price of gold drops up to Rs. 15000 per 10 gram Mr. Ram will be still obliged to buy the gold at the price mentioned in the contract. Here Shyam delivers the asset at a premium rate from the current market price.

FUTURES

Futures contract is similar to Forwards contract differing on the fact that both the parties make the deal through an Organised/Regulated Exchange without directly negotiating with each other.

In the above example between Ram & Shyam if a third party like an Exchange is involved then that Forwds Contract can be treated as a Futures Contract.

OPTIONS

An option is a contract that gives the right but not an obligation to buy or sell the underlying on or before the stated date price. The writer/seller of the option receives the premium with the obligation to sell the underlying asset if the buyer exercises his right.

Let’s take on the previous example:

Ram (Buyer) & Shyam (Seller) enter into a contract to buy Gold @Rs. 20000 per 10gm at a specified date.

Scene 1: On the date of delivery, the current price of gold is @15000 per 10gm. Now Ram has an option to either buy the asset or let the contract expire. Here Ram is not obliged to maintain the contract.

Scene 2: On the date of delivery, the current price of gold is @25000 per 10gm, but Shyam is still obliged to honor the contract if Ram Decides to buy the asset.

SWAP

An agreement is made between two parties to exchange cash flows in the future according to a prearranged formula. Swap is a series of forward contracts and helps market participants manage risk associated with volatile interest rates currency exchange rates and commodity prices.

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