Derivatives (Part – 1) : Meaning, Definition and Types of Derivatives

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Topics to be Covered Are

  • Meaning of Derivatives
  • Definition of Derivatives
  • Types of Participants
  • Functions of Derivatives
  • Why do investors enter derivative contracts?
  • Major types of Derivatives
    • Forward Contract
    • Future Contract
    • Options
    • Swap

Meaning of Derivatives

  • A derivative is a contract between two parties which derives its value/price from an underlying asset.
  • Basic principle behind entering derivative contracts is to earn profits by speculating the value of underlying asset in future.
  • The most common types of derivatives are futures, options, forwards, and swaps.
  • Example: The value of XYZ company share is ₹ 100 per share. There is a chance of increase in the price of share by 50 % in the next year. So, Mohan comes in a contract with XYZ company to purchase share at ₹ 125 per share in the next year even if the price of share raises more than this.

Definition of Derivatives

Derivatives are securities under the SCRA and hence, the trading of derivatives is governed by the regulatory framework under the SCRA.

The securities contracts regulation act, 1956 defines ‘derivative’ to include:

  • A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security.
  • A contract which derives its value from the prices or index of prices of underlying securities.

Types of Participants

Participants, who trade in the derivatives market can be classified under the following three broad categories:

Hedgers: Hedgers face risk associated with the price of an asset. They use the futures or options markets to reduce or eliminate this risk.

Hedgers Face Risk
  • Speculators: Speculators are the trader who does not hedge, but who trades with the objective of achieving profits through the successful anticipation of price movements.
  • Arbitragers: Arbitragers work at making profits by taking advantage of difference between prices of the same product across different markets.

Functions of Derivatives

  • Derivatives help in discovery of future as well as current prices.
  • Derivative market helps to transfer risks.
  • With the introduction of derivatives, the underlying market witnesses higher trading volumes.
  • Speculative traders shift to a more controlled environment of the derivatives market.
  • Derivatives trading acts as a catalyst for new entrepreneurial activity.
  • Derivatives markets help increase savings and investment eventually.

Mode of Derivatives

  • OTC (Over-the-counter) : Contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary.
  • ETD (Exchange-traded) : Standardized contracts such as futures and options that are traded or transacted on an organized futures exchange. They require payment of an initial deposit or margin settled through a clearing house.

Major Types of Derivatives

  • Forward Contract
  • Future Contract
  • Option
  • Swap

Forward Contract

A Forward Contract, often shortened to just forward, is a contract agreement to buy or sell an asset at a specific price on a specified date in the future. Since the forward contract refers to the underlying asset that will be delivered on the specified date, it is considered a type of derivative.

Example:

Forward Contract

Forward contracts have four main components to consider.

The following are the four components:

  • Asset: This is the underlying asset that is specified in the contract.
  • Expiration Date: The contract will need an end date when the agreement is settled and the asset is delivered and the deliverer is paid.
  • Quantity: This is the size of the contract, and will give the specific amount in units of the asset being bought and sold.
  • Price: The price that will be paid on the maturation/expiration date must also be specified. This will also include the currency that payment will be rendered in.

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