Derivative Instruments

Derivative Instruments? 

A derivative is an instrument whose value is derived from the value of one or more underlying, which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc.

4 most common examples of derivative instruments are Forwards, Futures, Options and Swaps. 

Forward Contracts? 

A forward contract is a customized contract between two parties, where settlement takes place on a specific date in future at a price agreed today. The main features of forward contracts are 

·         They are bilateral contracts and hence exposed to counter-party risk.

·         Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.

·         The contract price is generally not available in public domain.

·         The contract has to be settled by delivery of the asset on expiration date.

·         In case the party wishes to reverse the contract, it has to compulsorily go to the same counter party, which being in a monopoly situation can command the price it wants.

Futures?

Futures are exchange-traded contracts to sell or buy financial instruments or physical commodities for a future delivery at an agreed price. There is an agreement to buy or sell a specified quantity of financial instrument commodity in a designated future month at a price agreed upon by the buyer and seller. To make trading possible, BSE specifies certain standardized features of the contract. 

Difference between Forward Contracts and Futures Contracts? 

Sr.No Basis Futures Forwards a Nature Traded on organized exchange Over the Counter b Contract Terms Standardized Customised c Liquidity More liquid Less liquid d Margin Payments Requires margin payments Not required e Settlement Follows daily settlement At the end of the period. f Squaring off Can be reversed with any member of the Exchange. Contract can be reversed only with the same counter-party with whom it was entered into.

Options :

an option is a contract which gives the buyer (the owner or holder) the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on or before a specified date.

The seller has the corresponding obligation to fulfill the transaction, that is to sell or buy – if the buyer (owner) "exercises" the option. An option that conveys to the owner the right to buy something at a specific price is referred to as a Call; an option that conveys the right of the owner to sell something at a specific price is referred to as a Put.

Option trading

Exchange-traded options : also called "listed options. Exchange traded options have standardized contracts, and are settled through a clearing house with fulfillment guaranteed by the Options Clearing Corporation (OCC).

·         stock options,

·         bond options and other interest rate options

·         stock market index options or, simply, index options and

·         options on futures contracts

·         callable bull/bear contract

Over-the-counter options : OTC options, also called "dealer options.are traded between two private parties, and are not listed on an exchange.

·         nterest rate options

·         currency cross rate options, and

·         options on swaps or swaption