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WHAT ARE DERIVATIVES?

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WHAT ARE DERIVATIVES? A derivative is a financial instrument that derives or gets it value from some real good or stock. It is in its most basic form simply a
contract between two parties to exchange value based on the action of a real good or service. Typically, the seller receives money in exchange for an agreement
to purchase or sell some good or service at some specified future date

Features of Derivatives Market :


Features of Derivatives Market 1.The derivatives market is like any other market. 2.It is a highly leveraged market in the sense that loss/profit can be magnified
compared to the initial margin. The investor pays only a fraction of the investment amount to take an exposure. The investor can take large positions even when he
does not hold the underlying security. 3.Market view is as important in the derivatives market as in the cash market. The profit/loss positions are dependent on the
market view. Derivatives are double edged swords.

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4. Derivatives contracts have a definite lifespan or a fixed expiration date. 5. The derivatives market is the only market where an investor can go long and short on
the same asset at the same time. 6. Derivatives carry risks that stocks do not. A stock loses its value in extreme circumstances, whole an option loses its entire
value if it is not exercised.

Types of derivatives :
Types of derivatives Forwards A forward contract is a contract between two parties obligating each to exchange a particular good or instruments at a set price on a
future date. It is an over the counter agreement. A forward contract is an agreement to replace a risk with a certainty. The buyer in the contract is said to hold a
long position, and the seller is said to hold a short position. The specified price in the contract is called the delivery price and the specified time is called maturity.

Risks in a forward contract :


Risks in a forward contract Liquidity risk: these contracts a biparty and not traded on the exchange. Default risk/credit risk/counter party risk. Ex: Say Jay owned
one share of Infosys and the price went up to 4750/- three months hence, he profits by defaulting the contract and selling the stock at the market.

Futures :
Futures Future same as a forward contract, an agreement to buy or sell at a specified future time a certain amount of an underlying asset at a specified price.
Futures have evolved from standardization of forward contracts. Future contracts are organized/standardized contracts in terms of quantity, quality, delivery time
and place for settlement on any date in future. These contracts are traded on exchanges.

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These markets are very liquid In these markets, clearing corporation/house becomes the counter-party to all the trades or provides the unconditional guarantee for
the settlement of trades i.e. assumes the financial integrity of the whole system. In other words, we may say that the credit risk of the transactions is eliminated by
the exchange through the clearing corporation/house.

Positions in a futures contract :


Positions in a futures contract Long - this is when a person buys a futures contract, and agrees to receive delivery at a future date Short - this is when a person
sells a futures contract, and agrees to make delivery.

Futures differ from forward contracts in the following respects: :


Futures differ from forward contracts in the following respects: a. Futures are generally traded on an exchange. b. A future contract contains standardized articles.
c. The delivery price on a future contract is generally determined on an exchange, and depends on the market demands.

How does one make money in a futures contract? :


How does one make money in a futures contract? The long makes money when the underlying assets price rises above the futures price. The short makes money
when the underlying assets price falls below the futures price. Concept of initial margin Degree of Leverage = 1/margin rate.

Options :
Options Options- an agreement that the holder can buy from, or sell to, the seller of the option at a specified future time a certain amount of an underlying asset at
a specified price. But the holder is under no obligation to exercise the contract. The holder of an option has the right, but not the obligation, to carry out the
agreement according to the terms specified in the agreement.

Features of options :
Features of options An option is a security, just like a stock or bond, and is a binding contract with strictly defined terms and properties. Option Premium: Premium
is the price paid by the buyer to the seller to acquire the right to buy or sell. It is the total cost of an option. It is the difference between the higher price paid for a
security and the security's face amount at issue. The premium of an option is basically the sum of the option's intrinsic and time value.

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Call option: An option contract giving the owner the right to buy a specified amount of an underlying security at a specified price within a specified time.

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Put Option: An option contract giving the owner the right to sell a specified amount of an underlying security at a specified price within a specified time

Swaps :
Swaps An agreement between two parties to exchange one set of cash flows for another. In essence it is a portfolio of forward contracts. While a forward contract
involves one exchange at a specific future date, a swap contract entitles multiple exchanges over a period of time. The most popular are interest rate swaps and
currency swaps.

Features :
Features Swaps are generally customized arrangements between counterparties to exchange one set of financial obligations for another as per the terms of
agreement. The major types of swaps are currency swaps, and interest rate swaps, bond swaps, coupon swaps, debt equity swaps. The only Rupee exchanged
between the parties are the net interest payment, not the notional principle amount. The value of the swap will fluctuate with market interest rates. If interest rates
decline fixed rate payer is at a loss, If interest rates rise variable rate payer is at a loss. Conversely if rates rise fixed rate payer profits and floating rate payer
looses.

Swaptions :
Swaptions Swaptions are options on swaps. It is an option that entitles the holder the right to enter into having calls and puts, Swaptions have receiver Swaptions
(an option to receive fixed and pay floating) and a payer Swaptions (an option to pay fixed and receive floating).

What do derivatives do? :


What do derivatives do? Derivatives attempt either to minimize the loss arising from adverse price movements of the underlying asset Or maximize the profits
arising out of favorable price fluctuation. Since derivatives derive their value from the underlying asset they are called as derivatives.

How are derivatives used? :


How are derivatives used? Derivatives are basically risk shifting instruments. Hedging is the most important aspect of derivatives and also their basic economic
purpose Derivatives can be compared to an insurance policy. As one pays premium in advance to an insurance company in protection against a specific event, the
derivative products have a payoff contingent upon the occurrence of some event for which he pays premium in advance.

What is a Hedge? :
What is a Hedge? To Be cautious or to protect against loss. In financial parlance, hedging is the act of reducing uncertainty about future price movements in a
commodity, financial security or foreign currency . Thus a hedge is a way of insuring an investment against risk.