DERIVATIVES

A derivative is a instrument whose value is derived from the value of one or more underlying
assets
These underlying assets can be securities commodities, currency ,livestock and so forth.In India
securities contract regulation act 1956 define Derivatives as :

“ 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 typical finacial trasaction is marked by several risks.Derivatives allow us to manage these risks
more efficiently by unbundling these risks and allowing either hedging or taking only one risk at a
time .And therefore Derivatives have become increasingly important in the field of finance
.Derivatives permit the seperation of price risks and redistribution to others who can manage
them .Derivatives traded on organised exchanges provide liquidity and quick adaptability of
exposure to market changes.

Derivatives may be following forms :

FORWARDS :

A forward contract is an agreement between two persons for the purchase and sale of a commodity
or financial asset at a specified price to be delivered at a specified future date .

Advantages of Future Contract :

• It can be used to hedge or protect oneself from the price fluctuations on the future
commitment date to the extent of 100%.
• The upfront fees or margins are not applicable to Forward contracts and hence no initial
costs .

Disadvantages of Future Contract :

• Forward contracts are not performance guarnteed .Hence involve counter party risk .
• The investor can not derive any gain from favourable price movements either before or on
delivery date .
• Forward contracts are not traded in the secondary market, hence there is no ready liquidity
.
• Banks being one of the counter parties enter into reverse transactions to square positions
and charge huge bid ask spread .

Future Contract :

A Future contract is an agreement between a seller and a buyer which requires the seller to deliver
to the buyer a specified quantity of security , commodity or foreign exchange at a fixed time in
future at a price agreed to at the time of entering the contract. Futures contract are traded in
designated futures market unlike Forward contracts that are executed over the counter.The terms of
future contracts are standardized to reduce the transaction cost to the bare minimum .The oldest
Future exchange is Chicago Board of Trade in USA .
 Characteristics of Future :

Organised Exchanges : Future contract are traded in organised exchanges with a designated
physicalblocation for Future trading.This provides instant liquidity as Future contracts can be sold
and bought anytime like in a stock market.

Standardization : The Futures contracts are standardised in the sense that the price , the quantity and
the date of maturity is fixed by the exchange in which they are traded .

Margins : Only members of the respective exchanges can enter into Future contracts .They are
required to deposit margin money with the clearing house .The mount of margin money is generally
between 2.5% to 10 % of the value of contract but can vary .