Derivatives

Derivatives
Instruments whose value is derived from one
or more underlying financial asset
Underlying asset: financial security,
securities index, indexes and commodities
They have no intrinsic value
The underlying basis can be
Commodities including grain, coffee beans,
orange juice etc.
Precious metals like gold, silver
Foreign exchange rate
Bonds
Short term debt securities
Loans and deposits
Derivative instruments
1. Forwards:
A customized contract between two entities,
where settlement takes place on a date in the
future at todays pre-agreed price

1. Features of Forward contracts
1. Bilateral contracts
2. Customized contract
3. Long and short position
4. Delivery price
5. Synthetic assets
6. Settlement by delivery on expiration date
7. Popular contracts
Advantages of forward contracts
Flexibility of price, quantity and date
The trader knows the results
Payment is not required until the contract is
settled
Disadvantages of Forward
contracts
The user may not be able to negotiate good
terms
Users have to bear the spread
Deals can only be reversed by going back to the
original party and offsetting the original trade
The creditworthiness of the other party may be a
problem
2. Futures
A futures contract is a standardized contract
between two parties to buy or sell a stipulated
quantity (and quality) of a commodity, currency,
security, index or some other specified item at a
certain time in future at a certain price
Futures contracts
Standardized in terms of
Quantity
Quality
Date and month of delivery
The units of price quotation
The minimum price by which the price would change

Trading in futures
1. Long position
2. Short position
No risk of default
Illustration
If a futures contract maturing on December 23
rd

2013 and involving 500 shares of company X at
Rs. 375 is bought by investor A and sold by
another investor B, then each of these investors
has their rights and obligations to the clearing
corporations.
Marking to the market
The parties in the contract are required to keep
margins

Advantages of futures
Discovery of prices
Reduction of risk
High leverage
Profit in both bull and bear market
Lower transaction cost
High liquidity
Disadvantages of futures
Customers risk may not be fully covered
May not be available in the required currency
Procedure for conversion may be complex
During volatile trading conditions the potential
loss can be high
Difference between forward and
futures
Standardization
Liquidity
Conclusion of contract
Margins
Profit or loss settlement