The term “Derivative” as the name indicate is a financial instrument that has no independent value, i.e. its value is entirely “derived” from the value of other financial instruments called as “underlying asset”. This underlying asset can be gold, currency, stock or any commodity. In short, derivative is not an asset in itself but an agreement or a contract to transfer the real asset in future whenever exercised. The date and price of execution is mentioned in the contract as per agreement between the parties.
In the stock market, contracts in which someone agrees to buy or sell shares of a particular stock in the future are known as derivatives. The price and quantity of shares are defined in the contracts. Derivatives have the potential for great reward, but also carry great risk.
Let us try and understand a Derivatives contract with an example:
Rohit buys a futures contract in the scrip “Technix Media Group”. He will make a profit of Rs.5000 if the price of ‘Technix Media’ rises by Rs 5000. If the price remains unchanged Rohit will receive nothing. If the stock price of Technix Media falls by Rs 7000 he will lose Rs 7000. As we can see, the above contract depends upon the price of the Technix Media scrip, which is the underlying security. Similarly, futures trading can be done on the indices also. Nifty futures is a very commonly traded derivatives contract in the stock markets. The underlying security in the case of a Nifty Futures contract would be the Index-Nifty.
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Types Of Derivatives
There are varieties of derivatives available at present which includes:
Options : An options contract is an agreement giving the right, but not the obligation, to buy or sell a security or commodity at a particular price at a particular future time, or in a period of future time. The contract is not binding, and the person is not obligated to execute the trade. If, for example, someone buys an option to buy stock at $100 a share at a future date, and the price later rises to $150, the investor would use the option and make a large profit.
Futures : A futures contract is an agreement giving an obligation to sell a fixed amount of an asset at a particular price on a particular future date. These are standardized deals for fixed quantities that are carried out with the help of brokers between investors who don’t know each other. For Example Rohit wants to buy a Laptop, which costs Rs 40,000 but owing to cash shortage at the moment, he decides to buy it at a later period say 2 months from today. However,he feels that after 2 months the prices of Laptop may increase due to increase in input/Manufacturing costs. To be on the safer side, Rohit enters into a contract with the Laptop Manufacturer stating that 2 months from now he will buy the Laptop for Rs 40,000. In other words he is being cautious and agrees to buy the Laptop at today’s price 2 months from now. The forward contract thus entered into will be settled at maturity. The manufacturer will deliver the asset to Rohit at the end of two months and Ravi in turn will pay cash delivery.
Swap : A swap is a derivative in which two counterparties agree to exchange one stream of asset against another stream. At present many companies arrange currency swaps and interest rate swaps with other companies or financial institutions. For example, a French company that can borrow francs at a preferential rate, but which also needs yen, can arrange a swap with a Japanese company in the opposite situation. Such currency swaps are designed to achieve interest rate savings, but they are also open to risk, because whether a company saves or loses money will depend on the movement of interest.