INTRODUCTION TO DERIVATIVES MARKET

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Derivatives Market

Derivatives Market is a financial instrument or contract that derives its value from the underlying asset.

In a simple term, predict the future value of our asset holdings.

It may be a wide range of assets such as gold, agricultural commodities and financial assets including shares, bonds, and foreign exchange.

 

TYPES OF DERIVATIVES:

·       Forwards

·       Futures

·       Options

·       Swaps

These are the most traded derivatives products in the financial market.

There are some other complicated products too available in the derivative market.

Initially, let us try to understand the basic concept of these derivatives one by one.

 

FORWARDS:

It is a predetermined agreement between two merchants to buy or sell an underlying asset at a mentioned future date for a particular price that is previously decided on the date of the contract.

Both parties agreed and obligated to honor the commitment, irrespective of the price of the underlying asset at the time of delivery.

Forward contracts are negotiated between two parties, the terms and conditions are customized. These are known as Over the Counter (OTC) contracts.  

 

Let us understand, what is an over the counter market. It is a decentralized market where the market participants trade stocks, commodities and other financial instruments.

They are directly traded between two parties and without a central exchange or broker.

It is just like a vegetable market. OTC Markets do not have physical location, instead of trading is conducted electronically.

 

FUTURES:

Futures contracts are exchange-traded forward contracts.

It is similar to the forward contracts except the deal is made through an organized and regulated exchange rather than individual parties.

Let us understand the difference between futures and forwards contracts.


Forwards and Futures - Differentiation

 


OPTIONS:


There is one proverb in the trading world, Futures have no futures and options have many options.

For beginners, it is difficult to understand the terminology. Hereby we try to simplify the concepts as much as possible.

Before we dive into the complexities of option, it is important to understand what the options market actually is and how it works.

 

WHAT IS AN OPTION?

Before witting a definition, let us understand the simple example.

How do we reserve the bus seats in a crowd?  Most of us throw the handkerchief to reserve our comfortable seat.

Once we reserve the seat, we go to a nearby shop for purchase. Suddenly another bus comes early, what will we do?

Here we have two choices. One we go for the first one because we have the complete right to sit on that particular seat. Second, we may choose the next bus with the loss of a handkerchief.

Just understand the term rights and obligation. Let us go to the definition of the option.

 

An option is a contract that gives the right, but not an obligation to buy or sell the underlying on or before the stated date and at a stated price. While buyers of the option pays the premium and buys the right, writer or  seller of the option receives the premium with the obligation to sell or buy the underlying asset, if the buyer exercises his right.

 

Let us take another real-life example of how an option contracts work.

We are looking for a house at the rate of Rs. 25, 00,000 but we don’t have that much amount to buy.

The house finally comes up with a deal to the seller, and that gives us an option to purchase. The house is at a six-month predetermined rate.

The seller agrees, but for this option, we pay a price of Rs. 25, 00,000 consider the following cases that might arise

1. The government announces to launch a new airport near the land. Regards to the announcement, the market value of the house skyrocketed to two crores. Since the seller sells us the house for the twenty-five lakh that we agreed upon. In this case, we would make a huge profit of one Rs. 1, 99, 75,000

           2. When we purchase a home and felt this house not well designed, this makes us into the worst mindset. The good thing is that we didn’t buy the house, we bought an option.

 

KEY TAKEAWAYS:

·       We have all rights to purchase the option but not an obligation.

·       The great thing about option is we can exercise the rights of the option at any time before expiration date.

·       Options are derivatives, they derive their value from an asset. In our case the underlying asset is house.

 

SWAPS:

A swap is an agreement between two parties to exchange the cash flows in the future according to a predefined formula.

It is a series of forwarding contracts and reduces the risk associated with interest rates, currency exchange rates, and commodity prices.

 

CONCLUSION:

We all know about the cash market but don’t have any idea about future and the options market.

Here we have given the basic concept of the derivative market.

First try to understand the terminology, types of products available in the derivative market.

After which slowly step into the complexity of options trading. 

 

 

 

 


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