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A derivative is a contract between two parties which derives its value/price from an underlying asset. The most
common types of derivatives are futures, options, forwards and swaps. It is a financial instrument having no
independent value but derives from underlying assets.
Underlying Assets:
Stocks
Commodities
Currency
Interest rate
Index
Weather
Wipro, Infosys
Gold , jeera,
GBP,USD
Labor,Mibor
Nifty
Types of derivatives:
A.
B.
C.
D.
Forwards
Futures,
Options, and
Swaps
A. Forwards
It is a type of derivative contract where the term and condition are agreed at (t=0) today and the performance
and execution takes place on the future date. It is an OTC. This transaction has done privately without the
interaction of Stock & commodities.
B. Futures
It is nothing but a forward contract done through exchange. futures contract (more colloquially, futures) is a
standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality
for a price agreed upon today (the futures price) with delivery and payment occurring at a specified future date.
if you buy (go long) a futures contract and the price goes
up, you profit by the amount of the price increase times
the contract size; if you buy and the price goes down,
you lose an amount equal to the price decrease times the
contract size
Forward
Future
OTC
Exchange driven
Contract is customized
standardized contract
No regulation
C. Option Contract
An option is a contract between two parties giving the buyer the right, but not the obligation, either
to buy or to sell an underlying asset at a set price, on or before a predetermined date
Types of option Contract
1. Call Options
An Option contract that gives the holder the right to buy the underlying security at a specified price
for a certain, fixed period of time.
2. Put Options
An option contract that gives the holder the right to sell the underlying security at a specified price
for a certain fixed period of time.
D. Swaps
Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the
expected direction of underlying prices
Derivatives market participants:
Hedging
Arbitrage
The practice of taking advantage of a price difference between two or more markets
Speculation
Margin money
Margin money is often used in the context of derivatives or commodities market. Margin money is taken
by stock exchanges or regulator from traders in order to ensure that in the event of loss to trader, the stock
exchange does not incur loss. There are different types of margin which are taken by stock exchanges,
lets look at some of them
I.
Initial Margin
Initial margin is taken by the stock exchanges from traders in order to cover the largest potential loss
which can happen in one day. Both buyer and seller have to deposit the initial margins. The initial margin
is deposited before the day opens and also before the traders takes the position in the market. Based on the
volatility of underlying the initial margin can be between 5 to 20 percent.
II.
Mark-to-market margin
All losses of the trader must be met by the trader by depositing further collateral known as mark to
market margin in to the stock exchange, and any profit is credited to the account of trader at the end of
trading day.
III.
Additional margin
In case of sudden higher than expected volatility, additional margin may be called for by the stock
exchange. This is generally imposed by the stock exchanges when the markets have become too volatile
as was the case in year 2008 when Lehman brother collapse happened.
IV.
Maintenance margin
Some exchanges work on the system of maintenance margin, which is set at a level slightly less than
initial margin. The margin is required to be replenished to the level of initial margin, only if the margin
level drops below the maintenance margin limit
V.
Delivery margin
Short Note:
Option interest
Open interest represent the no of outstanding contract that are yet to be expired or yet to be
squared.
American option
In this case option can be exercised on or before the expiry date. Hence it gives more flexibility
binomial option price model helps to find option premium when the type of option is American.
European option
In this case option can be exercised only on the expiry date of the contract if doesnt provide
flexibility for the option buyer in this case the option premium is calculated on the basic of black
scholes model