Concepts of Derivative[/b]
(1) A derivative is an instrument whose value is derived from the value of one or more underlying, which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc. Four most common examples of derivative instruments are Forwards, Futures, Options and Swaps.
(2) Derivative is a financial contract whose value is based on, or "derived" from, a traditional security (such as a stock or bond), an asset (such as a commodity), or a market index. A derivative instrument is a contract between two parties that specifies conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments are to be made between the parties.
(3) In finance, Derivative means, the contracts whose value is derived from another asset, which can include stocks, bonds, currencies, interest rates, commodities, and related indexes. Purchasers of derivatives are essentially wagering on the future performance of that asset. Derivatives include such widely accepted products as futures and options.
(4) A derivative is a financial instrument whose value is dependent upon the change in the value of an underlying asset - such as a commodity, equity or bond – or upon an event such as a change in interest rates, foreign currency exchange (“FX”) rates, inflation rates or the weather. The risk associated with the change in the value of the underlying asset is transferred between the parties to the derivative contract.
What are the different types of Derivatives?
(1) Futures contracts
(2) Forward contracts
(3) Options
(4) Swaps.
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What are the major asset classes of Derivatives? [/b]
(1) Interest rate derivatives
(2) FX derivatives
(3) Commodity derivatives (including agricultural, energy, precious metals and other commodities)
(4) Credit derivatives (including credit default swaps)
(5) Equity derivatives.
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What are the Contracts related to Derivatives?[/b]
(1) Forward Contracts
A forward contract is a customized contract between two parties, where settlement takes place on a specific date in future at a price agreed today. The main features of forward contracts are
-They are bilateral contracts and hence exposed to counter-party risk.
-Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.
-The contract price is generally not available in public domain.
-The contract has to be settled by delivery of the asset on expiration date.
-In case the party wishes to reverse the contract, it has to compulsorily go to the same counter party, which being in a monopoly situation can command the price it wants.
(2) Futures Contracts [/b]
Futures are exchange-traded contracts to sell or buy financial instruments or physical commodities for a future delivery at an agreed price. There is an agreement to buy or sell a specified quantity of financial instrument commodity in a designated future month at a price agreed upon by the buyer and seller.To make trading possible, BSE specifies certain standardized features of the contract.
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Why Derivatives are used by the investors? [/b]
Derivatives are used by investors for the following reasons:
(1) To provide leverage or gearing, such that a small movement in the underlying value can cause a large difference in the value of the derivative;
(2) To speculate and make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level);
(3) To hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out;
(4) To obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives);
(5) To create option ability where the value of the derivative is linked to a specific condition or event (e.g. the underlying reaching a specific price level).
(6) Derivatives can be used for speculation ("bets") or to hedge ("insurance"). For example, a speculator may sell deep in-the-money naked calls on a stock, expecting the stock price to plummet, but exposing itself to potentially unlimited losses. Very commonly, companies buy currency forwards in order to limit losses due to fluctuations in the exchange rate of two currencies
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What are the Common examples of derivatives used in everyday business?[/b]
(1) ?A farmer entering into a wheat forward contract to lock in the price at which he sells his crop at harvest time;
(2) ?A manufacturer entering into an FX forward to lock the cost in US Dollars of machinery that it purchases from a foreign supplier;
(3) ?A computer chip company entering into a gold forward contract to fix the price it will pay for the gold it uses in its microprocessors;
(4) ?A commercial real estate developer entering into an interest rate swap to lock the rate on the floating rate debt it uses to finance the construction of a new building.
Which types of derivatives are most commonly used by end users for risk management?
(1) Interest rate derivatives,
(2) FX forwards and
(3) Commodity forwards.
The interest rate swap and the FX forward are, by far, the two most common products used by non-financial end users.
Where are derivatives traded?
Some derivatives are traded on organized and regulated exchanges (“exchange-traded” derivatives) and some are traded privately off exchange (“over-the-counter” or “OTC” derivatives).
Who are the different participants in the derivatives market?
(1) Dealers: A dealer is a firm that stands ready to take either side of a derivative transaction if so demanded by its customers. It is the dealer’s willingness and ability to buy or sell a derivative on demand that creates the market for the derivative (i.e., market making). Dealers are sometimes referred to collectively as “the sell side”.
If there were no dealers, customers would have to find another party willing to take the other side of their transaction. An example that might prove useful in demonstrating the concept of dealing and market making is that of a grocer. Without the grocer, a consumer would have to go directly to the baker and the butcher to buy bread and meat. The grocer is not in the business of baking or butchering; it buys from the baker and butcher and then sells to consumers for a profit – it makes a market in food products.
(2) End Users: Technically speaking, any non-dealer is an end user, including speculators and hedgers; however, throughout the policy debate over the regulation of OTC derivatives, the term end user has come to mean companies that use derivatives to hedge business risk. End users are sometimes referred to collectively as “the buy side.”
The end-user category can be broken down further into two sub-categories: hedgers and speculators.
(2.1) Hedgers are businesses that use derivatives to mitigate, reduce or eliminate risks associated with their businesses. Hedgers use derivatives to gain predictability, not to profit. Indeed, a firm that is hedging has decided to forego a potential windfall, if the underlying moves in a beneficial direction, for the certainty of fixing the price of the underlying. With a hedge, if the underlying is down, the derivative is up; if the underlying is up, the derivative is down. Virtually all types of companies, across all sizes and industry sectors, use derivatives to hedge risks associated with their businesses.
(2.2) Speculators use derivatives to take on risk in the hopes of making a profit. Examples of firms that frequently use derivatives for speculation include hedge funds, asset managers and proprietary trading firms.
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What are the common Economic functions of the derivative market?[/b]
Some of the salient common economic functions of the derivative market include:
(1) Prices in a structured derivative market not only replicate the discernment of the market participants about the future but also lead the prices of underlying to the professed future level. On the expiration of the derivative contract, the prices of derivatives congregate with the prices of the underlying. Therefore, derivatives are essential tools to determine both current and future prices.
(2) The derivatives market relocates risk from the people who prefer risk aversion to the people who have an appetite for risk.
(3) The intrinsic nature of derivatives market associates them to the underlying Spot market. Due to derivatives there is a considerable increase in trade volumes of the underlying Spot market. The dominant factor behind such an escalation is increased participation by additional players who would not have otherwise participated due to absence of any procedure to transfer risk.
(4) As supervision, reconnaissance of the activities of various participants becomes tremendously difficult in assorted markets; the establishment of an organized form of market becomes all the more imperative. Therefore, in the presence of an organized derivatives market, speculation can be controlled, resulting in a more meticulous environment.
(5) Third parties can use publicly available derivative prices as educated predictions of uncertain future outcomes, for example, the likelihood that a corporation will default on its debts.
In a nutshell, there is a substantial increase in savings and investment in the long run due to augmented activities by derivative Market participant.