 Derivative:

Financial derivatives are used for two main purposes to speculate and
to hedge investments. A derivative is a security with a price that is
dependent upon or derived from one or more underlying assets. The
derivative itself is a contract between two or more parties based upon
the asset or assets. Its value is determined by fluctuations in the
underlying asset. The most common underlying assets include stocks,
bonds, commodities, currencies, Interest rates and market indexes.
Derivatives can be traded privately (over-the-counter, OTC) or on an
exchange. OTC derivatives constitute the greater proportion of
derivatives in existence and are unregulated, whereas derivatives
traded on exchanges are standardized. OTC derivatives generally have
greater risk for the counterparty than do standardized derivatives.
It is financial security or contract between two parties whose value is
derive from an underline asset or a group of assets.
This underline asset can be stocks, bonds, index, commodities,
currencies and interest rates. Derivatives are defined in 1956 securities
contracts. Amended 1999.
Derivatives are traded OTC (Over the counter) as well as on exchanges
also. Derivative traded OTC can be customized. But derivative traded
on exchange are standardize.
Derivative do not have any physical existence but it makes contract
between two parties. For example, a derivative / security is issued
whose value is define based on price of rise in the market as price of
rise increases or decreases the value of the derivative also those up and
down.

 Some history of derivatives:

• 1875 Bombay Cotton trading company or association.
• 1952 Government Bank Money settlement trading or option trading.
• 1993 Sebi bank forgot trading or bodla system. (It allowed traders to
carry forward their position to next settlement cycle).
• 2000 Sebi approved derivative trading (may) it was started on, June
‘2000.
1
Page
  Types of derivatives:
Four types of derivatives are-
i) Forwards or (Traded OTC), ii) Futures, iii) Options, iv) swap.

1) Forwards: It is an agreement between parties to buy or sell an

underline asset on a specified date for a specified Price.
The party agrees to buy the Underline Asset on a certain Specified
Future date for a certain specified price, is set to have taken along
position.
Another party who agrees to sell the asset for same day for the same
price is set to have short position.
Forward contracts are customized contracts so, details like delivery
date price and quantity are negotiated by laterally by the parties to the
contract.
These contracts are traded over the counter and not on an exchange.
So, no initial margin or premium is payable.
Forward contracts are much popular in agree culture sector and FOREX
(Foreign Exchange Market).

2) Futures: They are similar to forward contracts. The future contracts

Is An agreement between two parties to buy or sell an asset at a certain
time in the future at a certain price.
But unlive forward contracts future contracts are standardized and
traded on an exchange. These contracts are standardized.
In term of, 1) standard underline asset, 2) Standard quality and quantity
on the underline asset that can be deliver, 3) Standard timing of such
settlement, 4) Standard tick (Minimum change in price)
The exchange specifies certain standard features of the future to
enable liquidity in the contracts. A future contract may be offset prior
to maturity by entering into an equal and opposite transaction.
In future contracts the losses as well as the profits for the buyers and
sellers are limited.
2
Page
  Terminologies in future contracts:
Long a party set to be long on an instrument when he or she purchase
that particular instrument.
1) Short: Opposite long a party set to be short when he or she sells a
contract which he or she doesn’t currently win. Short Position Indicates
and oversold position.
2) Spot price: The price at which an asset trades in the market are called
spot price. It is also known as cash price or current price.
3) Future Price: The price at which future contracted in the future
market.
4) Expiry date: The last day on which the contract will be traded, at the
end of which it we cease an exit.
5) Margin: The amount of money deposited by both buyers and sellers
of future contracts to ensure performance of terms of the contracts is
called margin money.
6) Basis: It is the difference between spot price and future price
of future of an asset.
7) Spread: A spread is the difference between two future prices to the
future involved may be intra commodity or inter commodity. Intra
commodity futures happen when the same underline good with
different expiration date has different future price.

 Pricing of future contract depend on the following variables:

1) Prices of underline asset in the market.
2) Rates of return expected from investment in the asset.
3) Risk free rate of interest.
3
Page