What is a Derivative?
Definition: A derivative is a financial contract that derives its value from an underlying asset, such as stocks, bonds, commodities, or currencies.
Parties Involved:
Buyer (Long): Agrees to buy the asset.
Seller or Writer (Short): Agrees to sell the asset.
Example of a Derivative
A farmer enters into a contract with a wholesaler to sell corn in the future at a price agreed upon today. This contract (a forward contract) hedges the farmer's risk against falling corn prices. The value of the contract depends on the future price of corn.
Types of Derivatives Contracts
- Forward Contracts
Definition: Private agreements to buy or sell an asset at a specific price and date in the future.
Features:
Customizable.
Traded in unregulated markets (high credit risk).
Example: A company agrees to buy oil at ₹5,000 per barrel six months later, regardless of the market price then.
- Futures Contracts
Definition: Similar to forward contracts but traded on exchanges.
Features:
Standardized terms and conditions.
Low credit risk and high liquidity.
Example: A trader buys a gold futures contract on an exchange to purchase gold at a fixed price in the future.
- Swaps
Definition: Contracts where two parties exchange cash flows or financial obligations.
Example: In an interest rate swap, one party pays a fixed interest rate, while the other pays a floating rate.
- Options Contracts
Definition: Grants the buyer the right (but not the obligation) to buy or sell an asset at a predetermined price in exchange for a premium.
Types:
Call Option: The right to buy an asset, used when prices are expected to rise.
Example: A trader pays ₹500 for a call option to buy stock at ₹1,000. If the price rises to ₹1,200, they profit by buying at the lower agreed price.
Put Option: The right to sell an asset, used when prices are expected to fall.
Example: A trader pays ₹500 for a put option to sell stock at ₹1,000. If the price falls to ₹800, they profit by selling at the higher agreed price.
