Saturday, February 7, 2015

Derivatives Market

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To understand the concept of Derivatives, first try to understand the following example -
Suppose you want to invest in shares, or bonds, or some other instruments. But you don't know what will happen to your investment, meaning, your (bought) share may give you profit, or give you loss (you often hear news, that someone has lost all his money in shares), because it all depends on the company how it works in the market (same thing applies for other investments too).

Certainly there is always a risk factor that works in your investment in these type of instruments. So, to reduce the risk, there is a concept of Derivatives.

Derivatives
A derivative is a contract / agreement between two or more parties, whose value depends on or associated with one or more underlying assets (e.g., shares, bonds, commodities, currencies, etc.)

Derivatives are one of the three main categories of financial instruments -
  1. Stocks (i.e,. equities or shares) (already discussed in previous post)
  2. Debt (i.e., bonds, mortgages) (already discussed in previous post)
  3. Derivatives (our topic of discussion)

Let's start with an example -
Suppose you want to buy an asset with Rs. 500 (example figure just to understand the concept). But you are worried what will be the market price of the asset after some months, and their is a high probability (your speculation) that the market price can become less than Rs. 400. So in that case you will make a loss of around Rs. 100.

Therefore, you decide to make an agreement with an investor, stating that you want to sell him the asset in Rs. 550 after 6 months (future agreement). The investor agrees with the agreement, because he thinks, he can sell the asset at a higher profit (may be Rs. 600, investor's speculation), if the market price is high.

Now analyze. If the market price of the asset after 6 months, becomes Rs. 650, then the investor will get a profit of Rs. (650 - 550) = Rs. 100. But you will get the fixed profit of Rs. (550 - 500) = Rs. 50, irrespective of the market price.
But if the market price of the asset becomes Rs. 420, then the investor will make a loss of Rs. (550 - 420) = Rs. 130, whereas you won't make any loss, but a fixed profit of Rs. (550 - 500) = Rs. 50.

Note that you won't make any loss, if you make the Derivatives agreement, however your profit will be fixed (may be less, if you don't make the agreement). You reduce the risk of any loss, in this type of derivatives agreement, and this process of reducing risk is known as Hedging.
Also note that, the value of the Derivatives is dependent on your asset (known as underlying asset).

Types of Derivatives
  • Forwards
  • Futures
  • Options, etc.

Forward Contracts
Forward contract (or forwards) is a non-standardized contract between two parties to buy or sell an asset at a specified future date, where the price is decided today (on agreement day) 

Points to be noted -
  • Buy/Sell will be done in future date
  • Price is decided today (reduces risk for the seller)
  • These are not standardized (no Future Exchange is involved. Contract is made just between buyer and seller - private agreement)

Future Contracts
Future contract (or futures) is a standardized contract between two parties to buy or sell an asset at a specified future date, where the price is decided today (on agreement day)

Points to be noted -
  • Buy/Sell will be done in future date
  • Price is decided today (reduces risk for the seller)
  • These are standardized (in contrast to Forwards). Contracts are negotiated at Future Exchanges, that acts as an intermediary between buyer and seller. There is also a guarantee from Clearing Houses)
Option Contracts
Option contract (or options) is an agreement/contract between two parties that gives purchaser the right to buy or sell  (option to buy/sell) an asset at a specified future date, where the price is decided today (on agreement day)

Points to be noted -
  • Buy/Sell will be done in future date
  • Price is decided today
  • Options are the right to buy or sell, not an obligation, meaning the purchaser of the option, could buy/sell the asset, but if he doesn't want to, then he has no obligation to buy/sell it. But in case of Forward and Future contracts, there is an obligation to buy/sell the asset (they are legally bound to buy/sell the asset).
There are other types of derivatives, like Warrants, Swaps, etc.



Hope this post will help you understand the concepts.
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Happy learning!

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