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WHAT ARE DERIVATIVES? A derivative is a financial instrument that derives or gets it value from some real good or stock. It is in its most basic form simply a
contract between two parties to exchange value based on the action of a real good or service. Typically, the seller receives money in exchange for an agreement
to purchase or sell some good or service at some specified future date
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4. Derivatives contracts have a definite lifespan or a fixed expiration date. 5. The derivatives market is the only market where an investor can go long and short on
the same asset at the same time. 6. Derivatives carry risks that stocks do not. A stock loses its value in extreme circumstances, whole an option loses its entire
value if it is not exercised.
Types of derivatives :
Types of derivatives Forwards A forward contract is a contract between two parties obligating each to exchange a particular good or instruments at a set price on a
future date. It is an over the counter agreement. A forward contract is an agreement to replace a risk with a certainty. The buyer in the contract is said to hold a
long position, and the seller is said to hold a short position. The specified price in the contract is called the delivery price and the specified time is called maturity.
Futures :
Futures Future same as a forward contract, an agreement to buy or sell at a specified future time a certain amount of an underlying asset at a specified price.
Futures have evolved from standardization of forward contracts. Future contracts are organized/standardized contracts in terms of quantity, quality, delivery time
and place for settlement on any date in future. These contracts are traded on exchanges.
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These markets are very liquid In these markets, clearing corporation/house becomes the counter-party to all the trades or provides the unconditional guarantee for
the settlement of trades i.e. assumes the financial integrity of the whole system. In other words, we may say that the credit risk of the transactions is eliminated by
the exchange through the clearing corporation/house.
Options :
Options Options- an agreement that the holder can buy from, or sell to, the seller of the option at a specified future time a certain amount of an underlying asset at
a specified price. But the holder is under no obligation to exercise the contract. The holder of an option has the right, but not the obligation, to carry out the
agreement according to the terms specified in the agreement.
Features of options :
Features of options An option is a security, just like a stock or bond, and is a binding contract with strictly defined terms and properties. Option Premium: Premium
is the price paid by the buyer to the seller to acquire the right to buy or sell. It is the total cost of an option. It is the difference between the higher price paid for a
security and the security's face amount at issue. The premium of an option is basically the sum of the option's intrinsic and time value.
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Call option: An option contract giving the owner the right to buy a specified amount of an underlying security at a specified price within a specified time.
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Put Option: An option contract giving the owner the right to sell a specified amount of an underlying security at a specified price within a specified time
Swaps :
Swaps An agreement between two parties to exchange one set of cash flows for another. In essence it is a portfolio of forward contracts. While a forward contract
involves one exchange at a specific future date, a swap contract entitles multiple exchanges over a period of time. The most popular are interest rate swaps and
currency swaps.
Features :
Features Swaps are generally customized arrangements between counterparties to exchange one set of financial obligations for another as per the terms of
agreement. The major types of swaps are currency swaps, and interest rate swaps, bond swaps, coupon swaps, debt equity swaps. The only Rupee exchanged
between the parties are the net interest payment, not the notional principle amount. The value of the swap will fluctuate with market interest rates. If interest rates
decline fixed rate payer is at a loss, If interest rates rise variable rate payer is at a loss. Conversely if rates rise fixed rate payer profits and floating rate payer
looses.
Swaptions :
Swaptions Swaptions are options on swaps. It is an option that entitles the holder the right to enter into having calls and puts, Swaptions have receiver Swaptions
(an option to receive fixed and pay floating) and a payer Swaptions (an option to pay fixed and receive floating).
What is a Hedge? :
What is a Hedge? To Be cautious or to protect against loss. In financial parlance, hedging is the act of reducing uncertainty about future price movements in a
commodity, financial security or foreign currency . Thus a hedge is a way of insuring an investment against risk.