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Financial derivatives are contracts that are based on or derived from some underlying assets, reference rate or index. Derivatives are securities where payment dates and amounts may vary according to maturity and/or amount. Derivatives are standard products. It is, in fact, not a very new concept. Derivatives transactions involve transferring risks from entities less willing or able to manage them to those more willing or able to do so. Derivatives helps to improve market efficiency because risks can be isolated and sold to those who are willing to accept them at the less cost. Economic benefits of derivatives are not dependent on the size of the institution trading them. It is an important tool that can help organizations to meet their specific risk-management objectives.
Users of Derivatives
Banks Fund managers Insurance companies Non-financial firms, and Central bank (issues bonds)
In future contract, contract terms are highly specified, uniform with specified commitments at all stock exchange. Trading of futures is subject to price limit to restrict volatility. In Future, contract is an obligation not right; all market partners have to fulfill it.
Location
Legal counterparty
Forward transactions are privately negotiated between two counterparties Most OTC forward transactions are bilateral contracts between two appropriate counterparties. It is difficult to extinguish exposure for an OTC transaction unless the transaction is unwound with the original counterparty, an agent will be left with the settlement obligation. Contracts are right, not obligation.
The vast majority of futures transactions are offset before the settlement date a buyer of a contract simply sells the contract before expiry.
Option
These contracts can be either customized and privately negotiated or standardized. An option is a derivative. That is, its value is derived from something else. In the case of a stock option, its value is based on the underlying stock. In the case of an index option, its value is based on the underlying index. They give purchaser the right to buy (call option) or sell (put option) a specified quantity of a commodity or financial asset at a particular price on or before a certain future date. In option, no purchase or sale of underlying asset is done. Options allow you to participate in price movements without committing the large amount of funds needed to buy stock outright. Options can also be used to hedge a stock position, to acquire or sell stock at a purchase price more favorable than the current market price, or, in the case of writing options, to earn premium income. When market price is going up than the delivery price, buyers start to make profit and vice-versa. It is traded only at organized exchange. In option, buyer has to pay for the instrument (option premium). There are two fundamental kinds of options: American option permits the owner to exercise at any time before or at expiration of contract. This option allows a higher degree of variations and more possibilities to gain profits. European option permits owner to exercise only at date of expiration. Option cannot be bought on credit, buyer of the options (both put or call) has to pay full price at the morning of the next working day.
Swaps
A derivative in which two parties agree to exchange one stream of cash flows against another is called Swaps. Swap contract is individually designed for needs of two parties. In swap, there is significant reduction of transaction cost. Calculation of these payments is based on agreement upon amount, called National Principal Amount. There are various types of swaps in financial market. They are: Interest rates swaps Currency swaps Credit default swaps.