DERIVATIVES

A derivative is an instrument whose value is derived from the value of one or more underlying, which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc. Four most common examples of derivative instruments are Forwards, Futures, Options and Swaps
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Derivatives involve payment/receipt of income generated by the underlying asset on a notional principal. Derivatives are a special type of off-balance sheet instrument in which no principal is ever paid. Transactions are carried out on a notional principal, transferring only the income generated by the underlying asset.

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Characteristics of derivatives Their origin is from some other security, commodity or a reference point (such as indexes) They help in hedging against risk of undue volatility. They are leveraged instruments for risk management based on original security or instrument.

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Derivatives are of two types exchange traded and over the counter
Exchange traded- It is trading done throughout the world through exchanges. It's more like the stock market. The most common are future and option derivatives. Over the counter- These are derivatives that are not traded through any exchange process. Some of the popular OTC instruments are forwards, swaps etc. (popularly known as OTC)

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What Does Over-The-Counter - OTC Mean?

A security traded in some context other than on a formal exchange such as the NYSE, BSE, NSE, etc. The phrase "over-the-counter" can be used to refer to stocks that trade via a dealer network as opposed to on a centralized exchange. It also refers to debt securities and other financial instruments such as derivatives, which are traded through a dealer network.

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Forwards A forward contract refers to an agreement between 2 parties to exchange an agreed quantity of an asset for cash at a certain date in future at a predetermined price specified in that agreement. The asset may be currency, commodity or instrument. The long position and short position take the form of buy and sell respectively in a forward contrast.
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Features of FORWARDS Over the counter trading (OTC) they are privately arranged agreements, not standardized ones and are traded OTC and not in exchange. No down payment. Settlement at maturity. Linearity: there are symmetrical gains or losses due to price fluctuations of the underlying asset. The loss of the forward buyer is the gain of the forward seller and viceversa. No secondary market. It is a private contract which is customized and cannot be traded on an organized stock exchange. Necessity of a third party (intermediary) to enable the parties to enter into a forward rate contract. Delivery is essential on maturity of the contract
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Futures
Futures contract is a standardized forward contract. It is legally enforceable and is always traded on an organized exchange. Definition: A futures contract is one where there is an agreement between two parties to exchange any asset or currency or commodity for cash at a certain future date, at an agreed price. It takes place only in organized futures markets and according to well established standards.
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Features of FUTURES
Highly standardized. Down payment- Down payment need not be paid at the time of the agreement but the contracting parties deposit a percentage of the contract price with the exchange. This is initial margin and it gives a guarantee that the contract will be honoured. Hedging of price risks Linearity: The parties to the contract get symmetrical losses or gains due to price fluctuations of the underlying asset in either direction. Secondary market is available Delivery of asset not essential on the maturity date of the contract. The difference between future and spot prices may be exchanged instead.
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Features of FUTURES Cond.

Settlements
Though future contracts can be held till maturity they are not so in actual practice. Futures are marked to the market and the exchange records profit and loss (Difference between futures price and the spot price on that day) on them on daily basis for both parties. Generally these profits or losses are accumulated in the margin accounts of the parties. But, if there are continuous losses and if the initial margin falls below a minimum level called maintenance margin, then the exchange authorities will interfere and the contract automatically lapses.

The default risk due to such a lapse is limited to the profit or loss booked during that day and it is borne by the exchange since it guarantees performance by both the parties.

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Forwards Vs Futures Contract

Nature of the Contract: A forward contract is not standardized. It is tailor made contract in terms of quantity, price, period, date, delivery conditions, etc. according to the convenience of the parties. A futures contract is standardized. Existence of Secondary Market: A forward contract is customized and is not standardized so it cannot be traded on an organized exchange. Thus it does not have a secondary market. A futures contract is traded on organized exchange and therefore has a secondary market. Settlement: A forward contract is settled only on the maturity date. A futures contract is settled daily, irrespective of the maturity date.
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Forwards Vs Futures Contract cond.

Modus operandi: Forward contract is entered into with the help of some financial intermediary like a bank while a futures contract is entered into through an organized exchange and a third party is not required. Down payment: In forward contract no down payment is made at the time of agreement while in a futures contract margin money is deposited with the exchange by the contracting parties. Delivery of the Asset: In forward contract delivery of the asset is essential on the date of maturity whereas a futures contract does not end with the delivery of the asset.
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OPTIONS
An option is a special contract under which the option owner enjoys the right to buy/sell an underlying asset (stock, bond, currency, commodity, etc) at a predetermined price on or before a specified date in future without the obligation to do so. The option holder is the buyer of the option and option writer is the seller of the option. The act of buying or selling the underlying asset as per the option contract is called exercising the option. The fixed price at which the option holder/writer can buy/sell the underlying asset is called the exercise price or striking price.
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