What are Derivatives?

Derivative is a product or contract whose value is derived from the value of some other asset. This some other asset is known as underlying asset.

Underlying assets can be of Financial Assets or Non Financial Assets.

  • Financial Assets : Shares, Bonds and Forex.
  • Non Financial Assets: Gold, Silver, CrudeOil, etc.,

Note: In Financial Markets, Derivatives is a contract, which means an agreement between two parties to buy or sell the underlying asset in the future date.

What is the primary objective of derivative?

  • To manage the risk in the underlying assets for holder/investor.

What is derivatives trading?

Derivatives trading means, buying and selling of agreements/contracts to buy/sell the underlying asset on a future date.

What are the types of derivatives?

  • Over The Counter (OTC) traded :
  • Exchange Traded :

What are the products in derivatives?

  1. Forwards --> An agreement directly entered to buy or sell the underlying asset on or before future date. Traded in OTC Markets
  2. Futures --> An agreement to buy or sell the underlying asset on or before the future date through an organised, regulated exchange. In other words, it is called as Exchange Traded Forwards.
  3. Options --> An agreement which gives the buyer the right to buy or sell the underlying asset at an agreed price on or before the future date.
  4. Swaps --> An agreement to exchange the future cash flows based on two underlying assets.

Who are the participants in derivatives market?

  1. Hedgers --> Those who are using derivatives to manage the risk in underlying assets.
  2. Speculators --> Those who are using derivatives to take risk using leverage with an intention to make profits.
  3. Arbitrageurs --> Those who aims to capitalize the price difference in two different markets by buing and selling simulataneously in these markets.

What are the functions of derivatives market?

  1. Helps in improving the price discovery based on actual valuations & expectations.
  2. Helps in transferring risk.
  3. Enables the shifting of trades from unorganised market to organised market.

What are the risk faced by the participants in derivatives market?

  1. Counterparty Risk (incase of OTC contracts like forwards and swaps)
  2. Liquidity Risk
  3. Price Risk
  4. Operational Risk
  5. Regulatory Risk