DERIVATIVES

DEFINATION:
The term "Derivative" indicates that it has no independent value, i.e. its value is entirely "derived" from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, live stock or anything else.

MAIN OBJECTIVE
The following three broad categories of participants in the derivatives market: HEDGERS: Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk. SPECULATORS: Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture. ARBITRAGEURS: Arbitrageurs are in business to take of a discrepancy between prices in two different markets, if, for example, they see the futures price of an assets getting out of line with the cash price, they will take offsetting position in the two markets to lock in a profit.

TYPES OF DERIVATIVES :

DERIVATIVES

OPTIONS

FUTURES

OPTION INDEX

OPTION STOCKS

INDEX FUTURE

STOCK FUTURE

PUT OPTION

CALL OPTION

PUT OPTION

CALL OPTION

FORWARDS: A forwards contract is a customized contract between two parties, where settlement takes place on a specific date in the future todays pre-agreed price. FUTURES: A futures contract is an agreement between two parties to buy or sell an asset at a certain time at a certain price. OPTIONS: Options are of two types-calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a give future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

DIFFERENCE BETWEEN FUTURES & OPTIONS

FUTURES Futures contract is an agreement to buy or sell specified quantity of the underlying assets at a price agreed upon by the buyer and seller, on or before a specified time. Both the buyer and seller are obliged to buy/sell the underlying asset. OPTIONS In options the buyer enjoys the right and not the obligation, to buy or sell the underlying asset.

Unlimited upside & downside for both buyer and seller.

Limited downside (to the extent of premium paid) for buyer and unlimited upside. For seller (writer) of the option, profits are limited whereas losses can be unlimited. Prices of options are however, affected by a)prices of the underlying asset, b)time remaining for expiry of the contract and c)volatility of the underlying asset.

Futures contracts prices are affected mainly by the prices of the underlying asset

Risk Reward

The eligibility criteria for stocks on which derivatives trading may be permitted A stock on which stock option and single stock future contracts are proposed to be introduced is required to fulfill the following broad eligibility criteria:The stock shall be chosen from amongst the top 500 stock in terms of average daily market capitalization and average daily traded value in the previous six month on a rolling basis. The stock's median quarter-sigma order size over the last six months shall be not less than Rs.1 Lakh. A stock's quarter-sigma order size is the mean order size (in value terms) required to cause a change in the stock price equal to one-quarter of a standard deviation. The market wide position limit in the stock shall not be less than Rs.50 crores. A stock can be included for derivatives trading as soon as it becomes eligible. However, if the stock does not fulfill the eligibility criteria for 3 consecutive months after being admitted to derivatives trading, then derivative contracts on such a stock would be discontinued

LIMITATIONS:
Lack of centralization of trading Illiquidity, and Counter-party risk

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