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Derivative

Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in acontractual manner.
The underlying asset can be equity, forex, currency, market index commodity or any other asset.

E.g wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the "underlying".

FACTORS DRIVING THE GROWTH OF DERIVATIVES


Increased volatility in asset prices in financial markets Increased integration of national financial markets with the international markets, Marked improvement in communication facilities and sharp decline in their costs, Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and

Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns reduced risk as well as transactions costs as compared to individual financial assets.

Derivatives Product
Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. Forwards: A forward contract is an agreement to buy or sell a specific asset at a certain time in future for a certain price fixed in advance at the time of making the agreement. Forward contract is one of the important tools to hedge against risk from price fluctuatuion. Forward contracts are not standardised and are not exchange traded contracts

They are tailor made contract for 2 parties so there is no liquidity


There is also counter party risk , if the other party defaults then the purpose behind entering in to such contract is defeated.

It can be used by a manufacturer to secure the price for his raw material or a farmer can secure a price for his crop or an exporter can secure himself against loss from exchange rate fluctuation by entering in to forward contract. Futures Contract:- It involves an agreement to buy or sell a particular quantity of a commodity of a particular specification on or before the particular date for a particular pre determined price known as delivery price.

These contracts are standardised and exchange traded and regulated. They involve almost no risk of loss from a counterparty default. They posses an important attribute of liquidity. These contracts can be traded like other commodities. The party who buys a futures is said to have taken a long position and the selling the futures contract is said to have taken a short position.

There is almost no risk from default because the clearing Corporation of the exchange is the counterparty for each contract.

The party with a long position may short the contract and vice versa

The parties to the contract are required to keep margin with the clearing corporation and margins are adjusted on daily basis to account for gains or losses. It is known as marking to the market

Futures contract can be maximum for a period of 1 year.

options
Options give the buyer(holder) a right but not an obligation to buy or sell an asset in future Options are of two types- calls and puts Call 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 given 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. When one buys an option he is said to be having a long position and when one sells he is said to be having a short position. The options can be exercised at the expiry of the contract period(which is known as European option contract) or anytime up to the expiry of the contract period(termed as American option contract) The option contract requires a price to be paid known as premium. The writer of the option receives the premium as compensation of the risk that he takes.

In the Money option:- a call option is in the money if the strike price is less than the current market price of the underlying asset,i.e spot price >strike price Spot price: the price at which an underlying asset trades in the spot market. Strike price: the price specified in the option contract is known as the strike price or the exercise price.

Out of the money option: a call option on the index is out of the money when the current index stands at a level which is less than the strike price(i.e spot price < strike price). A call option or put option is called At the money if the strike price is equal to current market price of the underlying asset.

Swaps
Swaps are private agreement between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. Interest rate swaps: these entail swapping only the interest related cash flows between the parties in the same currency

The derivatives market is the financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets.

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What is derivative market exchange-traded derivatives and over-thecounter derivatives with example if any Industries which operates in derivative market. Scope for derivative education. And any other u feel important need to add. vinod