Basics of Derivatives

Ever wonder what derivatives are? Check out this handy guide! 😉

A derivative is a contract or a product whose value is derived from the value of some other asset known as underlying. A variety of underlying assets serve as the foundation for derivatives.

These include:
→ Financial assets such as Shares, Bonds, and Foreign Exchange.
→ Metals such as Copper, Zinc, Gold, Silver, etc.
→ Energy resources such as Crude oil, Natural Gas, etc.
→ Agricultural products such as Wheat, Cotton, Sugar, Coffee, etc.

Cotton Futures

Gold Futures

Derivative Instruments

Forwards
It is a contractual agreement between two parties to buy/sell an underlying asset at a certain future date for a particular price that is pre-decided on the date of the contract.

Both the contracting parties are committed and are obliged to honor the transaction irrespective of the price of the underlying asset at the time of delivery. The terms and conditions of the contract are customized to cater to the needs of both parties. These are Over-the-counter (OTC) contracts, meaning they are a deal you make directly with a bank or a dealer. As a result, there is always counterparty risk involved.

Futures
Futures are standardized contracts similar to a forward contract, except that the deal is made through an organized and regulated exchange rather than being negotiated directly between two parties. The arrangements come with a fixed maturity date along with uniform terms for all the parties involved.

In simple language, futures are exchange traded forward contracts. The futures contract has little to no counterparty risk since the exchange is acting as a mediatory.

Options
An Option is a contract that gives the right, but not an obligation, to buy or sell the underlying on or before a fixed date and at a stated price. While the buyer of the option pays the premium and buys the right, the writer/seller of the option receives the premium with the obligation to sell/ buy the underlying asset if the buyer exercises his right.

There are two types of options:
→ American
→ European

American options can be exercised at any time prior to their expiration while the European options can only be exercised on the expiration date. In India, European options are used.

Swaps
A swap is an agreement made between two parties to exchange cash flows in the future according to a prearranged formula. A random variable (such as an interest rate, foreign exchange rate, commodity price, etc.) is used to determine at least one of these series of cash flows at the moment the contract is initiated.

Swaps are, broadly speaking, a series of forward contracts. They help the participants manage risk associated with volatile interest rates, currency exchange rates, and commodity prices.

Thanks for reading! Next week we’ll talk about the types of people who use derivatives and why they exist. Stay tuned!
See you all next week. 🙂
– Team TradingView

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