Derivative in Financial markets

Derivative is a product whose value is derived from the value of one or more basic variables, called underlying.

The underlying asset can be equity, index, foreign exchange (forex), commodity or any other asset.

Derivative products initially emerged as hedging (reducing or controlling risk) devices against fluctuations in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years.

The financial derivatives came into spotlight in post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products.

Types of Derivatives

Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price.

In its simplest form, it is a trade that is agreed to at one point in time but will take place at some later time. For example, two parties might agree today to exchange 500,000 barrels of crude oil for $42.08 a barrel three months from today.

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price.

Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts, such as futures of the Nifty index.

Options: An Option is a contract which gives the right, but not an obligation, to buy or sell the underlying at a stated date and at a stated price.

While a buyer of an option pays the premium and buys the right to exercise his option, the writer of an option is the one who receives the option premium and therefore obliged to sell/buy the asset if the buyer exercises it on him.

Options are of two types - Calls and Puts options:

‘Calls’ give the buyer the right but not the obligations 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 underlying asset at a given price on or before a given future date.

Presently, at NSE futures and options are traded on the Nifty, CNX IT, BANK Nifty and 116 single stocks.

Warrants: Options generally have lives of up to one year. The majority of options traded on exchanges have maximum maturity of nine months.

Longer dated options are called Warrants and are generally traded over-the counter.

Option Premium

At the time of buying an option contract, the buyer has to pay premium. The premium is the price for acquiring the right to buy or sell. It is price paid by the option buyer to the option seller for acquiring the right to buy or sell.

Option premiums are always paid up front.