What is Derivatives?
As the name suggests, derivatives are products whose value is derived from some other product. For example, the price of curd depends on the price of milk, because curd is a product derived from milk. In this example, the curd is the derivative and milk is the underlying.
Definition: 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 a contractual manner. The underlying asset can be equity, forex, commodity or any other asset.
Underlying Asset: In the financial markets, the underlying asset can be a stock, an index, foreign currency or any commodity like wheat, rice, gold and so on.
Derivative: In the financial markets, the derivative is a contract between two parties to buy or sell the underlying at an agreed price at a future date.
Why would anyone enter into a contract to buy/sell at a future date?
This practice is prevalent since centuries ago. So as a matter of fact, derivatives are not an invention of the modern economy but a practice passed on by our forefathers. In the past, farmers used to worry if they would find any buyers for their produce. At the same time, the traders used to worry if they would find food grains at an affordable price during the harvest season. So in order to reduce their risk, the farmers and the traders used to enter into a verbal contract before the harvest season. The trader would agree to buy the entire harvest at a future date at a pre-agreed price. Such a contract is called a forward contract. There were no standard terms and conditions of such contracts. The terms were mutually decided.
Need for a standardized market:
Now imagine a situation, if the trader wanted to back-out of the contract. He would have to find some other trader who would agree to honor the terms and conditions of his contract and transfer the contract to him. Since, the terms are mutually decided, it would be difficult for the farmer or the trader to find someone else to whom they could transfer the contract.
Would’nt it be wonderful, if the terms and conditions in such forward contracts were standardized and such contracts be traded in a market! This is where the exchange comes in. The exchange allows trading of contracts which have standardized terms and conditions, so that no two contracts are different. Such standardized forward contracts are called futures.
The exchange along with other financial institutions acts as the intermediaries between the two parties entering into the contract. The exchange has many safeguards which reduce the risk of one of the parties not honoring the contract.
Indian scenario:
The Indian Stock exchanges allow for trading in two broad types of contracts viz., the futures and the options. The underlying assets allowed are selected stocks and selected indices.
So we have the following types of contracts which can be traded on the Indian stock exchange:
1. Stock Futures
2. Index Futures
3. Stock Options
4. Index Options
What are the standardized terms of a derivative contract?
Few of the important terms which a derivative contract must have is:
Expiry Date: The exchange prescribes an expiry date for each contract. Expiry date is the future date on which the actual buy/sell transaction takes place between the two parties. In the Indian market, all contracts have a life-span of 3 months and expire on the last Thursday of the 3rd month.
For example, a contract introduced in January will expire on the last Thursday of March and a contract introduced in February will expire on the last Thursday of April and so on.
A March contract is a contract which expires in March but which was introduced for trading 3 months back in January. As a result, there will always be 3 different month contract trading on the stock exchange at any point of time.
Lot size: Lot size is the minimum quantity of shares in case of stock derivatives and units in case of index derivatives which must be bought/sold in 1 contract.
You can find a complete list of stocks along with their lot sizes which are currently allowed to be traded in the derivatives segment on the National Stock Exchange at http://www.conceptconsultants.info/derivatives/derivativelist.asp
Summary:
Derivatives are basically hedging products, which mean they are used to reduce the risk from future price fluctuations. It is a contract between two parties who agree to buy/sell an underlying asset at a pre-agreed price at a fixed future date called expiry date. Such a contract, which has standard terms and conditions specified by the stock exchange, is called a futures contract. This contract can be actively traded on the stock exchanges.
Futures and Options Tips
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