Overview of derivatives

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A derivative is an instrument that derives its value from the value of an underlying asset.

Derivatives are traded in two types: - Exchange-traded and Over the counter

Exchange-traded derivatives have the predetermined specifications, including the tenure/term of the instrument, the size of the contract, and prices are available to the public.

Over the Counter are created to meet the unique and non-standard requirements of two parts

The derivatives are also can be categorized based on the markets, where they trade, based on the underlying asset and based on the product features, etc.

Forward contract: - Forward contract is an agreement between the buyer and the seller, in which the buyer has the right and obligation to buy a specified asset on a specified date, and at the specified rate (OTC) Seller is under obligation to perform the contract.

Future contract: - These contracts will be representing the obligation on the part of the buyer and seller, but the terms and conditions of the contract is specified by the exchange when traded.

Options contract: - Options contract is in nature, where the buyer will have a right but not an obligation and on expiry, will decide whether to exercise the right to buy or sell.



Forward buyer and seller have an obligation

Initial Margin: - Future contracts are the standardized legal agreement to buy/sell something at a pre-determined price at a specific time in the future between parties not known to each other.

A margin account allows an investor to purchase stocks with a percentage of price covered by a brokerage firm

The initial margin represents the percentage of the purchase price that must be covered by the investor’s own money.

The maintenance margin represents the amount of equity, the investors must maintain in the margin account after the purchase has been made.

Margin call / Call Margin: - Margin call occurs when the value of investors falls below the broker's required amount. A margin call usually means that one or more of the securities held in the margin account has decreased in a value below a certain point. The Investor must either deposit more money in the account/sell some of the assets held in the account.

The maintenance margin is the minimum amount of equity, that must be maintained in a margin account.  The NYSE and FINRA require investors to keep at least 25% of the total value of the securities in the margin account.

Derivative markets have three participants mainly as follows:-

The participants can be broadly classified into three categories depending on their motives in the markets as follows: -

Hedger: - Hedgers are those who enter into a derivative contract to cover the risk.

A forward contract would eliminate price risk for both parties.

A forward contract is entered with the objectives of hedging against the price risk that is faced by the parties to the contract.

Such participants in the derivatives market are called Hedgers.

Hedgers would like to conclude the contract with the delivery of the underlying asset.

Speculators: - Speculators are those who enter into a derivative contract to make a profit by assuming risk.

Speculators have an Independent view of the future price of the underlying asset and take an appropriate position in the derivative to make a profit later.

Speculators' intention here is not to take the delivery of the underlying asset but instead gain the difference in the prices.

Speculators have a different view on the price of the asset than the one reflected in the price of the derivative.

Speculators perform an extremely important function, to render liquidity of the market.

Speculators are one who assumes the risk and serves the needs of the hedger who wish to avoid risk, because of speculators, hedgers find the counterparty conveniently.

Arbitrageurs: - Arbitrageurs are the third category of participants in the derivatives market. An arbitrageur performs the function of making prices in different market coverage and is in tandem with each other.

Arbitrageurs perform the economic functions of making efficient by taking a riskless position in different markets.

Hedgers and speculators wan to eliminate and assume risk respectively. The arbitrageurs take riskless positions and yet earn profits

The most common example pf arbitrageur is the price difference that may be prevailing in different stock markets.

An arbitrageur takes a riskless position and make a profit because markets are imperfect.

The difference between arbitrageurs and speculators are the amount of risk they assume.

While speculation has own opinion about the future price of the underlying asset by making investment, the arbitrageurs concentrates on the mispricing in different markets by taking riskless positions with no investments.

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