Financial Derivatives: Definition, Types, Risks

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Derivatives are financial contracts, which derive their value off a spot price time-series, which is called "the underlying". The underlying asset can be equity, index, commodity or any other asset. Some common examples of derivatives are Forwards, Futures, Options and Swaps. Derivatives help to improve market efficiencies because risks can be isolated and sold to those who are willing to accept them at the least cost. Using derivatives breaks risk into pieces that can be managed independently. From a market-oriented perspective, derivatives offer the free trading of financial risks.

What is the importance of derivatives ?

There are several risks inherent in financial transactions. Derivatives are used to separate risks from traditional instruments and transfer these risks to parties willing to bear these risks.

Who are the operators in the derivatives market ?

Hedgers - Operators, who want to transfer a risk component of their portfolio. Speculators - Operators, who intentionally take the risk from hedgers in pursuit of profit. Arbitrageurs - Operators who operate in the different markets simultaneously, in pursuit of profit and eliminate mis-pricing.

What are Forward contracts ?

A forward contract is a customized contract between two parties, where settlement takes place on a specific date in future at a price agreed today.

What are Futures ?

Futures are exchange traded contracts to sell or buy financial instruments or physical commodities for Future delivery at an agreed price. There is an agreement to buy or sell a specified quantity of financial instrument/ commodity in a designated Future month at a price agreed upon by the buyer and seller. The contracts have certain standardized specifications.

What do you mean by Closing out contracts ?

A long position in futures, can be closed out by selling futures while a short position in futures can be closed out by buying futures on the exchange. Once position is closed out, only the net difference needs to be settled in cash, without any delivery of underlying. Most contracts are not held to expiry but closed out before that. If held until expiry, some are settled for cash and others for physical delivery.

What is the concept of Basis ?

The difference between spot price and Futures price is known as basis. Although the spot price and Futures prices generally move in line with each other, the basis is not constant. Generally basis will decrease with time. And on expiry, the basis is zero and Futures price equals spot price.

What is the difference between Commodity and Financial Futures ?

The basic difference between commodity and financial Futures is the nature of the underlying instrument. In a commodity Futures, the underlying is a commodity which may be Wheat, Cotton, Pepper, Turmeric, corn, oats, soybeans, orange juice, crude oil, natural gas, gold, silver, pork-bellies etc. In a financial instrument, the underlying can be Treasuries, Bonds, Stocks, Stock-Index, Foreign Exchange, Euro-dollar deposits etc. As is evident, a financial Future is fairly standard and there are no quality issues while a commodity instrument, quality of the underlying matters.

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