Introduction to Derivatives: Everything you want to learn about financial derivatives

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This contract is usually between two financial institutions or between the financial institution and one of its corporate clients.

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Generally, it is not traded on an exchange. In a forward contract, one of the parties to be assuming a long position and agrees to buy the underlying asset on the certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price.

Derivative (finance) - Wikipedia

A forward contract is settled at maturity. The specified price in a forward contract will be referred to as the delivery price. At the time when parties entered into the contract, the delivery price is chosen so that the value of the forward contract to both parties is zero. The holder of the short position delivers the asset to the holder of the long position in return for a cash amount equal to the delivery price.

Key variable determines the value of a forward contract is the market price of the asset. Value of a forward contract is zero when parties enter into the contract. A future contract is like a forward contract. It is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. We generally trade futures contracts on the stock exchange.

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One way in which a futures contract is different from a forward contract is the exact delivery date is not usually specified. It is a general practice to refer a futures contract by its delivery month. Normally, the exchange specifies the period during the month when delivery must be made. For Example in the case of the bullion commodities future contract, the delivery period is 5 trading days after the expiry of the contract. We can understand it by one example- there is an August — future contract of Gold, this contract will expire on end of the month i.

Ideally delivery period is between 1 st to 5 th Aug. But if 5 th Aug falls on Saturday no Trading day then this date excludes from the delivery period and it remains for four days. Options on stocks were first traded on an organized exchange in Since then, there has been a dramatic growth in the options market.

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Nowadays you can trade options on many different exchanges across the world. The underlying assets include stocks, stock indices, foreign currencies, debt instruments, commodities, and future contracts. A call option is a security, which gives the owner the right to buy the underlying asset at a certain price by a certain date. A put option is a financial security. A put option is a right to sell shares of stock or index at a certain price by a certain date.

Naresh is the head of Research at Raghunandan Money. Naresh carries an equal flair for both technical and fundamental analysis and that makes him truly one of the reliable experts in the market. Why do we invest in stocks? Is it only to gain out of the appreciation in share Derivative instruments are tools to deal with future prospects of a financial in As an investor in the stock market, you need to know about various characteristi For those who are investing in the stock market for the first time, the entire p Stock classification is the process of grouping stocks for ease of understanding To open demat account in India needs lots of steps to follow and that too very s Scary huh.

Buy Why? The reason why it is so large is that there are derivatives available for many different assets including bonds, stocks, commodities, currencies, etc. Many investors prefer to buy derivatives rather than buying the underlying asset. The derivatives market is divided into two categories: OTC derivatives and exchange-based derivatives.

OTC, or over-the-counter derivatives, are derivatives that are not listed on exchanges and are traded directly between parties.

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Therese types are very popular amongst Investment banks. Exchange-based derivatives are ones that are listed on exchanges, such as The Chicago Mercantile Exchange. It is common for large institutional investors to use OTC derivatives and for smaller individual investors to use exchange-based derivatives for trades.

Financial Derivatives trading

Clients, such as commercial banks, hedge funds, and government-sponsored enterprises frequently buy OTC derivatives from investment banks. There are a number of financial derivatives that are offered either OTC Over-the-counter or via an Exchange. Derivatives values are affected by the performance of the underlying asset or, as mentioned, the contract. CFDs are highly popular among derivative trading, CFDs enable you to speculate on the increase or decrease in prices of global instruments that include shares, currencies, indices and commodities.

CFDs are traded with an instrument that will mirror the movements of the underlying asset, where profits or losses are released as the asset moves in relation to the position the trader has taken. Futures contract Common derivatives based on an agreement to buy or sell assets such as commodities like sugar or shares paid for at a later stage but with a set price.

Futures are standardized to facilitate trading on the futures exchange where the detail of the underlying asset is dependent on the quality and quantity of the commodity. Options Trading options on the derivatives markets gives traders the right to buy CALL or sell PUT an underlying asset at a specified price, on or before a certain date with no obligations this being the main difference between options and futures trading.

Essentially, options are very similar to futures contracts. However, options are more flexible.

How do Derivatives work?

This makes it preferable for many traders and investors. The purpose of both futures and options is to allow people to lock in prices in advance, before the actual trade. This enables traders to protect themselves from the risk of unfavourable prices changes. However, with futures contracts, the buyers are obligated to pay the amount specified at the agreed price when the due date arrives. With options, the buyer can decide to back out of the contract.

This is a major difference between the two securities.

Financial Derivatives - An Introduction

Also, most futures markets are liquid, creating narrow bid-ask spreads, while options do not always have sufficient liquidity , especially for options that will only expire well into the future. Futures provide greater stability for trades, but they are also more rigid. Options provide less stability, but they are also a lot less rigid. So, if you would like to have the option to back out of the trade, you should consider options.

If not, then you should consider futures. Forward contracts Financial instruments that are set up with more of an informal agreement and traded through a broker that offers traders the opportunity to buy and sell specified assets such as currencies. Here too a price is set and paid for on a future date. Swaps Another common derivative used in a contract setting when trading are swaps , they allow both parties to exchange sequences of cash flows for a set amount of time. They are not exchanged or traded instruments but rather customized OTC contracts between two traders.

Why trade financial derivatives?