Derivatives Market In India
What are Derivatives ??
A Derivatives is a term that is calculated on the value of another security. In short, Derivatives are whose underlying value arrives from other Financial Instruments. The Financial Instrument may be either of Mortgages, Bonds, Stocks, Commodities, or Currency. In-depth, the derivatives are classified as Futures, Forwards, Swaps, Options, or any other hybrid contract. To be more precise, the term Derivative does not hold its own value. The value of the Derivative is dependent on other securities.
What is the Derivatives Market ??
Derivatives Markets usually are branched into two types.
The OTC Derivative Market
Majorly known as OTC also recognized as Over The Counter Market is the largest market of the Derivatives. Additionally, it has a high risk of party defaulting. This is a place where the party need not go to the exchange and they directly tend to trade without any exchange interferences. Exotic Options, Swaps, Forward Rate Agreements are the few products that are traded on Over the Counter.
The Exchange Trade Derivatives Market
On the other side is Exchange Traded Market wherein, you can trust your counterparty for not defaulting. The Korea Exchange which lists KOSPI Index Futures & Options and Eurex that lists Interest rates and Index Products are the largest derivative exchange in the world. Charging for Initial Margin from both parties for trade assurance, the Exchange Traded is portrayed as an intermediary for all the transactions.
What Are the Different Types Of Trading In Derivatives ??
Futures, Forwards, and Options are the 3 types of Derivatives that entitles itself to be traded in the Exchange. And Swaps are the ones that are traded on OTC.
What Is A Forward Contract ??
Forward Contracts are the deals that are penned between a buyer and a seller on an OTC Market i.e Over The Counter. Wherein, the risk of defaulting either party is on a high note. Moreover, agreeing to the price that has to be dealt with in the future dates is set down today. Therefore, being a customized non-standard contract, the deal is directly settled on the future date fixed.
What Is A Futures Contract ??
Trading on the Exchange, the Futures Contract is standardized in terms of delivery, quality, and quantity. The Futures Contract is also a deal between the buyer and the seller that ideally terminates on the date of settlement. But prior the contract is expired on a pre-specific date that is known as the expiry of the contract. On the date of expiry, the contract is settled by delivering either cash or underlying assets. Here you can sight the daily changes in regards to the settlements made that continue until the day of settlement.
What Are Options ??
The value of Options depends on the other underlying instrument such as Index, Currency, a stock, commodity, or any other security. Moreover, being the type of derivatives and traded on Exchange, the investor has the right to buy or sell the contract but the same is not obliged. With the activeness of the two parties in the Options Contract, a seller is referred to as the writer, and the buyer is known as Holder.
Let us get your familiar with the Options Terms…
Strike Price is the fixed price which does not entail to change in the whole of the Option Contract Expiry. Moreover, it is the price on which the seller or the buyer tends to sell or buy their contract respectively.
NOTE:- The Strike Price differs from Market Price.
Premium / Down Payment
The investor holding this contract needs to pay a certain amount which is known as a premium to have the right to exercise his trade. If s/he is unable to square off the options contract at the set date then, he might lose his premium amount paid.
The Intrinsic Value is held on by the Money Call Options. Besides, the Intrinsic value of an underlying asset is set upon the Strike Price minus the Current Price.
When the holder urges to exercise his/her right to buy/sell the options contract, the contract is settled. If by any chance, the holder misses out on not exercising the options contract until maturity, then the contract is bound to settle on its own without earning any premium amount in the holder’s pocket.
Every contract holds its own individual expiry dates. However, if the contract isn’t settled or until its expiry date, then the same is automatically being squared off.
The quantities for the options contract here are fixed. For instance, if your contract is for 100 shares and when you tend to opt for either buy or sell of the same in the market, then the whole 100 shares are supposed to be transacted.
Types Of Options
Now since you have got a clear view on what options are, let us move ahead with the types of Options.
Call Options are the contracts that deliver the owner the right to buy any financial security, but not the obligation. When talking in terms of the investments and returns in call options the losses here are limited up to the premium price, but the profits are unlimited.
For Instance:- If ABC Co. is trading at Rs. 110 at expiry, and the strike price is Rs. 100. If the options premium cost the buyer Rs. 2, then the profit earned by the investor post option contract settle would be (110-100)-2 = Rs. 8.
Further classifying the Call Options into 2 types
- The Strike price less than the Current Market Price for the security is tagged as, “In The Money Call Option.”
- Whereas, the Stock Price higher than the current market price is called, “Out Of The Money Call Option.”
A buyer of the Put Options has the right but not the obligation to sell any financial security. The holder is eligible to transact the order at the set Strike Price before the expiry of the security contract.
For Instance:- If ABC Co. is trading at Rs. 110 at expiry, and the Strike Price is Rs. 90. If the Premium cost the seller Rs. 2, then the profit earned by the investor post option contract, settle would be (90-100)-2 = Rs. 8.
Further classifying the Put Options into 2 Types
- If the Strike Price is greater than the Current Price, then the security is considered as, “In The MoneyPut Options.”
- If the Strike Price is below the Current Market Price, then the security is considered as, “ Out Of The Money Put Options.”
Starting with the simple terms, Swaps are the contracts that include the exchange of one item for another. Earlier it used to be the Barter System practicing the exchange of one good for another. Swaps are the type of derivatives contracts that are traded on OTC Markets. There is an involvement of the two parties that exchange their cash flows for two financial instruments at the price pre-negotiated. Each stream of cash flow is globally referred to as “leg.” The swaps contracts are an exchange of Cash Flows and not Notional Flows.
Here is the list of five different types of Swaps an investor should know with the examples…
Interest Rate Swaps
When “A” with the Fixed Rates assumes that the rate may go down and he can be in loss, and “B” with the Floating Rates assumes that the rate may rise and he can be in loss; here with the consent of both the parties a swap contract is prepared.
Here the exchange of Principal amount and interest payments in different currencies is involved. The counterparties come up with the agreed Currency Swap contract to hedge the other investment position when the currency exchange rate fluctuations are sensed.
Here the floating rates for both legs vary. In Basis Swaps, with both streams having floating rates, it can either be a Currency Swap or Interest Rate Swap.
With the pre-agreed amount of the products and based on the commodity’s spot price for fixed cash flows, the counterparties tend to prepare the Commodity Swap Contracts.
Credit Default Swaps
Universally recognized as CDS, the Credit Default Swaps are mainly related to Insurance Companies. Suppose “A” takes insurance from XYZ Co. & “A,” thinks that might be in future dates XYZ Co. may default. Hence “A” goes to the protection seller to buy protection and can hedge its loss if by chance XYZ Co. defaults.
Why Derivatives ??
Derivatives have been the most attractive investment so far. The reason being the securities are standardized and one can freely trade it on exchange. Moreover, Derivatives contracts have the capability of covering you up in all the terms.
Earn money without a physical settlement
If you are in the urge to not sell the current shares and hold it for long-term investment but still want to earn the profits through them, then Derivatives can be a perfect choice. Here in the Derivatives Market, you can transact your positions without squaring off your shares.
When you purchase security from one Market at a lower cost and sell it in the other market at a higher price, then the difference between the price of the square off is recognized as Arbitrage Trades. If you have good calculations and knowledge, then you can perfectly play well here.
Hedge against price fluctuations
If there are price fluctuations and you seek to protect your securities from any loss, then Hedging could be the perfect get through. The Hedging can be an ideal backup that lets you protect the rise in the price of the security that you are supposed to buy. Additionally, it permits you to hedge the security you hold if the price falls.
Transfer of risk
With the wide range of strategies that let you smoothly go through your risk, there are multiple products that you can opt for in a Derivatives Contract. An Investor can benefit from transferring its risk from risk-averse investors to risk-loving investors.
The Participants of Derivatives Market
The Derivatives Market is also inclusive of numerous strategies and countable products to offer investors. However, it depends on the investors whether which product to opt for as per their requirements. Let us introduce you to the types of Investors that are deeply connected to Derivatives markets.
If you are possessing the shares of a particular company and you think that the same might uncover you with the loss in the near time. But at the same time, you do not want to sell it off. However, in a situation like this, acquiring the position in the Derivatives contract that is opposite of what you are holding right now will be your savior. In short by holding this security in the derivative market, you pass on your risk to someone who is willing to bear it with the expectation of earning more profits.
When talking about hedging, it is you transfer your risk to someone who is willing to bear your risk, but at the high not why will someone knowingly do so. Therefore, here the answer to the same is Speculation. Going with the rule “the more you risk the more you tend to fill your pockets.” Therefore, researching the market accurately and risking their portfolio the speculators tend to play in the market and earn the fluctuations that occurred.
Trading in the Derivatives Market will never ask you to pay the total value of your position. Instead, you only need to deposit a fraction of the total amount, also known as margin. This has also been a major reason for the investors to focus on margin trading due to minimal investment and holding large positions.
Considering the arbitrage trade as the low-risk trade, the arbitrageurs are the ones whose Derivatives instruments are calculated through the value based on the underlying asset in the Spot market. In simple terms, with all the calculations, the arbitrage tends to buy the security with the lower price from one market and sell off the same in another market at higher prices. This lets them earn the difference amount among the two markets of security.
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