Derivatives: Definition, Meaning, participant, contracts types and so on..

Derivatives: Definition, Meaning, participant, contract types and so on..

Finance | Derivative | Meaning |

A derivative is a Financial Product whose value can be derived by its underlying asset, The underlying assets can be Equity, Debt, Commodity, and Currency. Derivatives can either be OTC or NON- OTC.

OTC stands for over the counter contract, In this contract, trading is done between two parties without the supervision of an exchange. OTC trade is risky because of default - either of the party can default depends on the maturity price.

NON- OTC stands for Non - over the counter contract, In this contract, trading is done between two parties with the supervision of an exchange. OTC trade is safe as it is supervised by the exchange.

TYPES | OF DERIVATIVES | CONTRACT |

There are four types of derivative contracts

Forward
Future
Option
swap

1] FORWARD CONTRACT | It is a customized agreement between two parties to exchange an asset at a pre-agreed price and at a pre-agreed time period. These contracts are not traded on the stock exchange, Hence default rate in this contract is High.

Example:- Assume that a cotton producer has to sell cotton six months from now and is concerned about good rain and the price of cotton. It thus enters into a forward contract with its friend to sell cotton at a price of let say 100 Rs per quintal in six months, with settlement on a cash basis.

In six months, the spot price of cotton has three possibilities:

It is exactly 100 Rs per quintal. In this case, no money is owed by the producer or his friend to each other and the contract is closed.

It is higher than the contract price, say 110 Rs. The producer has to sell the cotton at the same price in which the contract is agreed upon at the price of 100 Rs. so, the producer has to bear a loss of 10 Rs

It is lower than the contract price, say 90 per quintal. The friend will have to but the cotton from the producer as the pre-agreed price of the contract which is 100 Rs. and the friend has to bear a loss of 10 Rs

limitation of Forward contract:-

CPD (Counter Party Default) - either of the party can default because trading is done without the supervision of an exchange.
Forward is an OTC contract, Hence no guarantor.
A forward contract is illiquid in nature.
Reversal is compulsory with the same counterparty.

2] FUTURE CONTRACT | It is a standardized agreement between two parties to exchange an asset at a pre-agreed price and at a pre-agreed time period. These contracts are NON- OTC ( exchange-traded ). It is similar to a Forward contract the only difference is that the Future is NON-OTC whereas Forward is OTC contract.

limitation of Forward contract:-

No CPD (Counter Party Default) Risk
The future is a NON-OTC contract.
A future contract is liquid in nature.
Reversal is not compulsory with the same counterparty.

3] OPTION CONTRACT | It is a standardized agreement between two parties to exchange an asset at a pre-agreed price and at a pre-agreed time period. However, there is a fourth element in option which is Right and Obligation where Buyer has a right known as exercise right and the seller left with an obligation to sell which is known an assignment

4] SWAP | are derivative contracts wherein two parties exchange their financial obligations. The cash flows are based on a notional principal amount agreed between both parties without an exchange of principal. The amount of cash flows is based on a rate of interest. One cash flow is generally fixed and the other changes on the basis of a benchmark interest rate. Interest rate swaps are the most commonly used category. Swaps are not traded on stock exchanges and are over-the-counter contracts between businesses or financial institutions.

PARTICIPANTS | DERIVATIVES:-