Before understanding what is derivative, let’s larn what is underlying asset.
Underlying asset: Underlying asset tin live existent asset such equally commodities, gilded etc or fiscal assets such equally index, involvement rates etc.
· These are fiscal instruments who value depend upon or is derived from around underlying asset.
· A derivative does non conduct maintain its ain physical existence, it emerges out of contract betwixt the buyer as well as seller of derivative instrument.
· Its value depends upon the value of underlying asset. Hence returns from derivative instruments are linked to returns from underlying assets.
· The almost mutual underlying assets are stocks, bonds, commodities, marketplace indices as well as currencies.
· Derivatives are mainly used to command risks. They tin live used to cut risks (a procedure known equally hedging) or to increase risks inwards monastic tell to lift returns (speculation)
Classification of Derivatives:
· Broadly nosotros tin separate it into 2 categories: Commodity derivatives as well as Financial Derivatives
· In instance of commodity derivatives, the underlying asset is a physical asset such equally rice, wheat, pulses etc.
· In instance of Financial derivatives, the underlying asset is a fiscal asset such equally equity shares, stock index, central rates etc.
· Financial derivatives are farther classifying into Forwards, Futures, Options, Swaps.
In this article, nosotros volition focus on Forwards as well as Futures, inwards the side past times side article nosotros volition focus on Options, swaps.
Forwards: A frontwards contract is a someone bilateral contract betwixt 2 parties to purchase as well as sell a specified asset at a specified toll on a specified date.
Consider a farmer inwards Haryana, Mr. Sardana, plans to grow 1000kgs of wheat this year. He tin sell his wheat for whatever the toll is when he harvests it, or he could lock inwards a toll similar a shot past times selling a frontwards contract that obligates him to sell 1000kgs of wheat to ITC ltd. after the harvest for a specified price. By locking the toll now, he is truly eliminating the endangerment of falling wheat prices. On the downside, if prices ascent later, he is foreclosing the chance of futurity profits. The transaction that Mr. Sardana has entered into is known equally Forward Transaction as well as the contract roofing such transaction is known equally Forward Contract.
Let’s conduct maintain other instance from Financial frontwards contract indicate of view, Suppose an Indian Company has to pay import bills of $150000 after three months. So, the companionship is facing the risks of rupee depreciation i.e. the toll of US dollars may become upwardly (as inwards $1=Rs.65 to $1=Rs.70 it agency rupee depreciates). To guard against such central charge per unit of measurement risk, companionship may acquire into into a frontwards understanding with another companionship to purchase $150000 at a specified toll after three months. This way it has hedged its position. On the downside, the rupee may appreciate (i.e. $1=Rs.65 to $1=Rs.60).
· Each Contract is custom designed as well as parties may attain upwardly one’s heed expiration date, asset type etc.
· Both the parties conduct maintain equal rights as well as obligations. The buyer is obliged to purchase as well as seller is obliged to sell at maturity.
· Forward contracts are someone as well as non-regulated.
· Being a someone contract, at that spot are chances of default past times whatever party.
· Contracts are to a greater extent than oftentimes than non held till maturity.
· The investor agrees to sell the asset is said to deal brusk frontwards seat inwards the asset, as well as the buyer is said to deal a long frontwards position.
Futures: A futures contract is a modified frontwards contract. It is a contract to purchase or sell a specified asset at a specified toll on a specified futurity date. It is traded on exchange as well as is a standardised contract.
· Futures contract has no default endangerment because central acts equally a counterparty as well as guarantees delivery with the aid of clearing house.
· An investor tin offset his futurity seat past times engaging inwards an contrary transaction earlier the stipulated maturity of the contract.
· Margin Requirement: All futures contracts conduct maintain margin requirements. Margin coin is required to live deposited with the central past times both the parties to safeguard their interests. There are 2 types of Margins-Initial Margin and Maintenance Margin. Initial Futures Margin is the amount of coin that is required to opened upwardly a purchase or sell seat on a futures contract. The margin charge per unit of measurement varies betwixt v as well as 15% of the full contract value. Maintenance margin is the amount of coin necessary when a loss on a futures seat requires ane to allocate to a greater extent than funds to render the margin to the initial or master margin level.
· Example of Margin Requirement: Let’s assume nosotros conduct maintain a contract value of Rs.20,00,000 as well as the initial margin is 5% as well as maintenance margin is 2%, as well as thence both the parties of the contract has to deposit Rs.1,00,000 (i.e. 5% of 20,00,000). Now margin concern human relationship is settled on daily footing i.e. grade to marketplace settlement. If margin amount inwards the concern human relationship on whatever solar daytime falls below the maintenance margin of Rs. 40,000, as well as thence a variable telephone hollo upwardly is made to replenish the margin amount to the degree of initial margin.
Financial Futures are based on an underlying fiscal instrument, rather than a physical commodity. They are categorized equally follows:
1.Bond Futures 2. Short involvement Futures 3. Stock index Futures 4. Currency Futures.
Pricing of Futures (or Forward) Contract:
· The theoretical or fair toll of the futures contract tin live determined through Cost of Carry Model. The actual toll of Futures contract is determined through the forces of furnish as well as need inwards the Futures market.
· Cost of Carry reflects the cost of asset the underlying asset or shares over the life of futures contract reduced past times the amount the shareholder would have inwards dividends or income on those assets during that time. There are the next situations:
Applicable Pricing Model
When the underlying asset provides no income (or dividend)
When the underlying asset provides known income
When the underlying asset provides known income yield (or dividend yield)
Here F= Futures(or Forwards) Price, S= Spot Price, r=continuously compounding charge per unit of measurement of interest, t=time duration of Futures inwards years, I= acquaint value of income or dividend at r, q= income yield (or dividend yield)
Let’s encounter around examples here:
q. Consider the toll of shares of X ltd. is Rs.50 inwards the spot market. The risk-free charge per unit of measurement is 12% per annum continuous compounding. An investor wants to acquire into into a six months frontwards contract. Calculate the frontwards price?
a.) F=Sert = 50e(.12)6/12 = Rs.53.09
q.) Consider 12-month stock index futures contract on NIFTY index. The electrical current value of index is 5200 as well as continuously compounding endangerment gratis charge per unit of measurement of render is 10%p.a.. Stock index is expected to provide Rs.120 at the halt of year. Calculate toll of ane futures contract if lot size is 100?
a.) Firstly let’s calculate PV of Dividend that nosotros volition have after ane twelvemonth i.e. 120e-0.10 = 108.58. Now F= (S-I)ert = 100*(5200-108.58)e.10 = Rs.562689
Note: The value of frontwards as well as futures contracts is flora using endangerment gratis investment rate.
Standardisation of Contract
They are non regulated
They are regulated
Counter political party default risk
Party may default
Clearing solid guarantees the transaction
At the halt of contract
They are marked to marketplace on daily footing which agency settled solar daytime past times solar daytime until the halt of contract.
They are pop alongside hedgers
They are pop alongside speculators.
Initial as well as maintenance margin