Derivative Instruments & Derivative Markets
Derivatives are products whose value is derived from the value of one or more basic variables, which are called Underlying Assets. The underlying asset can be equity, index, foreign exchange (Forex), commodity or any other asset. This means that any instrument that derives its value on its underlying equity, index, foreign exchange (Forex), commodity or any other asset, is a Derivative Instrument.
Please note that derivative products initially emerged as hedging devices against fluctuations in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. But after 1970s, the financial derivatives came into spotlight thanks to the growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two thirds of total transactions in derivative products.
Different Types of Derivatives
The derivatives can be Forwards or Futures or Options or Warrants.
Forward & Future Contract: A forward contract is a customized contract between two parties to buy or sell an asset at a specified future time at a price agreed upon today. Futures contracts are special types of forward contracts in the sense that they are standardized exchange-traded contracts, such as futures of the Nifty index.
Options: An Option is a contract which gives the right, but not an obligation, to buy or sell the underlying at a stated date and at a stated price. While a buyer of an option pays the premium and buys the right to exercise his option, the writer of an option is the one who receives the option premium and therefore obliged to sell/buy the asset if the buyer exercises it on him.
Options are of two types – Calls and Puts options.
- ‘Calls’ give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date.
- ‘Puts’ give the buyer the right, but not the obligation to sell a given quantity of underlying asset at a given price on or before a given future date. Please note that options generally have lives of up to one year. The majority of options traded on exchanges have maximum maturity of nine months. Longer dated options are called Warrants and are generally traded over-the counter.