The term ‘Derivative’ stands for a contract whose price is derived from or is dependent upon an underlying asset. The underlying asset could be a financial asset such as currency, stock and market index, an interest bearing security or a physical commodity. Today, around the world, derivative contracts are traded on electricity, weather, temperature and even volatility.
According to the Securities Contract Regulation Act, (1956) the term “derivative” includes: 1. A security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; 2. A contract which derives its value from the prices, or index of prices, of underlying securities. A derivative is a financial contract whose value is derived from the value of something else, such as: - stock price, commodity price, an exchange rate, or an index of price. A derivative enables a trader to Hedge himself from the risk by taking “long or short” position in the derivative market as per their expectations regarding future. A derivative also enables a speculator to speculate in the derivative market for a large amount of money by depositing a certain percentage of money as margin amount, so as compared to spot market derivative market provide more amount of exposure to the trader and he/she is having more chances to earn large amount of money. In India, most derivative users describe themselves as hedgers and Indian law require the derivative to be used for hedging purpose only. Participant in the Derivative Market :-
1.) Hedgers: use futures or options markets to reduce or eliminate the risk associated With price of an asset. 2.) Speculators: use futures and options contracts to get extra leverage in betting on future movements in the price of an asset. 3.) Arbitragers: They take positions in financial markets to earn riskless profits. The arbitrageurs take short and long positions in the same or different contracts at the same time to create a position which can generate a riskless profit. For example, rice farmers may wish to sell their harvest at a price which they consider is ‘safe’ at a future date to eliminate the risk of a change in prices by that date. To hedge their risks, farmers can enter into a forward contract and any loss caused by fall in the cash price of rice will then be offset by profits on the forward contract. The agreed future price of the contract is known as Strike Price and the price in the current market is known as Spot Price. Thus, hedging by derivatives is equivalent of insurance facility against risk from market price variations, provided you are rational and having practical knowledge. Characteristics of Derivatives: -
1.) Lot size: - Every future stock is having a lot size which is pre-defines by the regulators and Derivative contract can only be made in that lots. For ex: - if lot size is 250 one can make contract either for 1 lot means 250 shares or 2 lot means 500 shares and in progression, one cannot make contract for 260 or 240 contract. 2.) Margin: - Every trader has to maintain a margin a/c in which he maintain certain percentage of margin amount of total value of the contract. And there is minimum maintenance margin amount also, if margin a/c reaches that point trader is called refill the a/c up to margin amount. 3.) Expiry Time: - Every derivative contract is having expiry time, in case of equities it is either for 1 month or 2 month or 3 month, in case of currency it is up to 12 months. 4.) Every equity derivative contract expires on the last Thursday of its maturity month. 5.) At the end, generally there is cash settlement only.
Process of Convergenc: -
It means that at the time of maturity both the price of future stock and the price of spot stock will be same. Before the maturity date future price > spot price because the person paying in spot is losing interest and the...