SFM
This query is : Resolved
30 August 2010
ANYONE PROVIDE ME EXPLANATION AND EASY REFERENCE OF DERIVATIVES.....
30 August 2010
Derivatives:
Simply stated these are products whose value change in response to changes in the prices of some other products often called an underlying. Such underlying could be anything whose value is fairly measurable. These products could be simple in structure or complex exotic in nature. The more complex the product the more indecipherable they become and if one were to trade or enter into such products, one would do so at one’s peril. Most losses reported arise from such exotic or leveraged products the consequences of which were never clearly understood by the users. When losses hit them, they invariably end up alleging the bankers misrepresented the nature of the products, including the leading multinational companies.
Derivative products are now available with all kinds of underlying. We have equity derivatives in the form of equity and index futures and options, financial derivatives in the form of forward contracts, financial futures, swaps, interest rate futures, option on currencies etc. There are commodity and weather derivatives, bond and interest rate derivatives etc. Innovation it appears is seemingly limitless leading to various permutations and combinations using these derivatives.
The market players are speculators, hedgers and arbitragers. For speculators the derivatives market is highly attractive due to the very low initial investment that is required. Speculators are very important to the market for without them adequate liquidity may not exist in the market. To speculate in the spot market she has to invest in the underlying scrip and hold it for the duration of her expectation and sell the same at a later date to realise her gain. If she has to short the underlying she would have to borrow the same at very high cost in the form of margins which inhibit the utilisation of money at her hands. On the other hand for a small margin she can lock into a derivatives position like futures or options and if her guess comes right she can enjoy a very high return. Shorting is simply selling the derivative and hence a very easy task. Let us say one person is bullish on Infosys whose market price is currently 2000. If he buys the share he will pay 2000 and if the share goes to 2500 he makes a gain of 500 which is 25% absolute return. On the other hand he might buy Infosys future at a price say 2100/-. [Note the price is for a futures contract with 16 days to maturity] His initial investment for this at 10% would be 200. When Infosys goes up to 2500, Infosys future might go up to 2560. [With 10 days for the contract maturity] He can sell his futures and gain 460. This gain is 130% in absolute terms. The gain could be higher if the futures price is at a discount to spot and later corrects itself to be higher than spot. In a normal market, futures prices are generally higher than the spot prices except for bond futures where the reverse rule would apply. The future would be at a discount in all cases where the intervening income is higher than the funding cost of the underlying.
Types of Derivatives:
1) Forward Contract
2) Futures
3) Swaps
4) Forward Rate Agreement
5) Options
Simply stated these are products whose value change in response to changes in the prices of some other products often called an underlying. Such underlying could be anything whose value is fairly measurable. These products could be simple in structure or complex exotic in nature. The more complex the product the more indecipherable they become and if one were to trade or enter into such products, one would do so at one’s peril. Most losses reported arise from such exotic or leveraged products the consequences of which were never clearly understood by the users. When losses hit them, they invariably end up alleging the bankers misrepresented the nature of the products, including the leading multinational companies.
Derivative products are now available with all kinds of underlying. We have equity derivatives in the form of equity and index futures and options, financial derivatives in the form of forward contracts, financial futures, swaps, interest rate futures, option on currencies etc. There are commodity and weather derivatives, bond and interest rate derivatives etc. Innovation it appears is seemingly limitless leading to various permutations and combinations using these derivatives.
The market players are speculators, hedgers and arbitragers. For speculators the derivatives market is highly attractive due to the very low initial investment that is required. Speculators are very important to the market for without them adequate liquidity may not exist in the market. To speculate in the spot market she has to invest in the underlying scrip and hold it for the duration of her expectation and sell the same at a later date to realise her gain. If she has to short the underlying she would have to borrow the same at very high cost in the form of margins which inhibit the utilisation of money at her hands. On the other hand for a small margin she can lock into a derivatives position like futures or options and if her guess comes right she can enjoy a very high return. Shorting is simply selling the derivative and hence a very easy task. Let us say one person is bullish on Infosys whose market price is currently 2000. If he buys the share he will pay 2000 and if the share goes to 2500 he makes a gain of 500 which is 25% absolute return. On the other hand he might buy Infosys future at a price say 2100/-. [Note the price is for a futures contract with 16 days to maturity] His initial investment for this at 10% would be 200. When Infosys goes up to 2500, Infosys future might go up to 2560. [With 10 days for the contract maturity] He can sell his futures and gain 460. This gain is 130% in absolute terms. The gain could be higher if the futures price is at a discount to spot and later corrects itself to be higher than spot. In a normal market, futures prices are generally higher than the spot prices except for bond futures where the reverse rule would apply. The future would be at a discount in all cases where the intervening income is higher than the funding cost of the underlying.
Types of Derivatives:
1) Forward Contract
2) Futures
3) Swaps
4) Forward Rate Agreement
5) Options
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