An agreement or contract made between two parties to purchase or sell specific assets at a specified price within a predetermined time period, then such types of agreement or contract are known as derivatives or financial derivative. The assets on which the contract is made is known as underlying assets.
In other words, a financial derivative is a security deriv4ede from the underlying assets and the values of a financial derivative are determined by the market price of underlying assets. The main purpose of derivatives is to manage financial risk, exchange, rate risk, stock, and commodity price changes risk. Financial derivatives are used either to minimize risk or transfer risk between two counterparties.
Derivatives are often used for commodities, such as oil, silver, gasoline, or gold. Another asset class is currencies, often the U.S. dollar, Npr, Rs. In some cases, the government can also fix the asset rate. Financial derivatives are done in the terms of the commodity(rice, wheat), financial security(share, debenture), currency($, Inr, yen).
It is not much popular in developing countries as compared to the developed country because of little investment. Sometimes contract rate may also increase or decrease according to the market if both parties agreed to buy and sell.
Financial Derivative – Characteristics
A financial derivative contract is a contract to buy or sell a commodity or security at a predetermined price and at a preset date. Futures contracts are standardized by specific quantity sizes and expiration dates. Futures contracts can be used with commodities, such as oil and wheat, and precious metals such as gold and silver.
2.Values Depends on underlying assets:
Financial derivatives are the financial assets derived from underlying assets(commodity, financial security, currency)
3.Oppositely Related Payoff(profit):
Financial derivatives are zero-sum games, which means if one party makes a profit of a positive amount another party of the contract makes a loss by the same amount. There are oppositely related payoffs.
4.Right and Obligation:
By contract, derivatives are obligatory for two parties. However, there are some derivatives that give the right to one party and obligation to another party.
Derivatives are agreements for future transactions. If the contract is a private contract and created in the over-the-counter market, the contracting parties select the maturity period of the contract as per their requirements.
6.Provide Means And Managing Risk:
Derivative securities are used by business organizations, individuals, and governments to manage the different types of risk exposures. Risk arises from changes in prices of commodities, exchange rate, interest rate, and other market variables.
A producer may be anxious about the future sale of his/her product. For example, a farmer may be anxious about uncertain sales and the low price of his product. By using derivatives, producers and farmers can make their sales certain. Thus, derivatives assets provide the mean of managing risk.
Financial Derivative- Types
An option is a contract between two parties option buyer and option seller to buy or sell a specified asset at a specified price on or before a specified future date. An option buyer is also known as an option holder and an option seller is also known as an option writer. The contract gives the right to the holder and it is obligatory to the writer. The holder of an option pays a certain amount to the option writer at the time of contract and this amount is called an option premium.
A)Call Option: A call option gives the right to the holder to buy underlying assets at a specified price (exercise price) on a specified date.
B)Put Option: A put option gives the right to the holder to sell the underlying assets at a specified price (exercise price) on the specified date.
A forward contract is like an option contract to some extent, but an option contract gives the right but not the obligation to go through with the transaction. On the other hand, parties involved in a forward contract incur the obligation to ultimately buy and sell the good. Forward markets have no physical facilities for trading, there is no building or formal corporate body organized as the market.
A futures contract is also a contract between two parties, a buyer and seller to buy or sell something at a future date at a price agreed upon today. The future contract involved forwarding contracts and possesses many of the same characteristics.
For example, the buyer of a futures contract, who has the obligation to buy the good at a later date, can sell to contract in the future market, which relieves him other of the obligation to purchase the goods. Likewise, the seller of the futures contract, who is obligated to sell the goods at a later date, can buy the contract back in the future market, relieving him or her of the obligation to sell the goods.
4.Option On Futures:
An option on a futures contract gives the buyer the right but not obligation to buy or sell a futures contract at a later date at a price agreed upon today. Option on futures trade on a futures exchange and are a rare case where the derivatives contract and the instrument on which is it derives trade side by side in an open market. The gain/loss of options in the future depends on the price of the commodity underlying the future. Option on futures trades on the futures exchange.
A swap is a contract in which two parties agree to exchange cash flows. For example, one party is currently receiving cash from one investment but would prefer another type of investment in which the cash flows are different. The party contracts a swap dealer, a firm operating in the over-the-counter market, who takes the opposite side of the transaction.
Role/Function of Derivative Markets
All investors, however, want to keep their investment at an acceptable risk level. Derivative markets enable those wishing to reduce their risk to transfer it to those wishing to increase it, whom we call speculators. Because these markets are so effective at reallocating risk among investors, no one needs to assume an uncomfortable level of risk.
Consequently, investors are willing to supply more funds to the financial markets. This benefits the economy because it enables more firms to raise capital and keeps the cost of that capital as low as possible.
Forward and futures markets are an important source of information about prices. Future markets, in particular, are considered a primary means for determining the spot price of an asset. Future and forward prices also certain information about what people expect future spot prices to be. Spot prices contain the same information, but it may be harder to extract that information from the spot market than from the futures market.
Derivative markets offer several operational advantages. Firstly they entail lower transaction costs, this means that commission and other trading costs are lower for traders in these markets. This makes it easy and attractive to use these markets in either of lieu spot market transaction or as a complement to spot positions. Secondly, the derivatives market particularly the future and options exchange, have greater liquidity than the spot markets.
Spot markets for securities probably would be efficient even if there were no derivatives markets. A few profitable arbitrage opportunities exist, however, even in markets that are usually efficient. The presence of these opportunities means that the prices of some assets are temporarily out of line with what they should be. Investors can earn returns that exceed what the market deems fair for the given risk level.