What are derivatives?

Futures and Options

Derivatives are contracts whose value is derived from an underlying asset, either a financial asset or a commodity. These contracts are designed to fluctuate in response to changes in the value of the underlying asset based on market conditions. In this article, we will explore two common types of derivatives: Futures and Options.

Futures

Futures are financial contracts that grant the holder the right to buy or sell an underlying asset at a predetermined price on a future date. These contracts are standardized and negotiable, allowing the contract holder to transfer their obligations to a third party before the expiry date. For example, Investor A may need 1000 Kg of sugar on March 31st for production needs. To secure the purchase, Investor A enters into a futures contract for 100 Kg of sugar on January 1st. If the price is 5000, Investor A will pay 50,000 to purchase 1000 Kg of sugar. Upon contract maturity on March 31st, Investor A will pay INR 50K, and the seller will deliver 1000 Kg of sugar.

Options

Options are another type of derivative, with their value determined by the underlying asset. Underlying assets can be stocks, indexes, currencies, commodities, or other securities. Option contracts grant investors the right to buy or sell an asset at a specified price on or before a predetermined date. Unlike futures contracts, option contracts provide the right but not the obligation to purchase.

There are two main types of options:

  1. Call Options: From the buyer’s perspective, call options are purchased when an investor expects the market to rise. This allows the buyer to buy the underlying asset at the specified price.

  2. Put Options: From the buyer’s perspective, put options are purchased when an investor expects the market to fall. This grants the buyer the right to sell the underlying asset at the specified price.

American and European Options

Options can also be classified as American or European options based on their exercise style.

  1. American Options: These options can be exercised at any time until the expiration date. The NSE provides some security options that follow the American style.

  2. European Options: These options can only be exercised on the maturity date. All index options traded on NSE adhere to the European style.

In conclusion, derivatives like futures and options play a significant role in the financial markets. They offer investors opportunities to hedge against risks, speculate on price movements, and diversify their investment portfolios. Understanding the nuances of these financial instruments can help investors make informed decisions and manage their investments effectively.

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