Derivatives

Introduction

• Derivative is a financial contract whose value is derived from the value of other assets, commonly known as ‘underlying’. The underlying could  be a share, interest rate, or any stock market index, etc.
• The underlying is the identification tag for a derivative contract. When the price of the underlying changes, the value of the derivatives also changes.
• Derivatives are very much similar to insurance as they take care of market risks- volatility in interest rates, currency rates, etc.

Features of Derivatives

• Derivatives reduce risk and thereby increase the willingness to hold the underlying asset.
• Derivatives enhance the liquidity of the underlying asset.
• It lowers the transaction cost.
• It can help the investors to adjust the risk and return characteristics of their stock characteristics.
• Derivatives help better price discovery. 
• It provides information on the magnitude and the direction in which various market indices are expected to move.
• Derivatives help to hedge assets from market risks, interest rates risks, and exchange rates risk.

Types of Financial Derivatives

• Forwards: It is a financial contract between two parties obligating each to exchange a particular commodity or instrument at a set price on a future date. 
• Futures: Futures are derivative financial contracts that obligate parties to buy or sell an asset at a predetermined future date and price.

• Warrants:  Warrants are long-term options with a three to seven year of maturity profile. 

• Options: Options are financial instruments or a contract or a derivative instrument that gives the holder the contract to buy or sell a specified quantity of the underlying assets at a particular price on or before a specified time period.

• Swaps: Swaps are customized arrangements between counterparts to exchange one set of financial obligations for another per the terms of agreement.