Equity Derivatives

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What are derivatives?

Derivatives are financial contracts, which derive their value off a spot price time-series, which is called "the underlying". The underlying asset can be equity, index, commodity or any other asset. Some common examples of derivatives are Forwards, Futures, Options and Swaps.

Derivatives help to improve market efficiencies because risks can be isolated and sold to those who are willing to accept them at the least cost. Using derivatives breaks risk into pieces that can be managed independently. From a market-oriented perspective, derivatives offer the free trading of financial risks

What is the importance of derivatives?

There are several risks inherent in financial transactions. Derivatives are used to separate risks from traditional instruments and transfer these risks to parties willing to bear these risks.

For an instance, you can take positions in a "Futures" contract and for a relatively small amount of margin money you can take a larger exposure.
You could also trade in "Options" for a small premium, which gives you the right in case of "Call" option (obligation in case of Writing of any option) to Purchase/ Sell a pre-determined number of shares at a pre-determined price.
Derivatives lets you trade in a large number of stocks and also in Index for a small margin. For example, if you had only Rs 1 lakh instead of Rs 5 lakh to buy a stock, by paying margin of Rs. 1 Lakh you can create position in Derivatives Futures for higher value.

Types of Derivative Instruments

Derivative contracts are of several types. The most common types are Forwards, Futures, Options and Swap.

  • Forward Contracts
    A forward contract is an agreement between two parties - a buyer and a seller to purchase or sell something at a later date at a price agreed upon today. Forward contracts, sometimes called forward commitments, are very common in everyone life. Any type of contractual agreement that calls for the future purchase of a good or service at a price agreed upon today and without the right of cancellation is a forward contract.
  • Future Contracts
    A futures contract is an agreement between two parties - a buyer and a seller - to buy or sell something at a future date. The contact trades on a futures exchange and is subject to a daily settlement procedure. Future contracts evolved out of forward contracts and possess many of the same characteristics. Unlike forward contracts, futures contracts trade on organized exchanges, called future markets. Future contacts also differ from forward contacts in that they are subject to a daily settlement procedure. In the daily settlement, investors who incur losses pay them every day to investors who make profits.
  • Options Contracts
    Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.
  • Swaps
    Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are interest rate swaps and currency swaps.
    1. Interest rate swaps: These involve swapping only the interest related cash flows between the parties in the same currency.


    2. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

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