Derivative Trading

Derivative Trading

Subject – Economy

Context – Capital and commodity markets regulator Securities and Exchange Board of India (SEBI) has suspended futures and options trading for one year in a host of agricultural commodities including chana, mustardseed, crude palm oil, moong, paddy (Basmati), wheat and soyabean and its derivatives.

Concept –

• Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset.
• A derivative can trade on an exchange or over-the-counter.
• Common derivatives include futures contracts, forwards, options, and swaps.

Options

• An option gives the buyer the right, but not the obligation, to buy (or sell) an asset at a specific price at any time during the life of the contract.
• They tend to be fairly complex, options contracts tend to be risky. Both call and put options generally come with the same degree of risk. When an investor buys a stock option, the only financial liability is the cost of the premium at the time the contract is purchased.
• Options are based on the value of an underlying security such as a stock. As noted above, an options contract gives an investor the opportunity, but not the obligation, to buy or sell the asset at a specific price while the contract is still in effect. Investors don’t have to buy or sell the asset if they decide not to do so.

Futures

• A futures contract gives the buyer the obligation to purchase a specific asset, and the seller to sell and deliver that asset at a specific future date unless the holder’s position is closed prior to expiration.
• Options may be risky, but futures are riskier for the individual investor. Futures contracts involve maximum liability to both the buyer and the seller
• A futures contract requires a buyer to purchase shares—and a seller to sell them—on a specific future date, unless the holder’s position is closed before the expiration date.
• Futures contracts tend to be for large amounts of money. The obligation to sell or buy at a given price makes futures riskier by their nature.
• They are preferred by speculators.

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: These entail swapping only the interest related cash flows between the parties in the same currency and
  • 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.

Forwards

• Forward contracts or forwards are similar to futures, but they do not trade on an exchange.
• These contracts only trade over-the-counter.