This article is based on the request of few people who wanted me to throw lights on futures and options. To understand this first we have to understand what derivatives are.
Derivatives are instruments whose value depends on value of the underlying asset. What do you mean by the above mentioned statement? Let’s take an example of an orange juice. The value of an orange juice depends on the value of the underlying asset orange. Hence orange juice can be termed as a derivative of orange.Like that the value of derivatives that we are going to discuss here will rely on the value of underlying asset. Here the underlying asset can be commodities (wheat, rice, oil seeds etc), metals, currency, stocks.basically derivatives in finance parlance can be classified into four headings.
• Forward Contracts
• Futures Contracts
• Option Contracts
• Swap
Forward contracts
It is nothing but an agreement between two parties to buy a product at a future date whose price is determined by the present. Why it happens? Generally everyone in this world are scared about uncertainties due to inflation, monsoons etc which leads to price raise. So a seller who is scared of price fall in future is ready to compromise on his high profits and agrees to sell his product for an optimal profit to a buyer who is scared about price rise in future. So the buyer agrees to buy the product at a future date at a price determined today with the risk minimizing attitude of if price goes very high I am safe that I can buy with the determined price. If price goes very high the buyer is benefited and if it falls the seller is benefited. This generally happens in agricultural commodities because of unpredictability of monsoons. But as we all know this is a risky transaction for one and other is benefited. So in later days lot of people started to take a backseat when loss comes to them. So people thought about other ways of solving this problem. Here came futures and options.
Future contracts
This is same as forward contracts but here we have two differences.
1. It takes place with the presence of third party (the exchange)
2. It is just a notional commitment between the parties.
What do you mean by notional commitment?
The actual seller produces the commodity and gives it to exchange and gets the receipt. The commodity is maintained at the exchange warehouses after quality check. Now the receipt is traded as the commodity is traded and it passes on from people to people who are interested in buying. The exchange takes care of it at the maturity date. Every increase in price is a benefit to the buyer and it will be accounted in his account because that is the value of that commodity that day. Any decrease in price is deducted from his account.
Option Contracts:
An option is nothing but a “Right Given to the Holder of the Option“. It may be a “Right to Sell” Or “Right to Buy“. The right to sell option is called a put option and right to buy option is called as call option.
When a person buys an option note only the right is transferred. It is not necessary that a person should execute the right on maturity date. Then the question arises how a seller can make profit out of it even if it is not executed on the maturity date. The buyer of the option has to necessarily pay a premium called option premium for buying that option. The buyer can buy a put option or a call option. The simple logic is a buyer who expects a price rise will buy a put option for a price determined today and a buyer who expects price fall will buy a call option. Call and put options are there in stocks, commodities etc.The next one is Swap which deals with currency rate exchanges which may not be that significant.
