WHAT IS DERIVATIVE MARKET?

WHAT IS DERIVATIVE MARKET?DIFFERENT TYPES OF DERIVATIVE MARKET.DIFFERENCE BETWEEN OPTIONS,FUTURES,FORWARD AND SWAP CONTRACTS

A derivative market is a financial instrument whose value is derived from or defined by one or more underlying asset.The commonly used underlying assets are stocks,bonds,currency etc.

Let me make you understand derivative market with the help of an example

Think that you and I made a contract on 31 January for oil that whatever be the price of oil after 3 months I will buy oil from you at price of 31 january.So if the price of oil after 3 months is higher then today then I will be in profit as I bought it at lower price i.e of price of 31 January.If the price of oil is lower then I will loose money as I bought it at higher price.    

Derivatives can be traded on exchanges and also OTC(over the counter)market.Most of the derivatives are traded OTC.In OTC market there is high risk of default.Derivatives can we use to hedge the position.Hedge is a way to protect oneself from financial loss.

For example If I have to buy US dollar on 19 March and I am worried that the price of US dollar to INR might increase so what I can do is that I can buy a derivative contract today so that whatever be the price of USD to INR is on 19 March I will protect myself from that.

There are 4 types of derivative contracts :

1. Future contract
2. Forward contract
3. Option contract
4. Swap contract

1 FUTURE CONTRACT :

Future contracts trade on exchange.In this contract the buyer and seller agreed on the specific price at specific date.The price of future contract is marked to market daily.

After entering the future contract the parties are obligated to perform the contract.The future contract can be used by the parties to hedge their position as they might be concerned about the price in future.As the future contract might be buy or sold by a speculator so they might not be interested in buying or selling the perticular asset underlyimg the future contract so the future contract can be cash settled before the expiration through offset contract. 

2 FORWARD CONTRACT :

These contracts are similar to future contract,the only difference is that they are traded OTC(over the counter)market.These contracts can be customised according to requirement of both parties.These contracts are unstandardised.In this contract there is high counterparty risk as the buyer or seller if the contract might not fulfill the contract.

3 OPTION CONTRACT :

This contract is also similar to future contract.It can also be used to hedge the position.In option contract the option buyer have to pay the premium to the option seller when entering the option contract so as to enjoy the upside because the option buyer can have limited loss or unlimited profit whereas the seller can have limited profit or unlimited loss.The buyer/seller is not obligated to fulfill the side of the contract when the other one decides to exercise the contract.

4 SWAP CONTRACT : 

Swaps means exchange of something with one another.Swap contract involves the exchange of one financial instrument with another between parties.These contracts are traded OTC market.Swaps can be used for exchange of currency exchange rate risk or the risk of default on loan etc.