Friday, November 14, 2008

Derivatives

Derivatives are financial contracts. They derive their value from an underlying stuff. This stuff can be anything - for example it can be an asset ( stocks, real estate, loans) or index ( interest rate, Sensex, ) or other stuff ( weather conditions, freight rates etc).

Forward ( when traded on exchange, it is called futures), options and swaps are types of drivatives.

Derivatives are used to lessen the financial risk when underlying stuff changes. 

People pay a premium to another party to insure against their asset losing value.

Inflation derivatives are insurance against inflation risk from one counterparty to another.

Freight derivatives are insurance against future freight hikes.

Derivatives offer leverage. Small movements in the price of underlying assets can bring in huge changes in derivative values.

Swaps are insurance against each other risks. Two parties swap each others risk ( they actually swap each others cash flows)

Futures and Forwards
Futures Contract is a contract, to buy something in the future at a price determined in the present.

Forward contract is similar but less standardized and not regulated and not traded on an exchange and do not require a margin to trade.

When the future price is higher than present price, it is called contango. The reverse is called backwardation.

Hedgers trade in futures as they have a stake in the underlying commodity and try to prevent themselves from risk. Specuators have no stake in the commodity and are just trying to make a quick buck.

Options :
Put Options is a contract to sell a futures contract. Call option is an option to buy a futures contract.
Strike price is the price at which these options are exercised.

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