Question

As in stated in Financial Instruments, explain the derivative markets and give example of option and future contracts trading!

Answer 1

Derivative in lay man language means derived value. In simple terms derivative is an instrument whose value is derived by something else. It is dependent on something else for its value.

Derivatives market is an open platform where in derivative products are freely traded. These derivative products are traded in two types one is Over the counter (OTC) and other is Customised contract.

OTC contract are traded over the exchange and the customised contract are no traded in market but dealt with the banks. In OTC contract the lot size, settlement date and conditions are pre determined. These are governed by the exchange. Trading and settlement are done by the exchange eradicating the counter party payment risk. The products are traded at their premium value and settled on net basis. In customised contract the lot size and settlement date is cutsomised as per customers need.  

Option Trading - For instance, The call option of ABC ltd with settlement date of 2 months, quoted on market is trading at premium of INR 50, where the strick price is INR 500 and market price of the stock is INR 450 with a lot size of 100. To buy the call option of 500, customer would have to pay premium * lot size = 50*100 = INR 5,000/-. Market movement will determine the change in the premium value. Proportionate change will occur in premium corresponding to change in market value of share. In the above case if the market price increases by 10% to INR 495, making the call more expensive as it would be profitable the premium price would also increase by 10% ie to INR 55. In this case initially the trader would have to pay INR 5000/- and he would receive INR 5,500/-. Correspondingly if the market price falls by 10% premium will also fall by 10%. Similar logic will apply for Put option as well.

Future Trading - Similar to above exampe if the future price of crude oil for 2 months is trading at INR 100 in the market with lot size of 100, trader would have to pay INR 10,000/-. He would have to pay a fraction amount upfront as compared to the margin kept with the broker. And if the price increases to 150 he would recieve 150*100 = 15000/-. Thereby making a profit of INR 5,000/-

As mentioned abpve, this mechanism makes future and option trading faster and easier.