Briefly describe a derivative security?

Expert Solution

Before explaning derivative security one must know about ,what derivative means hence the same has been explained first.

DERIVATIVE

A derivative is defined as a contract between the parties that has following characteristics

a)Its value changes in response to a specified underlying asset.

b)It is settled at a future date.

c)It requires little or no initial net investment.

The most common derivative securities are currency forwards ,future,options, interest rate swaps etc

FORWARD CONTRACT (i.e a derivative security)

a) Forward contracts are individually tailored & have no standardised size.

b)Forward contract settlement takes place on the date agreed upon between the parties.

c))Forward contracts may be delivered on the dates agreed upon & in terms of actual delivery.

d)Forward contracts are not subject to marking to market.

e)Margins are not required in forward contract.

f)In forward contract the liability happens to be unlimited because market fluctuations may be wide.

g)Transaction cost for forward contract is based on bid-ask spread.

h)In forward contracts credit risk is borne by each party & therefore ,every party has to bother for the creditworthiness of the counter party.

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