Derivatives in Security Markets are the financial instruments which derive their values from some underlying assets. The underlying asset could be Equities (Shares), Debt (Bonds, Treasury Bills, Notes), Currencies, Indices such as S&P 500, Nikkei 225, FTSE 100, NIFTY 50. Equity is a share in the ownership of a company. It is a claim on the company’s assets and earnings. The more equity of a company you have, the greater stake you have in the company ownership in the form of a shareholder. Debt instruments consists of Government and Corporate Bonds, Mortgages, Debentures, Certificates, Leases, Notes. Derivatives are traded either on a regulated exchange or over the counter(OTC) trading place. Derivatives helps in transferring the price risk arising due to fluctuation in asset prices from one party to another. This way derivatives helps in mitigating the risk arising out of future uncertainty in prices. Derivatives derive their name from their respective type of underlying asset i.e. if asset is an equity, its derivatives is called equity derivative and if asset is a currency, its derivative is called currency derivatives and so on.
Derivatives are broadly categorized in to 3 types:
A forward contract is a private agreement between two parties which is not much formal in terms and condition to buy or sell an asset over-the-counter(OTC), not on an exchange at a certain future date for a certain price that is pre-decided on the date of contract. Here the future date is called “expiry date” and the pre-decided price is called Forward Price. In this kind of agreement there is always a risk of one party may default on its side of agreement. This is called counter party risk. Forward contract has only one settlement date that is at the end of contract. Buyer of the contract is called the long investor having a long position. Seller of the contract is called short investor and is said to have a short position. Forward contracts are mostly used by Hedgers who wants to eliminate the volatility of an asset price.
Futures contracts are like Forward contract except that these are traded on a recognized stock exchange. These contracts are standardized by the exchange. All the terms other than the price is set by the exchange unlike the 2 parties which was in the case of Forwards. Both the parties are protected against counter party risk in case of Futures contracts as a Clearing Corporation is introduced in between the 2 parties who holds a certain amount as security from both the party. This amount is called Margin Money. In case of one party defaults in payment then the Clearing Corporation fulfil the obligation of this party by paying from its margin money to the other party. Futures contracts are marked – to – market daily that is at end of the day market close whatever is the price of the stock, daily changes in the value of contract from previous day are settled day by day until end of contract. Here parties are vulnerable to volatility in the price of the underlying asset and are liable for losses incurred daily. If this fluctuation will cause either party margin money limit to go down below minimum margin requirement, their broker will issue a margin call. This party must deposit more funds as a collateral against further losses or be forced to close their position at loss. Both the parties of futures contract have the comfort of closing out the contract prior to the maturity by squaring off the transactions in the market. Futures contracts are used by Speculators who bet on the direction of market price movement of the stock.
An option is a contract between a buyer and a seller where one party gives the other party the right but not the obligation to buy or sell from other party the underlying asset on or before a specific day at an agreed upon price called the Strike price. For granting the option, the party granting the option collects a payment from the other party called option premium or option price. Options are traded both in exchanges and over-the counter(OTC). Hedgers use options to reduce the risk of holding an underlying asset. The party having right to buy is called option buyer or option holder. The party granting the right is called option seller or option writer. For the option holder, potential loss is limited to option premium. When an option is not exercised, it expires and option premium spent is lost. But if the spot price of the option rises, there unlimited profit for the holder. For the option writer, potential loss is unlimited.
Options are of 2 types:
- Call Option
- Put Option
A call option is a contract granting the right to the buyer of the option to buy the underlying asset on or before a specific day at an agreed upon price, but not the obligation to do so.
A put option is a contract granting the right to the buyer of the option to sell the underlying asset on or before a specific day at an agreed upon price but not the obligation to do so.
Moneyness of an Option
Moneyness of an option describes the relationship between its strike price and spot price which is the current market price of its underlying asset. Moneyness of an option is categorised in to 3 types:
A call option is in-the-money if the strike price of the option is below the market price of the underlying stock. A put option is in-the-money if the strike price is above the market price of the underlying stock.
A call option is out-of-the-money if the strike price is above the market price of the underlying stock. A put option is out-of-the-money if the strike price is below the market price of the underlying stock
A call option or a put option is at the money when both the strike price and market price are the same.