MECHANISM OF DERIVATIVES BY MANSUKH DEC 2010

Derivatives, a most influential part of the capital market is considered as a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes. For example, an India investor purchasing shares of an American company off of an American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Rupees.

Underlying Assets in Derivatives
Derivatives consists of some underlying instruments like Futures contracts,   
Forward contracts, Options and Swaps are the most common types of derivatives. Derivatives are contracts and can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.

Future Contracts: Futures contract mean a contractual agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a pre-determined price in the future. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. Futures contracts can be used either to hedge or to speculate on the price movement of the underlying asset.

Forward Contracts:  A forward contract is an agreement between two counterparties - a buyer and seller. The buyer agrees to buy an underlying asset from the other party (the seller). The delivery of the asset occurs at a later time, but the price is determined at the time of purchase.

Options Contracts:  An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties. One options contract may represents certain number of shares for a particular underlying stock. The quoted price of an option is per share. Option can be used for speculation or Hedging purpose, Speculation is as betting on the movement of a security and on Hedging is used to insure your investments against a downturn.

Futures vs Options
The primary difference between options and futures is that options give the holder the right to buy or sell the underlying asset at expiration, while the holder of a futures contract is obligated to fulfill the terms of his/her contract. In real life, the actual delivery rate of the underlying goods specified in futures contracts is very low. This is a result of the fact that the hedging or speculating benefits of the contracts can be had largely without actually holding the contract until expiry and delivering the good(s). For example, if you were long in a futures contract, you could go short in the same type of contract to offset your position. This serves to exit your position much like selling a stock in the equity markets would close a trade.

Conclusion: Both Futures and Options have been derived from any particular underlying stock and can be used either for raising money or protecting our investment from any probable risks. Hence we should use these instruments according to our need and investment norms. However, speculation is the territory in which the big money is made and lost. The use of options in this manner is the reason options have the reputation of being risky. This is because when you use an option contract you have to be correct in determining not only the direction of the stock's movement, but also the magnitude and the timing of this movement. To succeed, you must correctly predict whether a stock will go up or down, and you have to be right about how much the price will change as well as the time frame it will take for all this to happen. The combinations of these factors means the odds are stacked against you. That's why we need to understand more about options like type and use of it, so we will use our next series of stock market session to explain more about options.