DERIVATIVES.

DERIVATIVES.

Capital markets all over the world have been witnessing the dazzling development of derivatives. A derivative or derivative security is a financial instrument whose value depends on the value of an underlying security. Derivatives are son called because they derive their value from the underlying asset. For example, a ‘share option’ is a derivative whose value is contingent on the price of a share. So they are also known as “contingent claims”. In short, derivative is a contract between two parties where one party receives or makes a claim as an underlying asset and the other party has an obligation to meet the respective liability.

In developed countries, the derivative market is evolved to manage the out comes of the unsetting volatile prices.

In developing economies, derivative markets allow transfer of risk from unwilling economic participants. Equity and interest rate options, forwards futures and swaps are specialized derivatives dealt with in capital markets. Derivatives facilitate the transfer and management of risk. Derivatives are almost like insurance,the difference is that the insurance protects against from specific risks (fire, floods, theft etc.) while derivatives take care of the market risks-the volatility in interest rates, currency rates, commodity prices and share prices.

Purpose of derivatives

Derivative instruments are risk transfer instruments. Risk in business is to be faced rather than ignored. You have to look for risk and provide for it even when you take all the precautionary steps to protect yourself against risk. In this situation derivatives comes to rescue of risk averse individual, by offering a mechanism for transferring risk to risk takers. This is different from speculative activity because derivatives are entered and not necessity to make. For example, let us take the illustration of a textile spinner, whose activity is to buy cotton and sell cloth. The spinner faces the risk of fluctuating prices of raw materials ie, cotton. To protect himself against rising cotton prices, the spinner can enter in to a derivative for instance, an option contract, (the right to buy a certain quantity of cotton on a future date) at Rs.50 per kg. The derivative that deal that the spinner has entered in to say, to day, stems from his business requirement, that of needing a set quantity of cotton, which go into production of cloth. So the intend of buying a derivative as an option is to hedge against risk, not with a view to make profits. This derivatives are necessarily risk takers than speculative instruments.

To day, derivatives account for over 75% of financial market activities in Europe, north America, and east Asia. Derivatives that are traded now globally include options, futures, swaps etc.

Options

Option is a contract that gives its owner the right to buy or sell a specified asset at a stipulated price. There are two basic types of options. They are ‘call option’ and ‘put option’. The right to buy an underlying security by a certain date for a certain price is referred to as ‘call option’. An option which endows upon the buyer or holder the right to buy something at a specified price on or before a specified date. For example if you buy one call option on reliance you have the right to purchase 100 shares of Reliance’s shares at a specified price, any time between the date of contract and specified date for entering into the option contract the ‘option writer’ has to pay the call option price and this is termed as the option price.

The option price is one who initiate the option contract. The date on which the transaction take place is termed as expiration date or maturity. Put option is a contract that give sits owner the right to sell a security by a certain date for a certain price.

Any how an option gives its holder the right to either to buy or sell a security. The working of an option trading is in under. An investor buys 100 call options on say ‘Asian paints’ with a strike price of Rs.100. Suppose the current market price is Rs.95 and the maturity date falls after two months. The option price may takes as Rs.5 per share. If the market price on the maturity date is less than Rs.100 he will choose not to exercise the option because there is no meaning in buying for Rs.100 a share that has a lesser market value. But the investor incurs a loss of the option price of Rs.500 only. If the share price is above Rs.100 the option will be exercised. So that he can pocket a neat margin buying the shares at the current rate. The decision of the investor as to exercise the option or not, largely depends on the prevailing market price on the expiration date.