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Derivatives Trading

A derivative is an instrument whose value is derived from the value of one or more underlying, which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc. Four most common examples of derivative instruments are Forwards, Futures, Options and Swaps.

The fair price of a derivative is the price at which profitable arbitrage is infeasible. In this sense, arbitrage (and arbitrage alone) determines the fair price of a derivative: this is the price at which there are no profitable arbitrage opportunities.

Futures contract is a financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. 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. The futures markets are characterized by the ability to use very high leverage relative to stock markets.

Option

The right to purchase the underlying futures contract if the option is a call or the right to sell the underlying futures contract if the option is a put.

A call option conveys to the option buyer the right to purchase a particular futures contract at a stated price at any time during the life of the option.

A put option conveys to the option buyer the right to sell a particular futures contract at a stated price at any time during the life of the option.

The option buyer is the person who acquires the rights conveyed by the option seller.

The option seller (also known as the option writer or option grantor) is the party that conveys the option rights to the option buyer.

A forward contract is a customized contract between two parties, where settlement takes place on a specific date in future at a price agreed today. The main features of forward contracts are

  • They are bilateral contracts and hence exposed to counter-party risk.
  • Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.
  • The contract price is generally not available in public domain.
  • The contract has to be settled by delivery of the asset on expiration date.
  • In case the party wishes to reverse the contract, it has to compulsorily go to the same counter party, which being in a monopoly situation can command the price it wants.
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