FAQs
FAQs on Derivatives

1. What are derivatives

Derivatives are financial instruments which derive their value from the price of underlying assets / other financial prices.

2. Why use Derivatives?
 

Derivatives are financial instruments used for risk management as they allow risks to be spread and controlled. Derivatives are used to shift elements of risk and therefore can act as insurance.
 
3.What are the commonly used derivatives

        Forwards
        Futures
        Options
        Swaps
 
4. What is the nature of the underlying asset?
 

Underlying assets can be of several types, such as:
 

  • Shares, currencies and bonds.

  • Share indices.

  • Commodities.

  • Agricultural commodities such as wheat,corn, or rice.

  • Animal products.

  • Metals such as iron or gold.

Futures

5. What are forward and future contracts?
 

A forward or a future contract is an agreement between two parties to buy or sell an underlying asset at a certain time and price in the future for a certain price, decided today.
 
6. What is the difference between a futures and a forward contract?
 
Forwards are contracts to buy or sell an asset at a certain future time for a certain price. These contracts are usually traded over the counter and do not have standardized quantity and time period. These transactions are normally between two institutions or an institution and a corporate client.

On the other hand, Futures contracts have standardized quantity, a standardized expiry period, are exchange traded and usually fully covered from the counter party risk.
 
7. What are the Benefits of trading in futures ?
 

        - Hedge against risk
        - Financial leverage
        - Manage funds more efficiently
        - Timing of inflow and outflow of funds can be determined well in advance.

8. What is the relationship between cash price and futures price?

Futures price is spot price plus carrying cost. The futures price is, therefore, usually higher than the current spot price. The future price also takes into consideration the percentage dividends. The difference b/w the spot price and future price is called the Basis.

9. What are financial futures and how are they different from commodity futures.
 

Financial futures are futures where the underlying asset is a financial instrument. Commonly traded financial futures are Currency futures, Interest rate futures Equity Index Futures and Equity Futures
 
The main difference between financial futures contracts and commodity futures are:
 

  • Financial futures usually have a limited range of delivery dates based on a 3-month cycle: commodity futures often have monthly or seasonal delivery dates.

  • Most financial futures are cash settled,commodity futures contracts specify a delivery location.

10. What is meant by standardisation of futures?
 

The exchange standardises futures contracts in terms of the following features:
 

  1. Value or size: All futures contracts based on a particular underlying instrument, would be of the same size.

  2. Month of delivery: Usually 90-day contracts expire in March, June, September and December. Together with the month of delivery, the days on which delivery can be made are also fixed, if possible.

  3. Range of fluctuation: It is the tick or amount by which price of futures contract can move up or down. For example, in a futures contract, the tick could be Rs 0.25 or 25 paise.

Options

11. What are options ?
 

Options are contracts, which gives the buyer (holder) the right, but not the obligation, to buy or sell specified quantity of the underlying assets, at a specific (strike) price on or before a specified time (expiration date).

12. What are Call and Put Options?
 

The right to buy is called a call option and the right to sell is called a put option. These are the two basic types of options which can also be bought and sold. A Call Option is an option where the Buyer of a Call option gets the right to buy the underlying asset. He is not obliged to buy it A Put Option is an option where the Buyer of a Put option gets the right to sell the underlying asset.
 
13. What is a strike price?

The price at which the buyer of the option has the right to buy or sell is known as the strike price.
 
14. What is Option Premium?
 
Option Premium is the price paid by the buyer (of the option) to the seller to
acquire the right to buy or sell.

15. What are European & American Style of options?
 
American style option is the one which can be exercised by the buyer on or before the expiration date.
 
The European kind of option is the one which can be exercised by the buyer on the expiration day only and not anytime before that.
 
In India, Index Options are European style of options. Individual Stock Options are American style of Options.

16. What are, 'At the Money', 'In the Money' & 'Out of the money' Options?
 
At the Money - An option is said to be 'at-the-money', when the option's strike price is equal to the underlying asset price. This is true for both puts and calls.

In the Money

In case of call options:
 

A call option is said to be in-the-money when the strike/exercise price of the option is less than the underlying asset price
 
In case of Put Options:
 

A put option is in-the-money when the strike price of the option is greater than the spot price of the underlying asset.
 
Out of the Money
 

In case of call options:
 

A call option is said to be out-of-the-money when the strike/exercise price of the option is greater than the underlying asset price.
 
In case of Put Options:
 
A put option is in-the-money when the strike price of the option is less than the spot price of the underlying asset.
 
Options are said to be deep in-the-money (or deep out-of-the-money) if the exercise price is at significant variance with the underlying asset price.
 
17. What are Stock Index Options?
 
The Stock Index Options are options where the underlying asset is a Stock Index.
 
18. How can the Options be used for investments?
 
If you anticipate a stock to move in a certain direction, then acquire the right to buy/sell the stock at a predetermined price, for a specific duration of time. There can't be a more attractive investment opportunity. The decision as to what type of option to buy is dependent on whether your outlook for the respective security is positive (bullish) or negative (bearish). If your outlook is positive, buying a call option creates the opportunity to share in the upside potential of a stock without having to risk more than a fraction of its market value (premium paid). Conversely, if you anticipate downward movement, buying a put option will enable you to protect against downside risk without limiting profit potential (talk of short selling on the sly!). Purchasing options offer you the ability to position yourself with your market expectations in a manner that you can both profit and protect.

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