What are Derivative Contracts?

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I am sure most of you have heard of the stock market, but what about the derivative markets? Let us know through this post.

What are Derivatives?

Derivatives are financial instruments that derive their value from underlying assets, such as commodities, currencies, equity indices, etc. The underlying assets may include stocks, bonds, futures contracts, options, swaps, forwards, etc. Derivative contracts have been around the globe since ancient times. In fact, the word "derive" comes from the Latin meaning "to draw out". Derivatives may be traded over the counter (OTC) or through an exchange-traded market (ETR). OTC derivatives are traded privately between two parties, whereas ETR derivatives are traded publicly on exchanges.

Different forms of Derivative Contracts:

There are mainly four types of derivatives: Forwards, Futures, Options, and swaps.

• Forward contract - A forward contract is a binding contract between two parties that imposes an obligation to both parties to buy or sell an asset at a certain price and date.
• Future contract - A futures contract is the same as a forward contract. The only difference between the two is that future contracts are regulated by a recognized body, i.e., SEBI.
• Options - An option is a contract that gives the holder the right, but not the obligation, to buy or sell an asset at a specific price until a certain date.
• Swaps - Swaps refer to an exchange of one financial instrument for another between the parties concerned. This exchange takes place at a predetermined time or as specified in the contract.

Although trading in the derivative market can be profitable, it can also be risky. Not everyone may be a good fit for this type of trading. Investors in the derivative market can be categorized into three types:

• Hedgers: Hedgers are those who may be influenced by changes in an asset's price and who invest in derivative contracts to reduce their exposure to those risks.
• Speculators: Speculators are those who invest in securities just to profit from price swings.
• Arbitrageurs: Those who attempt to profit from the disparity in the pricing of an asset as a result of market circumstances are known as arbitrageurs.

Types of Derivatives market?

There are two main types of derivative markets operated worldwide

• Exchange-traded markets are organized and regulated by a central exchange, such as the New York Stock Exchange (NYSE) in the U.S.A and the Securities Board of India (SEBI) in India. These markets offer standardized contracts that are traded on the exchange, and they are subject to strict rules and regulations designed to ensure fairness and transparency.
• Over the Counter (OTC) markets, on the other hand, are decentralized and unregulated. In these markets, participants trade directly with one another, without the intermediation of a central exchange. OTC markets are often used for trading customized or complex derivatives, such as swaps or exotic options, and they are not subject to the same level of regulation as exchange-traded markets.

Is derivative trading legal?

In the US, derivatives are regulated by the Commodity Futures Trading Commission (CFTC), which was established in 1974. The CFTC regulates futures contracts, options on futures, swaps, and foreign currency transactions. The CFTC also supervises clearinghouses, which act as intermediaries between buyers and sellers. In India, derivatives are perfectly legal. However, the Securities and Exchange Board of India (SEBI) only permits certain types of derivatives to be traded. This includes futures and options trading, so the derivative market is most commonly known as the F&O market.

Conclusion

In conclusion, derivatives are financial instruments that derive their value from underlying assets and are used for hedging, speculation, and arbitrage. They come in various forms such as forwards, futures, options, and swaps, and can be traded over the counter or through exchange-traded markets. While derivative trading can be profitable, it also carries a level of risk and may not be suitable for everyone. The legality of derivatives trading varies from country to country and it is important to understand the regulations and laws in your jurisdiction before engaging in derivative trading.

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