25-08-2017, 09:32 PM
Frequently Asked Questions on Derivatives Trading At NSE
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1. What are derivatives?
Derivatives, such as futures or options, are financial contracts
which derive their value from a spot price, which is called the
“underlying”. For example, wheat farmers may wish to enter into
a contract to sell their harvest at a future date to eliminate the risk
of a change in prices by that date. Such a transaction would take
place through a forward or futures market. This market is the
“derivatives market”, and the prices of this market would be driven
by the spot market price of wheat which is the “underlying”. The
term “contracts” is often applied to denote the specific traded
instrument, whether it is a derivative contract in wheat, gold or equity
shares. The world over, derivatives are a key part of the fi nancial
system. The most important contract types are futures and options,
and the most important underlying markets are equity, treasury bills,
commodities, foreign exchange, real estate etc.
2. What is a forward contract?
In a forward contract, two parties agree to do a trade at some future
date, at a stated price and quantity. No money changes hands at the
time the deal is signed.
3. Why is forward contracting useful?
Forward contracting is very valuable in hedging and speculation.
The classic hedging application would be that of a wheat farmer
forward -selling his harvest at a known price in order to eliminate
price risk. Conversely, a bread factory may want to buy bread
forward in order to assist production planning without the risk of
price fl uctuations. If a speculator has information or analysis which
forecasts an upturn in a price, then he can go long on the forward
market instead of the cash market. The speculator would go long
on the forward, wait for the price to rise, and then take a reversing
transaction making a profi t.
4. What are the problems of forward markets?
Forward markets worldwide are affl icted by several problems:
(a) lack of centralisation of trading,
(b) illiquidity, and
© counterparty risk.
In the fi rst two of these, the basic problem is that of too much fl exibility
and generality. The forward market is like the real estate market in
that any two persons can form contracts against each other. This often
makes them design terms of the deal which are very convenient in that
specifi c situation for the specifi c parties, but makes the contracts nontradeable
if more participants are involved. Also the “phone market”
here is unlike the centralisation of price discovery that is obtained on
an exchange, resulting in an illiquid market place for forward markets.
Counterparty risk in forward markets is a simple idea: when one of
the two sides of the transaction chooses to declare bankruptcy, the
other suffers. Forward markets have one basic issue: the larger the
time period over which the forward contract is open, the larger are the
potential price movements, and hence the larger is the counter- party
risk.
Even when forward markets trade standardized contracts, and hence
avoid the problem of illiquidity, the counterparty risk remains a very
real problem.
5. What is a futures contract?
Futures markets were designed to solve all the three problems (listed
in Question 4) of forward markets. Futures markets are exactly like
forward markets in terms of basic economics. However, contracts are
standardised and trading is centralized (on a stock exchange). There is
no counterparty risk (thanks to the institution of a clearing corporation
which becomes counterparty to both sides of each transaction and
guarantees the trade). In futures markets, unlike in forward markets,
increasing the time to expiration does not increase the counter party
risk. Futures markets are highly liquid as compared to the forward
markets.