Derivatives
What ia a derivative?
A derivative is a risk-shifting agreement, the value of which is derived
from the value of an underlying asset. The underlying asset could be a
physical commodity, an interest rate, a company’s stock, a stock
index, a currency, or virtually any other tradable instrument upon which
two parties can agree.
Major derivative categories
Derivatives fall into two categories. One consists of customized, privately
negotiated derivatives, which are known generically as over-the-counter
(OTC) derivatives or, even more generically, as swaps. The other category
consists of standardized, exchange-traded derivatives, known generically
as futures. In addition, there are various types of product within each
of the two categories as described below.
How do privately negotiated (OTC) derivatives
differ from futures?
First, the terms of a futures contract—including delivery places
and dates, volume, technical specifications, and trading and credit procedures—are
standardized for each type of contract. For swaps, the same characteristics
are subject to negotiation by the parties to the contracts. Second, futures
contracts are always traded on an exchange, while swaps are traded on
a bilateral basis. Third, those who engage in futures transactions assume
exposure to default by the exchange’s clearinghouse; for OTC derivatives,
the exposure is to default by the counterparty. Fourth, credit risk mitigation
measures, such as regular mark-to-market and margining, are automatically
required for futures but optional for swaps. Finally, futures are generally
subject to a single regulatory regime in one jurisdiction, while swaps—although
usually transacted by regulated firms—are transacted across jurisdictional
boundaries and are primarily governed by the contractual relations between
the parties. Various products, including futures contracts and exchange-traded
options, fall within the generic category of futures, but all have the
common characteristics described above. The definitions that follow refer
exclusively to privately negotiated (OTC) derivatives.
Product description: Forward contracts
A forward is a customized,
privately negotiated agreement between two parties to exchange an asset
or cash flows at a specified future date at a price agreed on the trade
date. Entering a forward contract typically does not require the payment
of a fee.
Product description: Forward rate agreements
(FRA)
A forward rate agreement is a forward contact on a short-term interest
rate, usually Libor, in which cash flow obligations at maturity are calculated
on a notional amount and based on the difference between a predetermined
forward rate and the market rate prevailing on that date. The settlement
date of an FRA is the date on which cash flow obligations are determined.
What is an Index future Contract?
An Index future contract is where the underlying security is not an
individual share but the Index such as Sensex, Nifty, IT Index, Bank Index
and so on. These contracts derive their value from the value of the underlying
index.
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