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Introducing Derivatives : Futures And Options
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Forward contracts, we have explained in our previous segment, are used to reduce the risk from adverse price movements in financial assets and commodities.
When you lock-in the prices, you are protecting yourself from losses arising from price volatilities in prices of assets.
The most common derivatives contracts (which are traded on the exchanges) are futures, options and swaps. We will deal with futures and options first.
Derivatives are mainly used by three categories of participants in the financial (including currency) and commodities markets. They are hedgers, speculators and arbitrageurs.
Hedgers, as stated earlier, seek to eliminate risk associated with the swing in the prices of an asset.
Speculators try to anticipate the swing in prices of assets in the future and take positions accordingly in the derivatives market.
Arbitrageurs take advantage of the price differentials in the derivatives and futures segment and take offsetting positions in the two segments to make profits.
All three types of participants are responsible for the liquidity of the derivatives segment, pricing and the direction in which futures and options move.
Futures: These are standardised forward contracts. So if you want to reduce the risk in your portfolio of assets – stocks, commodities, precious metals – then instead of searching around for another party to enter into a contract, you just need to buy the ready-made, required futures contract through an exchange.
The following items are standardised in a futures contract:
•The quantity of the underlying asset.
•The quality of the underlying asset.
•The date on which the delivery of underlying asset takes place.
•The pricing of the contract and the minimum price change.
Options: In an options contract, the buyer (of the option) gets the right but not the obligation to buy or sell an asset at a predetermined price at or before a future specified date.
The option holder may decide to exercise the option of buying or selling only if the price moves favourably for him. So though he has the right, he may chose not to do it, so he is not obliged to exercise the option.
The main difference between a futures and options contract lies in the obligation of the purchaser. In a futures contract both parties are obliged to stick to the terms of the contract.
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