0. Introduction to Derivatives | Derivatives in stock market | Derivatives explained | Derivatives
Hello everyone, today I will be introducing
you to a new topic called Derivatives. Derivative in general means
deriving the value from something. E.g., The prices of Petrol, Diesel, Gasoline,
etc. are derived from the prices of Crude Oil. Assuming other factors remain constant, if the price of crude oil increases, the price
of gasoline will also increase and vice versa. Thus, we can say that gasoline prices
are a derivative of crude oil prices. Now let us understand Derivatives in Finance. What is a Derivative? Derivative is a financial instrument
or contract that derives its value from the price of an underlying asset or
multiple assets that can be equities, bonds, an index, interest rates, currencies,
cryptocurrencies, commodities, etc. The value of the contract depends on the
price fluctuations of the underlying asset. E.g., Jack and Jill enter into a contract on
1st of January to buy and sell a bar of Gold for $100.
They want the transaction to happen
on 31st of January, but they have agreed upon the price today. The transaction
price is fixed and it will not change. Suppose the actual price of gold increases to
$120, the contract benefits the buyer Jack, as he gets to buy the gold for
$100 when the actual price is $120. If the actual price of gold decreases to
$90, the contract benefits the seller Jill, as she gets to sell the Gold for $100
when the price is actually $90 only. This is a Derivative contract,
as it derives its value from the price of an underlying
asset, which in this case is Gold.
There are various types of Derivative
Contracts. The most common ones are – Forwards, Futures, Options, Swaps
and some complex Exotic Contracts. Derivatives are usually traded Over the
Counter (OTC) or on Centralised Exchanges. Futures and Options are traded on
Exchanges and others are mostly traded OTC. We will compare OTC and Exchange
traded contracts in the next video. As the underlying asset is required only
to derive the value of the contract, the seller may or may not be having the
underlying when entering into the contract. Derivatives can therefore be used for –
Hedging i.e., Risk mitigation or even for Speculation.
Example, A farmer wants to fix the selling price of his crop before
the harvest. He is thus hedging his risk. A doctor feels that crude oil prices will rise. He
is speculating based on his research or intuition.
The derivative contracts can be settled Either by
physically delivering the underlying or for cash. Most contracts are cash-settled.
If the contract is physically settled, Jill will deliver the gold and
Jack will pay her the 100$. If the buyer and seller do not want to
exchange the gold on the settlement date, they can choose to settle in cash.
The settlement amount will be the difference between the current
price and the agreed-upon price. The buyer will pay the difference if
the price drops and the seller will pay the difference if the price increases.
E.g., If the actual price is only $90, Jack will pay the difference of 10$ to Jill.
If the actual price is $120, Jill will pay the difference of 20$
to Jack, and the contract is settled. This is similar to a bet –
the loser pays the gainer.
FREE traffic, Autoresponder, Page Builder, Popup Creator, Link Tracker, and to Make Money Now!
