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Basics of Derivatives

Derivatives in Financial Markets

We can have derivative contracts on any assets. There are various types of derivatives contracts such as:

  • Commodity Derivatives
  • Currency Derivatives
  • Equity Derivatives
  • Interest Rate Derivatives, etc

Let us discuss some of the markets with respect to the above derivatives and the way they help in reduction of risk or uncertainty.

 

Commodity

Tata Steel produces and sells steel. It has a huge inventory of steel and is worried that two months later, if the price of steel drops in the spot market, then it will have to suffer losses when it is selling its steel.

 

On the other hand, there is a company like Maruti, which uses steel to produce cars. Maruti is seeing a huge increase in demand for cars in the next two months and plans to increase its production for which it needs steel. However, they are worried that two months later, if the price of steel in the spot market increases, then it will have to spend more money.

 

Thus, Tata Steel and Maruti enter into a contract in the derivative market to sell and buy steel respectively two months later at a pre-fixed price, thus locking the price uncertainty.

 

Currency

An exporter produces shirts and exports them to the United States. It is expected to receive a payment for the shirts it has supplied in a month's time. The current USD-INR exchange rate is ₹72 and he is expected to receive a payment of $1,000. Thus, as per current rate, he expects to get ₹72,000 a month later.

 

However, he is worried that a month later, when his dollar payment comes, the Indian rupee might strengthen, and the USD-INR exchange rate might become ₹70, and thus he would only receive a payment of ₹70,000 instead of ₹72,000, what he had thought earlier.

 

On other hand, an importer plans to import machinery for $1000 a month later and as per the current exchange rate plans to save ₹72,000 by month end so as to pay for the machine. However, he is worried that a month later, when he has to pay $1000 for the machinery, the USD-INR exchange rate might go up to ₹74 and he has to spend ₹74,000 instead of  ₹72,000 to get the machine.

 

Thus, the importer and the exporter enter into a contract in the currency derivatives market to buy and sell dollar respectively one month later at a pre-defined exchange rate locking the price uncertainty. 

 

Equity

An investor holds around 500 shares of Reliance since the last 2-3 years which he does not want to sell at the moment. However, he is worried that the next day, when the verdict of Reliance and RNRL case will be out in public domain and if Reliance loses the case, then the stock price of Reliance might go down significantly and his wealth will shrink for the time being.

 

On the other hand, there is a speculator who has already some insider information that Reliance will win the court case and its stock price will increase.

 

However, he does not want to buy Reliance shares in the spot market as he does not want to hold the same for a long period.

 

Thus, the investor and the speculator in the equity derivatives market enter into a contract to sell and buy Reliance respectively one month later at a pre-defined price rate locking the price uncertainty.

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