This should help.. was sent in a forwarded e-mail from a friend
What are Derivatives?
A derivative is a financial instrument whose value depends on the values of other underlying variables. As the name suggests it derives its value from an underlying asset. For Example - A derivative may be created for a share, or any material object. The most common underlying assets include stocks, bonds, commodities etc.
Let us try and understand a Derivatives contract with an example:
Ramesh buys a futures contract in the scrip "Infosys". He will make a profit of Rs.1000 if the price of Infosys rises by Rs 1000. If the price remains unchanged Ramesh will receive nothing. If the stock price of Infosys falls by Rs 500 he will lose Rs 500.
As we can see, the above contract depends upon the price of the Infosys scrip, which is the underlying security. Similarly, futures trading can be done on the indices also. These are termed as Index futures. Nifty futures are a very commonly traded derivatives contract in the stock markets. The underlying security in the case of a Nifty Futures contract would be the Index-Nifty. Sensex futures have also been introduced in our market.
What are the different types of Derivatives?
Derivatives are basically classified into the following:
* Futures /Forwards
* Options
* Swaps
What are Futures?
A futures contract is a type of derivative instrument, or financial contract where two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price.
The example stated below will simplify the concept:
Case1:
Rajesh wants to buy a Car, which costs Rs 100,000 but owing to cash shortage at the moment, he decides to buy it at a later period say 2 months from today. However, he feels that after 2 months the prices of Cars may increase due to increase in input/ manufacturing costs. To be on the safer side, Rajesh enters into a contract with the car Manufacturer stating that 2 months from now he will buy the car for Rs 100,000. In other words he is being cautious and agrees to buy the car at today's price 2 months from now. The forward contract thus entered into will be settled at maturity which in this case will be in 2 months from now. The manufacturer will deliver the asset to Rajesh at the end of two months and Rajesh in turn will pay cash delivery.
Thus a forward contract is the simplest mode of a derivative transaction. It is an agreement to buy or sell a specific quantity of an asset at a certain future time for a specified price. No cash is exchanged when the contract is entered into.
What are Index Futures?
As Stated above, Futures are derivatives where two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. Index futures are futures contracts where the underlying is a stock index (Nifty or Sensex) and helps a trader to take a view on the market as a whole.
What is meant by Lot size?
Lot size refers to the quantity in which an investor in the markets can trade in a derivative of particular scrip. For Ex-Nifty Futures have a lot size of 50 or multiples of 50. Hence if a person were to buy 1 lot of Nifty Futures, the value would be 50*Nifty Index Value at that point of time. Lot sizes are fixed and may differ from scrip to scrip.
Similarly lots of other scrip such as Infosys, reliance etc can be bought and each may have a different lot size. NSE has fixed the minimum value as two lakhs for any Futures and Options contract. Lot sizes are fixed accordingly which will be the minimum shares on which a trader can hold positions.
What is meant by expiry period in Futures?
Each contract entered into has an expiry period. This refers to the period within which the futures contract must be fulfilled. Futures contracts may have durations of 1 month, 2 months or at the most 3 months. Each contract expires on the last Thursday of the expiry month and simultaneously a new contract is introduced for trading after expiry of a contract.
