Derivative Contracts

Derivative Contract => 

- it is a Financial Instrument.

- it derives its value from an underlying asset.

1. Stock Derivative 

Stock/Share ---> Stock Future, Stock Option

Stock is the underlying asset and Stock Future is the derivative. If the stock prices increase then the Stock Future price will also increase.

Stock Future Derivative Contract (in short Future Contract) =>

It is a standard contract in which quantity of shares, date of expiry, etc are mentioned. 

2. Index Derivative 

NIFTY50 (India) -> Derives its value from 50 companies.

KOSPI (South Korea) -> Derives its value from 200 companies.

NIKKEI225 (Japan) -> Derives its value from 225 companies.

Hang Seng (Hong Kong) -> Derives its value from 82 comapnies.

Dow Jones Industrial Average (US) -> Derives its value from 30 companies.

3. Commodity Derivative 

Agro -> Turmeric, Corn, Rice, etc

Bullion -> Gold, Silver 

4. Currency Derivative (Forex)

USD-INR

EURO-INR etc

5. Intrest Rate Derivative 

NOTE -> NIFTY50 (any Index) derives its value from underlying stocks (of the 50 companies for NIFTY50) but NIFTY50 is not directly tradable so it is a derivative.

***

People enter into derivative contracts for mainly two reasons 

-> Speculation (Intent to make a profit) 

-> Hedging (Protection)

Speculation => taking a position (Buy/Sell) with the intention to make a profit.

Speculation in the stock market involves making investment decisions based on the expectation of future price movements, rather than the intrinsic value of the asset. Speculators aim to profit from short-term price changes rather than long-term value growth.

(My intention is to make a profit. Decide without firm evidence.)

example:-

There is a cricket match between India vs Bangladesh

I bet on India because I feel India will win as it has never lost a match against Bangladesh. (Here there's no evidence for India to win and I'm simply betting on India to make a profit.)

You bought shares of Apple Inc. (AAPL) because you speculated that the new iPhone launch would lead to an increase in the stock price. You expect that positive market sentiment and media coverage surrounding the new iPhone will boost Apple's stock. (There is no guarantee that there will only be positive sentiment so it comes under speculation)

Hedging => taking a position with the intention to minimize losses. (it simply means protection)

example:- you own 100 shares of APPLE

APPLE shares --> 100 quantity (Holding)

The share price of APPLE has been continuously increasing for the past few days and you are making a profit and now it is at its all-time high but you feel like it may fall now (Due to correction or due to bad quarterly results, etc).

If the price falls you'll make less profit on 500 shares but you also don't want to sell your share as the price may rise more. So to protect your profit and minimize the loss if the share price falls you will do Hedging.

How it works?

First, you'll --> Short(Sell) 1 Lot of Future Contract of APPLE share as you feel like the price may fall.

(1 Lot of Future Contract (standardized) of APPLE has 100 shares in it.) 

If APPLE share price falls --> APPLE Future (Short) rises 

Holding loss will be neutralized by the Future Contract profit. 

If APPLE share price rises --> APPLE Future (Short) falls 

Holding profit will neutralize the loss of the Future Contract(Short).

In both cases, our losses are neutralized. 

NOTE --> Derivatives were introduced with the intention to hedge the losses. 

***

Types of Derivative Contracts

1. Forward Contracts --> These are tailored-made contracts. (Two people talk with each other and make a contract according to their demands)

2. Future Contracts --> These are standardized contracts. (Stock Exchange makes them.)

3. Option Contracts

4. Swaps 

Forward and Swaps are types of Over-the-counter (OTC) contracts.