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DerivativesWhat are derivatives? Derivative as the name suggests are the financial contracts which derive their value from the underlying. The underlying may be the security or an index. Thus derivative instruments have no independent value. Rather their values are dependent on the price of the underlying instruments which they represent. What are forward contracts? Forward Contracts are contracts where two parties agree to do a trade at a future date at the pre determined or agreed price and quantity. Thus the trade takes place at a future date but the terms of the trade are determined previously.
What are the problems of forward contracts?
Forward Contracts are between two parties, Hence these are individual contracts which are settled between the two parties to the contracts. However these are not traded on the stock exchange. Hence they are illiquid. They also suffer from the counterparty risk as in case of default by one party, there is no settlement guarantee as they are not traded on the exchange.
What are future contracts? Future Contracts have come into existence to tide over the problems of the forward contracts. Future contracts are standardized contracts with standard conditions and terms. They are traded on the stock exchange and settlement of the contracts takes place through the clearing corporation of the stock exchange, which assumes the counterparty risk. This it acts as a buyer to the seller and a seller to the buyer and in case of default of any of the parties, the settlement is guaranteed by the clearing corporation. What is an Index future Contract? An Index future contract is where the underlying security is not an individual share but the Index such as Sensex, Nifty, IT Index, Bank Index and so on. These contracts derive their value from the value of the underlying index. |
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