What are Derivatives?

A: 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 Ex-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:
A: Anil buys a futures contract in the scrip "Satyam Computers". He will make a profit of
Rs.500 if the price of Satyam Computers rises by Rs 500. If the price remains unchanged Anil
will receive nothing. If the stock price of Satyam Computers falls by Rs 800 he will lose Rs 800.
As we can see, the above contract depends upon the price of the Satyam Computers scrip,
which is the underlying security. Similarly, futures trading can be done on the indices also. Nifty
futures is 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.
What are the different types of Derivatives?
A: Derivatives are basically classified into the following:
Futures /Forwards

Options

Swaps

What are Futures?
A: 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 of futures trading:

Case1:

Ravi wants to buy a Laptop, which costs Rs 50,000 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 Lap tops may increase due to increase in input/Manufacturing costs .To be
on the safer side, Ravi enters into a contract with the Laptop Manufacturer stating that 2
months from now he will buy the Laptop for Rs 50,000. In other words he is being cautious and
agrees to buy the Laptop at today's price 2 months from now.The forward contract thus
entered into will be settled at maturity. The manufacturer will deliver the asset to Ravi at the
end of two months and Ravi 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?
A: 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?
A: Lot size refers to the quantity in which an investor in the markets can trade in a derivative of
a particular scrip.For Ex-Nifty Futures have a lot size of 100 or multiples of 100.Hence if a
person were to buy 1 lot of Nifty Futures , the value would be 100*Nifty Index Value at that
point of time.

Similarly lots of other scrips 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 an 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 Trading?
A: 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.

What are the uses of Derivatives? What are the various derivative strategies that I can use?
A: Derivatives have a multitude of uses namely:

a) Hedging

b) Speculation &

c) Arbitrage