Learn about derivative markets: Forward, futures and options

When it comes to the stock market, there’s more than just equity investing. The fun begins when the derivatives enter the picture. More and more people are getting inclined towards derivative trading as it not only attracts good career opportunities but also opens the door for limitless earning potential. And most importantly, if we are interested in financial instruments, then why not try investment banking (will come to that later)? For now, let’s learn about derivative markets and the instruments that lay the foundation for the same.

What are Derivative Instruments?

Derivative instruments are those instruments that derive their value from an underlying asset. This includes futures, forward and options. Let’s learn about derivative markets in detail:

Forwards

A forward contract is a contract to buy or sell an asset at a specified price on a specified date. In forward contracts, the asset, date and price are already predetermined. Forwards are a great tool to rule out uncertainties and hedge the transaction. Let’s understand with a simple example.

A company has exported certain goods to the USA and is going to receive payment of $1 million after 1 month. However, the company is unsure about the rupee-dollar exchange rate after two months and is fearful that the rupee may appreciate in the future. The current exchange rate is Rs. 82/$. That means, the company will be receiving Rs. 82 million as per the current exchange rate. However, if the rupee appreciates to Rs. 78 after two months, then the company will only receive Rs. 78 million, a flat Rs. 4 million cuts or 4.87% less than the current rate. Therefore, the company is planning to enter into a forward contract whereby it will be selling $1 million to the other party at Rs. 80.5/$ regardless of the exchange rate. Now, if the rupee appreciates to Rs. 78/$, then the company will still be saving $2.5 million (Rs. 80.5 million – Rs. 78 million) because of the forward contract.

Futures

Futures contracts are derivative agreements to buy or sell an underlying asset at a predetermined price and date. Future contracts are similar to forwarding contracts but are more standardised and can be traded in exchanges. Being more standardised and regulated, they overcome the shortcomings of forwarding contracts. For instance, future contracts are not exposed to counterparty risk and are much more liquid as well. They are usually traded in lots. Let’s see a practical example.

Suppose a futures trader buys 1 lot (250 shares) of the November futures contract of TATA Motors Ltd. at a share price of Rs. 300 per share. That means that the trader has agreed to buy 250 shares of TATA Motors at Rs. 300 per share. Now, if the price rises to Rs. 350, then the trader will book a profit of Rs. 50 per share (Rs. 12,500 for the lot). However, if the share price drops to Rs. 270, then the trader will incur a loss of Rs. 30 per share (Rs. 7,500 for the lot).

Options

Options are derivative instruments that provide the option holder with the right but not the obligation to buy or sell an underlying asset at a predetermined price at a future date. The other party (known as the option writer) however is under the obligation to buy or sell the underlying asset if the option holder exercises his option. There are two types of options i.e., the ‘Call’ option and the ‘Put’ option. A call option gives the holder the right to buy an underlying asset at a predetermined price in the future. Whereas, a put option gives the holder the right to sell an underlying asset at a predetermined price in the future. Let’s understand options with an example.

Suppose a trader buys Reliance Call Options with a strike price of Rs. 3000. This gives the trader the right to buy Reliance’s shares at Rs. 3000 per share in the future. Suppose, the price of Reliance’s share increases to Rs. 3200 per share. Therefore, the trader can exercise his option and buy the shares at Rs. 3000 thereby giving a direct gain of Rs. 200. However, if the share price drops to Rs. 2700, the trader can avoid exercising his option. In such a case, the only loss trader would suffer will be the premium paid to purchase the call option.

In a Nutshell

The world of derivative instruments is quite interesting! Most people who love financial markets aspire to a career in investment banking. Investment banking is a large field that provides multiple career opportunities from handling client portfolios to equity research to engaging in complex merger and acquisition transactions and so on.

If you are keen on building a career in the financial domain, then investment banking is what you should be going for. You can enrol in an investment banking course online to begin your education and training. Imarticus Learning provides a comprehensive investment banking certification course to help students not only get the education and training but also provides placement opportunities to kickstart their career. When are you becoming an investment banker?