Investment FAQs – Derivatives

The term ‘Derivative’ indicates that it has no independent value. Its value is entirely ‘derived’ from the value of its underlying asset. The underlying asset can be securities, commodities, bullion, currency, livestock, etc. In other words, Derivative means a forward, future, option or any other hybrid contract of pre-determined duration, which is linked for the purpose of contract fulfillment to the value of a specified real or financial asset.

Derivatives include -

A security derived from a share, loan, and debt instrument whether secured or unsecured, risk instrument or contract for differences or any other form of security. 

Futures Contract means a legally binding agreement to buy or sell the underlying security on a future date. Future contracts are the organised/standardised contracts in terms of quantity, quality (in case of commodities), delivery time and place for settlement on any date in future. The contract expires on a pre-mentioned date which is called the expiry date of the contract. On expiry, futures can be settled by delivering the underlying asset or cash. Cash settlement enables the settlement of obligations arising out of the future/option contract in cash.

Options Contract is a type of contract which gives the buyer/holder of the contract the right (not the obligation) to buy/sell the underlying asset at a pre-determined price within or at the end of a specified period. The buyer / holder of the option purchases the right from the seller/writer for a consideration which is called a Premium. The seller/writer of an option is obligated to settle the option as per the terms of the contract when the buyer/holder exercises his right. The underlying assets are the same as in a futures contract.

An Option to buy is called Call option and option to sell is called Put option. Further, if an option that is exercisable on or before the expiry date is called American option and one that is exercisable only on expiry date, is called European option. The price at which the option is to be exercised is called Strike price or Exercise price.

Futures contract based on an index i.e. the underlying asset is the index, are known as Index Futures Contracts. For example, futures contract on NIFTY Index and SENSEX Index. These contracts derive their value from the value of the underlying index.