WHAT IS DERIVATIVE?
Let me explain this with an example
Let’s say we have a normal Cricket bat and another bat with the M S Dhoni Signature on it.
Which one do you think will have more value?
Obviously, The one with the signature of M S Dhoni on it will be more valuable than normal bats.
In this case, What we can see is that the value of the bat is derived from the person’s signature present on it.
So, the Derivative is the bat and the Underlying asset is the signature of MS Dhoni because the signature is deriving the value of the bat.
Now, let’s get to know what is Forward and Futures contracts are
Let me explain this with an analogy.
Suppose we have to construct a house after 3 months one of the things which is required is iron for building it.
There are three cases for prices of Iron:
Case 1: Iron price will increase
Case 2: Iron price will decrease
Case 3: Iron price will remain the same.
Now let’s think from the perspective of Consumer and Dealer
Case 1: We as a consumer are in fear that the price of iron will increase after 3 months.
Case 2: The dealer is in fear that the price of the iron will decrease in the next 3 months due to sales going down.
So to avoid this fluctuation in prices we and the dealer can do a forward contract.
In this, Both the parties will sign a deal in which they will agree that whatever price of iron will be after 3 months we are going to buy and sell the Iron at the current market price.
Following are scenarios that can happen after 3 months :
Scenario 1: Price of Iron increase
In this, we will be in profit,
Because we bought that iron at a lower price than the current market price and the dealer will make a loss because he is selling the iron at a lower price than the current market price,
Scenario 2: Price of iron will decrease
In this, we are going to make a loss,
Because the current market price of Iron is low but we are buying that at higher rates and the dealer is making a profit because he is selling it at a higher price than the market.
What problem you can see in this contract
Chances of fraud increase because no one is regulating the contract.
So similar things happen in the futures market the only difference is that it is regulated by the SEBI.
Ok, don’t worry I will explain how?
Once again take an analogy
There is a MacBook which costs around 1 lakhs and There is one coupon.
1. Whoever has this coupon will get that MacBook next month.
2. You can buy and sell this coupon If you have it.
So, this coupon is deriving its value from the Macbook., Macbook is Underlying assets and the coupon is derivative.
Therefore, The coupon will carry its own value, and people will Buy/Sell that coupon because that will give you a laptop.
THE QUESTION MUST BE ARISING IN YOUR MIND
Q. Why will people buy the coupon instead of the laptop?
Ans: coupon value is cheaper than a laptop so people will prefer to have a coupon instead of a laptop
Q. Why will they buy and sell the coupon if they are getting a laptop at the end of the month?
Ans: Simply because between that month the price of mac can increase or decrease which will lead the coupon price to increase or decrease.
So one can book profit and sell that token instead of taking the laptop at the end of the month.
Similarly, these things happen in derivative markets
Let’s take an example of reliance stock from this reliance stock which is our underlying assets we are deriving Reliance futures from reliance.
From the above analogy only just replace the MacBook with reliance stock which is the underlying asset and The coupon replaces that with Reliance futures.
These are the cases
1. If the price of reliance stock increases then the reliance future also increases.
2. If the price of the reliance decreases the coupon value also reduces.
3. If prices remain constant, the future will behave the same.
and you know more than reliance stock people trade in reliance future.
1. Because they provide leverage benefits to traders
2. More liquidity
3. Transaction cost is low compared to the spot market.
For Option contracts Stay Tuned!!!
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