Derivatives & Contracts – RBI Grade B Phase 2

Derivatives

A derivative is an instrument whose value is derived from the value of one or more underlying assets.Therefore the underlying asset determines the price and if the price of the asset changes, the derivative changes along with it.. The most common examples of derivative instruments are Forwards, Futures, and Swaps.

Forward

A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. The main features are

There must be an agreement

And the agreement is to for buy or sell the underlying assets

The transaction is takes for predetermined future date

The price is also predetermined for this transactionA future contract is effectively a forward contract which is standardized in nature and is exchange traded. Future contracts remove the lacunas of forward contracts as they are not exposed to counterparty risk and are also much more liquid. The standardization of the contract is with respect to

Swaps

A swap is a derivative in which two counterparties agree to exchange one stream of cash flows against another stream. Swaps can be used to hedge interest rate risks or to speculate on changes in the underlying prices. Since swaps are not used in equity markets in India, we would not go into further details of swaps.

Future contracts

A future contract is effectively a forward contract which is standardized in nature and is exchange traded. Future contracts remove the lacunas of forward contracts as they are not exposed to counterparty risk and are also much more liquid.

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