OTC MARKET #
OTC Market is customized trading market which utilizes telephone & computers to make trade. Advantage:- Terms are not specified, hence participants have more flexibility to negotiate. Disadvantage:- The credit risk is higher.
OPTION CONTRACT #
Option contract gives the option buyer the right to buy (sell) an asset at the exercise price from (to) the option seller.
Call option: Gives the option holder the right to buy the underlying asset at a specified price.
Put option: Gives the option holder the right to sell the underlying asset at a specified price.
Payoff & profit of call option & put option
Where X = Exercise price/ Strike price of option,
ST= Stock price at Maturity,
C= Call premium
P= Put premium
FORWARD CONTRACT #
It is a contract between two parties to buy or to sell an asset at a specified future time at a price agreed today.
Payoff of long position = St – K
Payoff of short position = K – St
Where K = delivery price
FUTURES CONTRACT #
It is a more formalized, legally binding agreement to buy/sell a commodity/ financial instrument at a price agreed today but delivered and paid on a later date.
HEDGING STRATEGIES #
Hedgers use forward contracts & options to reduce or eliminate financial exposure by entering into an offsetting position.
SPECULATIVE STRATEGIES #
Speculators use derivatives to make bets on the market. Risk is higher than average, in return for a higher– than– average profit potential. Speculation requires limited amount of initial investment creating significant leverage.
ARBITRAGE OPPORTUNITIES #
Arbitrageurs earn a risk-free profit through the discovery and manipulation of mis-priced securities by entering into equivalent offsetting positions. Arbitrage opportunities does not last long as supply & demand forces eliminates the pricing differences.
SOME OTHER IMPORTANT DERIVATIVE TERMS #
MARKET MAKER: A dealer in securities or other assets who undertakes to buy or sell at specified prices at all time.
SPOT CONTRACT: An agreement to buy/sell an asset today.
AMERICAN OPTIONS: Contract can be exercised any time between issue date & expiration date.
EUROPEAN OPTIONS: Contract can be exercised only at the time of expiration.