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The value of a Derivative is derived from on underlying market. Derivatives always refer to future price.
Derivatives are of two types OTC products and Exchange traded products. The Derivatives that can be directly negotiated and obtained from banks and investment institutions are known as over the counter (OTC) products.
Derivative products can be broadly categorized into Options, Futures & Swaps.
Options refer to contracts where the buyer of an Option has a right but no obligation to exercise the contract.
Put Option gives a right to the holder to sell an underlying product at a pre-fixed rate on a specified date. Call option gives a right to the holder to buy the underlying product at a pre-fixed rate on a specified date or during a specified period. The pre-fixed rate is known as Strike Rate.
Options are two types, an American type option can be executed at any time before expiry date and European type option can be exercised only on expiry date. In India we use only European type of Option.
The option is in the money (ITM), if the strike price is less than the forward rate in case of a Call Option or strike price is more than the forward rate in case of a put option.
The Option is out of Money (OTM) if the strike price is more than the forward rate in case of call option or if the strike price is less than forward rate in case of a put Option.
A Swap is an exchange of cash flow. An interest rate Swap is an exchange of interest flows on an underlying asset or liability.
For USD the bench mark rates are generally LIBOR ( London Inter Bank Offer Rate). MIBOR is used as a base rate for short term and Medium Term lending.
The Interest rate Swaps (IRS) and Forward rate agreements (FRA) were first allowed by RBI in 1998.
Currency and interest rate Swaps with basic structure without in built positions or knock-out levels are plain vanilla type Swaps.
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