Business Times

Part one – derivative basic terms

Derivatives Demystified
By Upul Arunajith

As in any field, be it Medicine, Accounting, or even Sports, there are numerous technical terms that are not within the comprehension of the average person. This is no indication that these terms are complicated. Derivative terms are no exception to the above. Anyone who is interested can master the subject with the passage of time. Provided below is a list of the basic terms as would apply to Derivatives.

Financial instrument that derives its value from another underlying product i.e, gold, oil, or equity.

Forward Contract:
Agreement between two parties (“buyer” and “seller”) to buy and sell a particular product (wheat) on a Future date for an agreed upon price that is loosely defined.

Futures Contract:
A structured forward contract that trades in an organized exchange and its performance guaranteed by a clearing house corporation.

Process of transferring the unwanted risk associated with a future purchase / sale of a product in the spot market (cash market) by taking an opposite position in the derivatives market. Akin to an insurance policy.

Controlling a large exposure with a relatively small amount of cash outlay.

Ability to buy / sell securities in enough quantity without impacting the bid - offer price.

Mark to Market:
The process of valuing the portfolio daily to the market price and the gains and losses recognized.

A deposit of good faith the Derivatives clearing house corporation requires the buyers and sellers of Futures contracts to pay upfront and maintain throughout the life of the contract

Option Contract:
Instrument that gives the holder of the contract the right to exercise but not the obligation, trades in an exchange and performance guaranteed by the clearing house corporation.

Short Selling:
Process of borrowing a stock to sell and selling at a high price in anticipation of buying it back at a lower price when the spot market price drops in the future

Process of taking a calculated risk and taking a position in the market on the assumption the market will move in their favour based on historical and implied market data.

Strike Price:
The price at which the underlying product can be bought / sold by exercising the Option contract. Same as the exercise price.

Zero sum Game:
Derivative facilitates a shift of gains and losses. One party’s win is another party’s loss. No win-win outcome.

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Part one – derivative basic terms


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