Options are the outcome of the excessive search for better financial instruments. They belong to a class of instruments called derivatives. An option is an alternative that is created through a financial contract. Today, options are available on index, stocks and foriegn currencies. Though they offer unlimited profit with limited downside potential, one needs to take utmost care while dealing with options.
With the announcement of Interest Rate Futures, (IRFs), the RBI has gone one step forward in introducing derivatives in the Indian debt market. Earlier, the RBI had introduced Interest Rate Swaps, and with the announcement of IRFs , the debt market players in India now have two derivatives, based on interest rates. The next derivatives that should appear in the debt market are `Options'. This article attempts to give a basic idea on these derivatives, which are very popular in developed markets.
A derivative is basically a contract that derives its value from an underlying asset. A commodity derivative is thus a contract, the financial status of which is derived or arrived at from the price movement of the underlying commodity. To illustrate, a contract between a farmer and trader involving the sale of 100 kilo of pepper @ Rs.100 per kg on December 15, 2003, is a derivative contract. Whether the spot (market) price is up or down on December 15, 2003, the farmer will get Rs. 100 per kilo from the trader. If the spot price moves below Rs. 100, the farmer is protected against the fall in price (traders' loss) and if the spot price moves up, (above Rs. 100) the farmer will not get the benefit of price rise (traders' profit).
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