What are derivatives?Who are the users and what are the purposes of use?Enumerate the basic differences between cash and derivatives market

(i) A derivative is in essence a ‘claim’ on the underlying asset at a predetermined
price and at a pre-determined future date/ period. The
underplaying asset may be share, share index, currency or commodity like
gold, crude oil etc.
The value of a derivative is entirely dependent on the value of its underlying
asset. Suppose a person buys Reliance equity call option contract (on 1st June,
2005), under this contract he has the right of buying Reliance shares @ Rs.3000
on 25th April 2008; the value of this contract will rise and fall as the spot price

of Reliance equity share rises or falls. Should the spot price of Reliance equity

rise, the value of this option will rise and vice versa. (Remember that value of

option cannot be negative)

Forwards, futures and options are three common derivative instruments.

(ii) Broadly, there are three users of the derivatives:

(a) Hedgers – those who want to hedge their risks.

(b) Speculators : they use the derivatives for making speculation gains.

(c) Arbitragers: they try to make gains arising out of market inefficiencies.

(iii)

Cash market / Derivative market

Full payment for the asset purchased is required./ Either margin or option premium is to be paid (which is only a small fraction of the value of the underlying asset)

No mark-to-market system Mark-to-market is required in case of futures./ This market is for users or investors. This market is for hedgers, speculators and arbitragers.

Transactions re generally delivery based./ Transactions are generally cash settled.

The underlying assets are tangible assets./ In some cases the underlying assets are intangible assets like share index.

There is no concept of market lot. There is the concept of market lot ( also refereed as contract size)

While purchasing in this market, one has to consider his payment capacity, besides the consideration of risk

bearing capacity./ While entering in this market, one has to consider his risk bearing capacity.