Basics of Stock Market – Part 5

Hello Readers,

Hope you have read the previous parts of this series, if not then click here:

In the previous parts, we had discussed about the shares, share issue process, Bonds and Loans.

We were discussing about Long term Debt Asset class under which we had discussed completely about the “Other Cash” category which further includes Loans.

Don’t get confused. Let me remind you this hierarchy again.

The parent is Long Term Debt

His child is Exchange-traded derivatives

His grandchildren are “Bond futures” and “Options on bond futures”

In this part, we will discuss about the further categories of Long term debt asset class.

Now, the 3rd child of Long term debt asset class is Exchange-traded derivatives.

This Exchange-traded derivative includes “Bond futures” and “Options on bond futures”.  (That means, the grandchildren of Long term debt are “Bond futures” and “Options on bond futures”).

(you can also see the table in the 1^st part of the this series for better understanding)

Let’s start:

First of all what are derivatives?

A derivative is a security with a price that is dependent upon or derived from one or more underlying assets. The derivative itself is a contract between two or more parties based upon the asset or assets. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.

What are Bond Futures?

Bond futures are contractual obligations for the contract holder to purchase or sell a bond on a specified date at a predetermined price. A bond future can be bought in a futures exchange market and the prices and dates are determined at the time the future is purchased.

Here the future exchange market refers to the marketplace where these contracts are traded.

In the above para, we have discussed about the two types of Bond futures:

• Which will be traded at the certain specified future date and at predetermined price i.e. the price is already decided on the date of contract.
• Which will be traded at the certain specified future date at the future exchange market but the price will be the price of that bond on that future date.

However, the 2^nd form of derivative can be risky because it involves trading at a future date with only current information. The risk is potentially unlimited, for either the buyer or seller of the bond because the price of the underlying bond may change drastically between the exercise date and the initial agreement.

For example: You have entered in a contract with a certain person on 29/5/2017 to purchase his bonds. The date of purchasing that bond is determined at 07/07/2017. Now, the price at which that bond will be traded will depends upon the price of that bond on that future date.

If the price of the bond on 29/5/2017 was Rs. 150 and the price of same bonds is Rs. 1380 on 07/07/2017 i.e. the purchase date, then in that case it will become more risky for you because the price has drastically changed.

For better understanding of the concept, let’s understand what are the Future Contracts and how it works:

Meaning:

A futures contract is a legal agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a predetermined price at a specified time in the future.

 How it works:

Future contracts are used by two categories of market participants: Hedgers & Speculators.

The producers and users of commodities who use the futures market are called hedgers. Buying and selling futures as a risk management tool is called hedging.

Producers or purchasers of an underlying asset hedge or guarantee the price at which the commodity is sold or purchased

Speculators are people who analyze and forecast futures price movement, trading contracts with the hope of making a profit. Speculators put their money at risk and must be prepared to accept outright losses in the futures market.

Now here we start our discussion on  2^nd grandchild of Long Term Debt i.e. “Options on Bond Futures:”

As per the investopedia, An option on a futures contract gives the holder the right to enter into a specified futures contract. If the option is exercised, the initial holder of the option would enter into the long side of the contract and would buy the underlying asset at the futures price. A short option on a futures contract lets an investor enter into a futures contract as the short who would be required to sell the underlying asset on the future date at the specified price.

Now what that means……..?

Let me help you understand with the help of an example:

Just imagine, you went to a provisional store and bought 100 packets of certain item. The shopkeeper along with your ordered quantity gave you an option to buy more packets at 50% discount within a week.

Now, here just try to understand the meaning of Option. As per the option given by shopkeeper, it implies an additional benefit i.e. option is a kind of additional benefit along with the goods purchased.

Now relate the same with the Bond futures.

What is the purpose of option here?

The futures specified in the option contract allow someone to enter into the specified futures contract when the option expires.

It means that in the case of Bond futures, the holder is awarded with an option that he can enter into the contract at the end of the option. The option can be a contract of purchase or sale of bonds.

In options trading, the option holder has the right, but not the obligation, to buy or sell the underlying instrument at a specified price on or before a specified date in the future. If the holder decides to buy or sell the underlying instrument (rather than allowing the contract to expire worthless or closing out the position), he or she will exercise the option, and make use of the right available in the contract.

Here we end our concept related to Exchange-traded derivatives under the head Long term debt.

Kindly Note: The author’s intention is only confined to create awareness about the stock market. Do not take anything as any investment advice as the author do not deals in investment advisory services.