Answer Posted / arvind kulkarni

Derivatives—contracts that gamble on the future prices of
assets--are secondary assets, such as options and futures,
which derive their value from primary assets, such as
currency, commodities, stocks, and bonds. The current price
of an asset is determined by the market demand for and
supply of the asset; however, the future price of an asset
typically remains unknown. A week or a month in the future,
the price may increase, decrease, or remain the same.
Buyers and sellers often like to hedge their bets against
this uncertainty about future price by making a contract
for future trading at a specified price. The contract—a
financial instrument--is called a derivative.

A future or forward contract is formed when both the buyer
and the seller are committed and legally obliged to
exchange the underlying asset when the contract matures. An
option, on the other hand, is a contract that gives its
owner the right, but not the obligation, to buy or sell the
underlying asset on or before a given date at the agreed-
upon price.
Example
Suppose you expect that six months from now the price of
the U.S. dollar with respect to the Canadian dollar will be
higher than it is today, and would like to purchase US
$1,000 six months from now at today’s rate. Suppose the
current price of US $1,000 is CAN $1,200.

Another person expects that the price of the U.S. dollar
will decrease over the coming six months, and is willing to
sell U.S. dollars at today’s rate. Both of you can make a
contract that will be exercised six months from now.
Interestingly, neither of you needs to put down any
currency today when signing the contract. When the contract
matures, transactions must be carried out at the agreed-
upon rate. This type of contract is called a forward
contract.

Alternatively, suppose the contract is sold for a non-
refundable fee of $25. If the price of the U.S. dollar goes
up, you are likely to exercise your right. On the other
hand, if the price of the U.S. dollar goes down, you will
be better off not exercising your right; in this case, you
are losing only the fee. This type of contract is known as
a ’call option.’ Similarly, a ’put option’ gives the owner
the right to sell rather than buy.

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