The below are the most important concepts one has to understand for better clarity of derivatives.
Let us review some introductory concepts pertaining to investment opportunities and investors. Many of these ideas may already be familiar and usually are applied in the context of trading stocks and bonds. These concepts also apply with slight modifications to trading in derivatives.
7.1 Spot
The spot market or cash market is a public financial market in which financial instruments or commodities are traded for immediate delivery. It contrasts with a futures market, in which delivery is due at a later date.
7.2 Settlement date
The date on which a trade (bonds, equities, foreign exchange, commodities, etc.) settles. That is, the actual day on which transfer of cash or assets is completed and is usually a few days after the trade is done.
7.3 Risk preference
Suppose you were faced with two equally likely outcomes.
If the first outcome occurs, you receive INR 100/-
If the second outcome occurs, you receive INR 200/-.
From eliminatory statistics, you know that the expected outcome is INR 100 * (0.5) + INR 200*(0.5) = INR 150/- which is the amount you would expect to receive on an average after playing many times. How much would you be willing to pay to take this risk?
If you say INR 150/- you are not recognizing the risk inherent in the situation you are simply saying that a fair trade would be for you to give up INR150/- for the chance to make INR 150/- on average.
You would be described as risk neutral,meaning that you are indifferent to the risk. Most individuals, however, would not find this a fair trade. They recognize that the INR 150/- you pay is given up for certain, while the INR 150/- you expect to receive is earned only on average. In fact, if you play twice, lose INR 150/- once and then gain it back, you will feel worse than if you had not played.
Thus, we say that most individuals have risk aversion. They would pay less them INR 150/- to take this risk. How much less depends on how risk averse they are.
People differ in their degrees of risk aversion. But let us say you would pay INR 125/-. Then the difference between INR 150 and 125 is considered the risk premium. This is the additional return you expect to earn to justify taking the risk.
Although most individuals are indeed risk averse, it may surprise you to find that in the world of derivative market, we can actually pretend that most people are risk neutral. No, we are not making some heroic, but unrealistic assumption. It turns out that we obtain the same results in a world of risk aversion as we do in a world of risk neutrality. Although this is a useful point in understanding derivative markets, we shall not explore it in much depth.