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Topic:- Derivatives
Submitted by: Parneet Kaur(175) Puneet Kumar (177) Labpreet Singh (172)
Features of Derivatives
Derivative are of three kinds future or forward contract, options and swaps and underlying assets can be foreign exchange, equity, commodities markets or financial bearing assets. As all transactions in derivatives takes place in future specific dates it is easier to short sell then doing the same in cash markets because an individual can take of markets and take the position accordingly because one has more time in derivatives. Since derivatives have standardized terms due to which it has low counterparty risk, also transactions costs are low in derivative market and hence they tend to be more liquid and one can take large positions in derivative markets quite easily. When value of underlying assets change then value of derivatives also changes and hence one can construct portfolio which is needed by one and that too without having the underlying asset. So for example if one want to buy some stock and short the market then he can buy the future of a stock and at the same time short sell the market without having to buy or sell the underlying assets.
Characteristics
Contd. Measure to hedge against the price risk. Lowest possible Transaction cost/ Liquidity. These can be closely matched with specific portfolio requirements. Close relation with underlying assets.
Why Derivatives
Speculate Hedge a portfolio of shares, bonds, foreign currency. Undertake arbitrage- i.e. benefits from mispricing. Engineer or structure desired positions.
Categorization / Types
Derivatives are usually broadly categorized by the: Relationship between the underlying and the derivative (e.g., forward, option, swap) type of underlying (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives or credit derivatives) market in which they trade (e.g., exchange-traded or overthe-counter) pay-off profile (Some derivatives have non-linear payoff diagrams due to embedded optionality) Another arbitrary distinction is between: 1) vanilla derivatives (simple and more common) and 2) exotic derivatives (more complicated and specialized) There is no definitive rule for distinguishing one from the other, so the distinction is mostly a matter of custom.
Instruments
Derivative instruments can be divided into exchange-traded derivatives and over-thecounter (OTC) derivatives
Contd.
Types of OTC
Exotic options
Contd.
Types of ETD ETD (Exchange Traded derivatives)
Future Contracts
Options
Contd.
Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets. More complex derivatives can be created by combining the elements of these basic types. For example, the holder of a swaption has the right, but not the obligation, to enter into a swap on or before a specified future date.
Uses
Derivatives are used by investors to provide leverage or gearing, such that a small movement in the underlying value can cause a large difference in the value of the derivative speculate and to make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level) hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out obtain exposure to underlying where it is not possible to trade in the underlying (e.g., weather derivatives) create option ability where the value of the derivative is linked to a specific condition or event (e.g., the underlying reaching a specific price level)
Advantages
They are easier to buy and sell than the underlying shares; They are a useful alternative to holding the underlying shares, which are often difficult to obtain; Gearing can be achieved through their use (exposure to a stock can be achieved without huge amounts of capital outlay). Flexibility. Risk reduction.
Disadvantages
Credit Risk/Large notional Value. Crimes . Interest rate. Leverage of economys Debt.
Conclusion
Derivatives are gaining popularity day by day and are used successfully through out the world, these are providing substitute for badla system. These are providing hedge open position in both cash and future markets.