Derivatives Basics

By: Ajay Mishra

JSSGIW faculty of Management,Bhopal

Introduction

In business decisions are made in the presence

of RISK
A decision maker confront two types of risk

Business
Risk

Financial
Risk

Business Risks
Uncertainity

of future

sales.
Cost

of Inputs.

Financial Risks
Interest

rates
Exchange rates
Stock prices
Commodity prices

 Our

financial system is replete

with risk
It also provides a means of
dealing with risk in form of
deriavatives.

Derivatves

They are the financial instruments whose

returns are derived from those of other
financial instruments.
Their performance depends on how other
financial instruments performs.
Derivatives serve a valuable purpose in
providing a means of managing financial risk.

Derivatives

By using derivatives companies and individuals can

transfer, for a price, any undesired risk to other
parties.
The vast majority of derivatives, however created in
private transactions in over the counter markets.
Derivative can be based on real assets, which are
physical assets and include agricultural
commodities, metals, and source of energy.
It also be based on financial assets which are Stocks,
Bons/Loans and currencies.

Derivative Markets and Instruments

What is an Instrument?

Instrument

An asset or an item of ownership

Having a positive monetary value

A Liability or an item of ownership

having a negative monetary value

Derivative Markets and Instruments

A security is a tradable instrument

representing a claim on a group of assets.
We know that A contract is an enforceable
legal agreement.
For a asset transaction the required asset be
delivered immediately or shortly thereafter.
Payment usually is made immediately or
sometime credit arrangements are made.

Derivative Markets and Instruments

On the first basis the markets are known as

cash market or spot market. Where:
Sale is made

Payment is remitted

Goods or security is delivered

Derivative Markets and Instruments

For other type of arrangements which allow

the buyer or seller to choose whether or not to
go through with the sale.

These type of arrangements are conducted in

derivatives market.

Derivative Markets and Instruments

Derivatives markets are market for

contractual instrument whose performance is
determined by the way in which another
instrument or asset performs.
Like all other contracts they are also
agreements between two parties as a buyer
and a seller, with a price where the buyers try
to buy as cheaply as possible and sellers try to
sell as dearly as possible,

Derivative Markets and Instruments

Various types of
derivative contracts

OPTIONS,
OPTIONS, FORWARDS
FORWARDS
FUTURES
FUTURES AND
AND SWAPS
SWAPS AND
AND
RELATED
RELATED DERIVATIVES
DERIVATIVES

Option (Introduction)

Contract between two parties a buyer and a seller.

Gives the buyer the right but not the to obligation,
to purchase or sell something at a later date at a price
agreed upon today
Buyer pays a sum of money called price or premium
Seller stands ready to sell or buy according to the
terms and when the buyer so desires.

Option (Introduction)

An option to buy something is referred to a CALL

An option to sell something is called a
PUT.
Major options are for the purchase or sale of
financial assets such as stocks and bonds, but there
are also options on future contracts, metals, and
currencies and even loan guarantees and insurance
are forms of options.
Stock itself is equivalent to an option.

Forward Contracts (Introduction)

Contract between two Parties to purchase or

sell something at a later date at a price agreed
upon today
The two parties in a forward contract incur
the obligation to ultimately buy and sell the
good
They trade strictly in an over the counter
market consisting of direct communication.

Futures Contracts (Introduction)

Contract between two parties to buy or sell

something at a future date at a price agreed upon
today.
The contract trades on a future exchange and is
subject to a daily settlement procedure.
Unlike forward contracts however the future
contracts trade on organised exchanges.
The buyer of a future contract who has the obligation
to buy the good at the later date, can sell the
contract in future market, which relieves him of the
obligation. Likewise the seller can buy the contract
back relieving him of the obligation to sell the good.

Swaps and other Derivatives

A Swap is a contract in which two parties agree to

exchange cash flows.
The firm and the dealer in effect swap cash flow
streams. Depending on what later happens to price or
interest rates.
In this one party might gain at the expense of others.
An option to enter into a swap is called swaption.

Return and Risk

Return
Return

RISK