Essential of Islamic Finance

Assignment
Dated 20-Mar-2010

Submitted to : Irshad Ahmed

From :Safdar Bin Zafar

ID.2822
Class.(Sat 6:30)
Derivative
What Does Derivative Mean?

A security whose price is dependent upon or derived from one or more

underlying assets. The derivative itself is merely a contract between two or more
parties. Its value is determined by fluctuations in the underlying asset. The most
common underlying assets include stock bonds, commodities, currencies,
interest rates and market indexes. Most derivatives are characterized by high
leverage.

Explain

Futures contracts, forward contracts, options and swaps are the most common
types of derivatives. Derivatives are contracts and can be used as an underlying
asset. There are even derivatives based on weather data, such as the amount of
rain or the number of sunny days in a particular region.

Derivatives are generally used as an instrument to hedge risk, but can also be
used for speculative purposes. For example, a European investor purchasing
shares of an American company off of an American exchange (using U.S. dollars
to do so) would be exposed to exchange-rate risk while holding that stock. To
hedge this risk, the investor could purchase currency futures to lock in a specified
exchange rate for the future stock sale and currency conversion back into Euros.

Common derivative contract types

There are three major classes of derivatives:

1. Futures/Forwards are contracts to buy or sell an asset on or before a

future date at a price specified today. A futures contract differs from a
forward contract in that the futures contract is a standardized contract
written by a clearing house that operates an exchange where the contract
can be bought and sold, while a forward contract is a non-standardized
contract written by the parties themselves.
2. Options are contracts that give the owner the right, but not the obligation,
to buy (in the case of a call option) or sell (in the case of a put option) an
asset. The price at which the sale takes place is known as the strike price,
and is specified at the time the parties enter into the option. The option
contract also specifies a maturity date. In the case of a European option,
the owner has the right to require the sale to take place on (but not before)
the maturity date; in the case of an American option, the owner can
require the sale to take place at any time up to the maturity date. If the
owner of the contract exercises this right, the counterparty has the
obligation to carry out the transaction.
 3. 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.

Examples

The overall derivatives market has five major classes of underlying asset:

 interest rate derivatives (the largest)

 foreign exchange derivatives
 credit derivatives
 equity derivatives
 commodity derivatives

Benefits

Nevertheless, the use of derivatives also has its benefits:

 Derivatives facilitate the buying and selling of risk and many people
consider this to have a positive impact on the economic system. Although
someone loses money while someone else gains money with a derivative,
under normal circumstances, trading in derivatives should not adversely
affect the economic system because it is not zero sum in utility.
 Former Federal Reserve Board chairman Alan Greenspan commented in
2003 that he believed that the use of derivatives has softened the impact
of the economic downturn at the beginning of the 21st century

Criticisms
The use of derivatives can result in large losses because of the use of leverage,
or borrowing. Derivatives allow investors to earn large returns from small
movements in the underlying asset's price. However, investors could lose large
amounts if the price of the underlying moves against them significantly. There
have been several instances of massive losses in derivative markets