Introduction to derivatives

Credit Assignment

By

MUHAMMAD BILAL 18 BBA 001

Business Administration (Financial management)

Under the supervision of

SIR MUHIBULLAH NAHRIO

SBBU Business Administration

SHAHEED BENAZIR BHUTTO UNIVERSITY, SANGHAR CAMPUS

Date of the submission

7–JUN– 2020
What is derivatives

A derivative security is a financial contract between two parties for buying or selling a property,
assets, commodity, or other security at a predetermined price within a specific time period.
Generally, a derivative security is a contract representing a group of underlying assets. The most
common underlying assets are bonds, stocks, commodities, currencies, market index and interest
rates. The value of a derivative security is derived from or dependent on the performance of
underlying assets or group of assets. These underlying assets are traded separately from the
derivatives.

Hedgers

They are the investors who hedge a risk. And, hedging means reducing a risk with a position that
will help tackle risky factors or influences arising out of current market conditions. A hedger will
try to achieve a position which is opposite to the risk he takes. This investor will try to reduce or
eliminate price risk conditions in conditions of price volatility in the market.

Speculators

Speculators invest in the derivatives markets by constantly studying the price movements and
taking a position that gives them maximum gains. Their intention is primarily to make maximum
profits. Compared to Hedgers, they tend to take a higher risk which can lead to maximum returns
or huge loss in the markets. Speculators have to predict the future trends in the market as
accurately as possible to place themselves in the right position in the market.

Arbitrageurs

Arbitrageurs operate in a swift manner with almost instant decisions being made to earn positive
gains without taking any risk. They increase the liquidity in the market by grabbing the time-
bound arbitrage opportunities in the market and trading the derivatives instruments immediately.
With arbitrageurs, the investors don’t lose money, earn positive gains and trade with no risk.
Arbitrageurs take advantage of the price differences that exist for a share in different markets for
a limited time.
What are the types of derivatives?

Forward contract

A forward contract is nothing but an agreement to sell something at a future date. The price at
which this transaction will take place is decided in the present.

However, a forward contract takes place between two counterparties. This means that the
exchange is not an intermediary to these transactions. Hence, there is an increase chance of
counterparty credit risk. Also, before the internet age, finding an interested counterparty was a
difficult proposition. Another point that needs to be noticed is that if these contracts have to be
reversed before their expiration, the terms may not be favorable since each party has one and
only option i.e. to deal with the other party. The details of the forward contracts are privileged
information for both the parties involved and they do not have any compulsion to release this
information in the public domain.

Future contract

In future contract one party agrees to sell an asset to the other on a fixed price within an agreed
upon time period. 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. these contracts are of standard nature and the agreement cannot be
modified in any way. Exchange contracts come in a pre-decided format, pre-decided sizes and
have pre-decided expirations. since these contracts are traded on the exchange they have to
follow a daily settlement procedure meaning that any gains or losses realized on this contract on
a given day have to be settled on that very day.
Option

Option is markedly different from the first two types. In the first two types both the parties were
bound by the contract to discharge a certain duty (buy or sell) at a certain date. The options
contract, on the other hand is asymmetrical. An options contract, binds one party whereas it lets
the other party decide at a later date i.e. at the expiration of the option. So, one party has the
obligation to buy or sell at a later date whereas the other party can make a choice. Obviously the
party that makes a choice has to pay a premium for the privilege. There are two types of options
first is call option, Call option allows you the right but not the obligation to buy something at a
later date at a given price. Second is put option put option gives you the right but not the
obligation to sell something at a later date at a given pre decided price.

Swap

A swap is most commonly used for trading loan terms. Here the two parties signing the contract,
agree to swap their loan terms. Interest rate swap is where one goes from fixed interest rate loan
to variable interest rate loan or the opposite. Someone with a fixed interest rate loan signs the
contract with some having a variable interest rate loan, where other loan terms are similar. The
loan will be in the original borrower’s name but both the parties are obligated to make the
payment towards the other’s loan according to the agreement.