Derivatives markets

➢The derivatives market refers to the financial market for financial derivatives.

➢ They are financial instruments whose value derived from the value of the underlying financial
instruments.

➢They can be based on different types of assets, such as equity and commodities, interest rates,
indexes and so on.
 Derivatives markets:
Financial Derivatives:

1. Options: financial derivative contracts that give the buyer the right, but not the obligation, to buy or sell an underlying
asset at a specific price (referred to as the strike price) during a specific period of time.
For example, assume a trader buys one call option contract on ABC stock with a strike price of $25. He pays $150 for the
option. On the option’s expiration date, ABC stock shares are selling for $35. The buyer/holder of the option exercises his
right to purchase 100 shares of ABC at $25 a share (the option’s strike price). He immediately sells the shares at the current
market price of $35 per share. He paid $2,500 for the 100 shares ($25 x 100) and sells the shares for $3,500 ($35 x 100).
His profit from the option is $1,000 ($3,500 – $2,500), minus the $150 premium paid for the option. Thus, his net profit,
excluding transaction costs, is $850 ($1,000 – $150). That’s a very nice return on investment (ROI) for just a $150
investment.
 Derivatives markets:
Financial Derivatives:

2. Futures: standardized contracts that allow the holder of the contract to buy or sell the respective underlying asset at
an agreed price on a specific date. The parties involved in a futures contract not only possess the right but also are
under the obligation, to carry out the contract as agreed.

3. Forwards: they are similar to futures contracts in the sense that the holder of the contract possess not only the right
but is also under the obligation to carry out the contract as agreed. However, forwards contracts are over the counter
products, which means they are not regulated and are not bound by specific trading rules and regulations.

4. Swaps: derivative contracts that involve two holders, or parties to the contract, to exchange financial obligations.
Interest rate swaps are the most common swaps contracts entered into by investors.
 Derivatives markets:
Motivations behind transactions in financial derivatives:
1. Financial speculation involves the buying, holding, selling, and short-selling of stocks, bonds, commodities,
currencies, real estate, derivatives, or of any other financial instrument, in order to profit from fluctuations
in its price.
2. Hedging involves engaging in a financial transaction that offsets a long position by taking an additional
short position, or offsets a short position by taking an additional long position, with the aim is to remove
unwanted risk while still allowing some profit to be made from the transaction.
3. Arbitrage is the strategy of taking advantage of price differences in different markets for the same asset.
For it to take place, there must be a situation of at least two equivalent assets with differing prices.
 2. INTRODUCTION TO
FINANCIAL INTERMEDIARIES
Why do financial intermediaries exist?

Transaction costs

Financial
Asymmetric
market information
failures

Uncertainty
Financial intermediaries
2. COMMERCIAL BANKS
 Introduction to the banking industry:
Are banks different?
64%

93%
High leverage

More
Banks stakeholder

More regulated
 Banks’ traditional business is lending which
generates income for banks: As loans have to be
funded, the difference (or spread) between the
Commercial banks lending and borrowing rates determines a bank’ s
profitability.

Semplified Semplified income

Balance sheet statement

Assets Liabilities Costs Revenues

Reserves Equity Interests Interest

expenses income
Loans Deposits

➢Banks are financial intermediaries that accept deposits from individuals and institutions and make loans.

10
 Commercial Banks
➢ Banks raise funds primarily by issuing checkable deposits (deposits on which checks can be written), savings deposits

(deposits that are payable on demand but do not allow their owner to write checks), and time deposits (deposits with

fixed terms to maturity). They then use these funds to make commercial, consumer, and mortgage loans and to buy

government securities and municipal bonds. The difference (or spread) between the lending and borrowing rates

determines a bank’ s profitability.

➢ Banks also profit from various fee-earning activities like capital market transactions, such as underwriting and trading,

and derivatives transactions.