Derivatives Topic Finance and Management

Contents

Derivatives ....................................................................................................................................

1 Meaning 

2 Types of Derivatives 

2.1 Forwards 

2.2 Futures 

2.3 Swaps 

2.4 Options 

3 Some related concepts 

3.1 OTC Derivatives and Exchange Traded Derivatives 

3.2 Long or Short a Derivative 

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 Derivatives Topic Finance and Management

Derivatives

Meaning

A derivative is a contract between two or more parties whose value is based on an agreed-
upon underlying nancial asset or set of assets.

Types of Derivatives

There are four types of Derivatives:

1. Futures–The underlying asset can be Stocks, Currency, Commodities, Interest Rate

2. Options-The underlying asset can be Stocks, Currency, Commodities, Interest Rate
3. Forwards-The underlying asset can be Stocks, Currency, Commodities, Interest Rate
4. Swaps–The underlying asset can be only currency and Interest Rate

Forwards

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 Derivatives Topic Finance and Management

Futures

A futures contract is a contract between two parties where both parties agree to buy and sell a
particular asset of speci c quantity and at a predetermined price, at a speci ed date in future.

 The futures contract is held at a recognized stock exchange. The exchange acts as mediator
and facilitator between the parties.
 I n the beginning both the parties are required by the exchange to put beforehand a nominal
account as part of contract known as the margin.
 Since the futures prices are bound to change every day, the differences in prices are settled
on daily basis from the margin. If the margin is used up, the contractee has to replenish the
margin back in the account. This process is called marking to market. Thus, on the day of
delivery it is only the spot price that is used to decide the difference as all other differences
had been previously settled.

Forwards vs Futures

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 Derivatives Topic Finance and Management

Swaps

A swap is a derivative contract through which two parties exchange the cash ows or liabilities
from two different nancial instruments.

Types of Swaps:

1) Interest Rate Swaps

In an interest rate swap, the parties exchange cash ows based on a notional principal amount
(this amount is not actually exchanged) in order to hedge against interest rate risk or to
speculate.

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 Derivatives Topic Finance and Management

For example

 Party Y agrees to pay Party X a predetermined, xed rate of interest on a notional principal on
speci c dates for a speci ed period of time
 Party X agrees to make payments based on oating interest rate to Party Y on that same
notional principal on the same speci ed dates for the same speci ed time period.

2) Currency Swap

A currency swap, sometimes referred to as a cross-currency swap, involves the exchange of

interest—and sometimes of principal—in one currency for the same in another currency.

Currency swaps were originally done to get around exchange controls, governmental
limitations on the purchase and/or sale of currencies.

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 Derivatives Topic Finance and Management

3) Credit default swap (CDS)

A credit default swap (CDS) is a nancial derivative or contract that allows an investor to
"swap" or offset his or her credit risk with that of another investor. For example, if a lender is
worried that a borrower is going to default on a loan, the lender could use a CDS to offset or
swap that risk.

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 Derivatives Topic Finance and Management

Options

Options are nancial instruments that are derivatives based on the value of underlying
securities such as stocks. An options contract offers the buyer the opportunity to buy or sell—
depending on the type of contract they hold—the underlying asset. Unlike futures, the holder is
not required to buy or sell the asset if they choose not to.

Types of Options:

 
Call options allow the holder to buy the asset at a stated price within a speci c timeframe.
 
Put options allow the holder to sell the asset at a stated price within a speci c timeframe.

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 Derivatives Topic Finance and Management

Some Related concepts

OTC Derivatives and Exchange Traded Derivatives

1) OTC Derivatives:

An over the counter (OTC) derivative is a nancial contract that does not trade on an asset
exchange, and which can be tailored to each party's needs.

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 Derivatives Topic Finance and Management

The Forwards contract

we discussed above are OTC derivatives because two parties are getting into the contract
directly.

2) Exchange Traded Derivatives

An exchange traded derivative is a nancial contract that is listed and trades on a regulated
exchange. Simply put, these are derivatives that are traded in a regulated fashion.

Exchange traded derivatives have become increasingly popular because of the advantages
they have over the counter (OTC) derivatives, such as standardization, liquidity, and elimination
of default risk.

Futures and options are two of the most popular exchange traded derivatives.

Long or Short a Derivative

 Being long a derivative means an investor or trader has bought the derivative with the
expectation of a price increase,
 Being short a derivative means an investor or trader is a seller of a derivative with the
expectation of a price decrease.

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 Derivatives Topic Finance and Management

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