NATIONAL UNIVERSITY OF MODERN LANGUAGES

DEPARTMENT OF MANAGEMENT SCIENCES

LAHORE CAMPUS
______________________________________________

CLASS: BBA-VII (M)

DATE: 28-12-2023

SUBMITTED BY:

Mariyam Waheed (LCM-4110)

SUBMITTED TO:

Sir Waseem Abbas

TOPIC:

Derivatives Markets

_______________________________________________________
 Derivatives Markets

Derivatives are financial contracts whose value is based on the price or performance of an
underlying asset, index, or other financial indicator. They derive their value from the fluctuations
in the value of the underlying asset.

In essence, derivatives are agreements between two parties that establish conditions under which
they will exchange financial instruments or cash flows. These contracts can be used for various
purposes, including managing risk, speculating on price movements, and achieving specific
investment goals.

The key characteristic of derivatives is that their value is derived from an underlying asset, which
could be anything from stocks, bonds, currencies, commodities, interest rates, or market indices.
Traders and investors use derivatives to hedge against price volatility, speculate on market
movements, and diversify their portfolios.

Derivatives come in various forms, such as options, futures contracts, forwards, and swaps.
These instruments are traded on organized exchanges or over-the-counter (OTC) markets.

Types of derivatives

Forward Contract:
A forward contract is a customized agreement between two parties to buy or sell an asset
at a specified future date for a price agreed upon today. Unlike futures contracts, forward
contracts are typically traded over-the-counter (OTC), meaning they are privately negotiated
between the buyer and the seller. Forward contracts are used for various purposes, including
hedging against price fluctuations and customizing terms to meet specific needs.
Here's a more detailed explanation of forward contracts:
1. Customization:
 Forward contracts are highly customizable. The parties involved can tailor the terms of
the contract to meet their specific needs, including the quantity of the asset, the price, and the
delivery date.
2. Underlying Asset:
The underlying asset can be almost anything, including commodities (such as gold, oil, or
wheat), currencies, bonds, or even stock indices.
3. Agreement Terms:
The contract specifies the agreed-upon:
● Quantity: The amount of the underlying asset to be bought or sold.
● Price: The price at which the transaction will occur.
● Delivery Date: The date on which the transaction will be settled.
4. Lack of Standardization:
Unlike futures contracts, which are standardized and traded on organized exchanges,
forward contracts are private agreements. As a result, there is no secondary market for forward
contracts, and their terms can vary widely.
5. Over-the-Counter (OTC) Trading:
Forward contracts are traded directly between the buyer and the seller, often with the
assistance of financial institutions or brokers. This direct negotiation allows for flexibility but
may lack the transparency and liquidity of exchange-traded instruments.
6. No Marking to Market:
Unlike futures contracts, forward contracts are not marked to the market. There is no daily
adjustment of the contract's value based on market price changes. Instead, the parties settle the
contract at the agreed-upon future date.
7. Counterparty Risk:
Since forward contracts are private agreements, they expose the parties to counterparty
risk. If one party fails to meet its obligations, the other party may face difficulties in enforcing
the contract.
8. Settlement:
Settlement of a forward contract occurs at the end of the agreed-upon period. The buyer
pays the agreed-upon price, and the seller delivers the specified quantity of the underlying asset.
9. Hedging and Speculation:
Like futures contracts, forward contracts can be used for hedging against price volatility or
for speculative purposes. For example, a company might enter into a forward contract to lock in
the price of a commodity it needs for production.
Forward contracts provide flexibility and customization but come with certain risks,
particularly counterparty risk and lack of liquidity. They are commonly used in over-the-counter
markets, especially when parties have specific requirements that cannot be met by standardized
futures contracts.

Future Contract:
A futures contract is a standardized financial agreement to buy or sell an underlying asset
at a predetermined price on a specified future date. It is a type of derivative contract that
obligates both parties to fulfill the terms of the contract at the agreed-upon date. Futures
contracts are widely used for hedging against price fluctuations, speculation, and achieving
specific investment objectives.
Here are the key components and features of a futures contract:

1. Purpose of Futures Contracts:

● Hedging: One primary purpose of futures contracts is to hedge against price volatility.
Producers and consumers of commodities, for example, use futures contracts to lock in
prices for future delivery, providing certainty in the face of unpredictable market
fluctuations.
● Speculation: Traders and investors use futures contracts to speculate on the future
direction of prices. By taking positions in futures markets, they seek to profit from
anticipated price movements.

2. Standardization:
Futures contracts are standardized to ensure a fair and transparent marketplace.
Standardization includes the size of the contract, the expiration date, and the method of
settlement. This uniformity allows for easy trading on organized exchanges.
3. Key Terms:
● Contract Size: Each futures contract represents a standardized quantity of the underlying
asset. For example, a crude oil futures contract might represent 1,000 barrels of oil.
● Expiration Date (Delivery Date): This is the date on which the contract matures. At
maturity, the contract must be settled by either physical delivery of the underlying asset
or a cash settlement.
● Futures Price (Delivery Price):The agreed-upon price at which the underlying asset will
be bought or sold upon contract expiration.

4. Trading Process:
Futures contracts are traded on organized exchanges, such as the Chicago Mercantile
Exchange (CME) or Eurex. Buyers and sellers enter into contracts through a centralized
marketplace, and the exchange facilitates the process.

5. Marking to Market:
Each day, the value of the futures contract is adjusted based on the market price of
the underlying asset. This process is called marking to market. Profits and losses are realized
daily, and participants may be required to post additional margin if the account falls below a
certain level.

6. Margin Requirements:
To participate in futures trading, participants must deposit an initial margin with the
clearinghouse. This margin acts as a performance guarantee. Maintenance margins may also be
required to ensure that the account remains adequately funded.

7. Leverage:
Futures contracts provide significant leverage, allowing traders to control a large
position with a relatively small amount of capital. While leverage magnifies potential returns, it
also increases the risk of significant losses.
8. Clearinghouse:
The clearinghouse acts as an intermediary between buyers and sellers, ensuring the
integrity of the contract. It guarantees that both parties fulfill their obligations, reducing the risk
of default.

9. Settlement:
Futures contracts can be settled in two ways:
● Physical Delivery: The actual delivery of the underlying asset occurs.
● Cash Settlement: The contract is settled in cash, where the difference between the
contract price and the market price is paid.

Futures contracts are versatile financial instruments used across various asset classes,
including commodities, financial instruments, and stock indices, providing participants with
tools for risk management and investment strategies.

Options:
Options are financial derivatives that give the holder the right, but not the obligation, to
buy (call option) or sell (put option) an underlying asset at a predetermined price (strike price)
before or at the expiration date. Options are widely used for various purposes, including hedging
against price fluctuations, speculation on market movements, and enhancing portfolio
management strategies.
Here's a more detailed explanation of options:

1. Types of Options:
● Call Option: Gives the holder the right to buy the underlying asset at the strike price
before or at the expiration date.
● Put Option: Gives the holder the right to sell the underlying asset at the strike price
before or at the expiration date.
2. Components of an Option Contract:
 ● Underlying Asset: The asset on which the option is based, such as stocks, commodities,
currencies, or indices.
● Strike Price: The predetermined price at which the underlying asset can be bought or
sold.
● Expiration Date: The date when the option contract expires and becomes invalid.
● Option Premium: The price paid by the option buyer to the option seller for the rights
conveyed by the option.
3. Option Styles:
● American Options: Can be exercised by the holder at any time before or at the expiration
date.
● European Options: Can only be exercised at the expiration date.
4. Option Exercising:
● Call Option Exercising: The option holder can buy the underlying asset at the strike price.
● Put Option Exercising: The option holder can sell the underlying asset at the strike price.
5. Option Premium Determinants:
● Intrinsic Value: The difference between the current market price of the underlying asset
and the strike price.
● Time Value: The value attributed to the time remaining until the option's expiration. It
decreases as the expiration date approaches.
● Volatility: Higher volatility tends to increase the option premium.
6. Option Strategies:
● Traders and investors can combine multiple options (and sometimes the underlying asset)
to create various strategies, such as:
● Covered Call: Involves holding a long position in the underlying asset and
selling a call option against it.
● Protective Put: Involves holding a long position in the underlying asset and
buying a put option to hedge against potential downside risk.
● Straddle: Involves buying a call and a put with the same strike price and
expiration date.
 ● Butterfly Spread: Involves combining multiple options to create a position that
profits from low volatility.
7. Risk and Reward:
● Option Buyer: The maximum loss is limited to the premium paid. The potential gain is
theoretically unlimited for call options and limited to the strike price minus the premium
for put options.
● Option Seller: The maximum gain is limited to the premium received. The potential loss
is theoretically unlimited for call options and limited to the strike price minus the
premium for put options.
8. Options Market:
● Options are traded on organized exchanges, and the standardized contracts provide
liquidity and transparency. The options market facilitates the buying and selling of
options contracts between investors and traders.
Options play a crucial role in financial markets, offering participants a range of strategies to
manage risk and capitalize on market opportunities. Understanding the mechanics of options is
essential for those engaging in options trading or using options as part of their investment and
risk management strategies.

Swaps:

Swaps are financial derivatives in which two parties agree to exchange cash flows or other
financial instruments over a specified period. Swaps are typically used to manage risks, hedge
exposures, or gain specific advantages in the financial markets. The most common types of
swaps include interest rate swaps, currency swaps, and commodity swaps.
Here's a more detailed explanation of swaps:
1. Interest Rate Swaps (IRS):
● Purpose: Interest rate swaps involve the exchange of interest rate cash flows between
two parties.
● Structure: One party pays a fixed interest rate, while the other pays a floating (variable)
interest rate based on a reference interest rate, such as LIBOR (London Interbank Offered
Rate).
● Example: In a plain vanilla interest rate swap, Party A may pay a fixed interest rate of
4%, and Party B pays a floating rate based on LIBOR. If LIBOR is 3%, Party B pays 3%
to Party A, and Party A pays 4% fixed to Party B.
2. Currency Swaps:
● Purpose: Currency swaps involve the exchange of cash flows in different currencies.
● Structure: Two parties agree to exchange principal and interest payments in one
currency for equivalent amounts in another currency.
● Example: Company X in the United States and Company Y in the Eurozone may enter
into a currency swap. Company X pays Company Y in dollars, and Company Y pays
Company X in euros, allowing each company to access funding in a different currency.
3. Commodity Swaps:
● Purpose: Commodity swaps involve the exchange of cash flows based on the price
movements of commodities.
● Structure: One party may agree to pay a fixed price for a commodity, while the other
pays a floating (market) price.
● Example: In an oil price swap, Party A agrees to pay Party B a fixed price for a certain
quantity of oil, and Party B pays the current market price. This allows both parties to
manage their exposure to fluctuations in oil prices.
4. Equity Swaps:
● Purpose: Equity swaps involve the exchange of cash flows based on the performance of
an equity index or individual stocks.
● Structure: One party may pay the total return on an equity index or stock, including
dividends, while the other pays a fixed or floating rate.
● Example: In an equity swap, Party A may pay Party B the total return on the S&P 500
index, and Party B pays a fixed rate in return.
5. Cross-Currency Interest Rate Swaps:
 ● Purpose: Cross-currency interest rate swaps combine elements of both interest rate and
currency swaps.
● Structure: Parties exchange interest payments in different currencies.
● Example: If a company in the U.S. wants to borrow in euros and a European company
wants to borrow in dollars, they might enter into a cross-currency interest rate swap to
exchange their debt payments.
6. Credit Default Swaps (CDS):
● Purpose: Credit default swaps provide insurance against the default of a particular
borrower or credit event.
● Structure: The buyer of the CDS pays a premium to the seller. If a credit event occurs
(e.g., default on a bond), the seller compensates the buyer.
● Example: Investor A buys a CDS from Investor B to protect against the default of
Company X's bonds. If Company X defaults, Investor B compensates Investor A.
7. Weather Derivatives:
● Purpose: Weather derivatives allow parties to hedge against financial losses caused by
unexpected weather conditions.
● Structure: Payments are based on weather-related indices, such as temperature or
rainfall.
● Example: An energy company may use a weather derivative to hedge against
lower-than-expected temperatures, which would reduce the demand for heating.
Swaps are versatile financial instruments used by corporations, financial institutions, and
investors to manage risks and optimize their financial positions. They provide flexibility in
tailoring agreements to meet specific needs and are traded over-the-counter (OTC) rather than on
organized exchanges. The terms of a swap are typically negotiated directly between the parties
involved.

Difference between Forward contract and Future contract

1. Standardization:
● Forward Contracts: Highly customizable; terms are negotiated directly between parties.
 ● Futures Contracts: Standardized contracts with fixed terms, traded on organized
exchanges.
2. Trading Venue:
● Forward Contracts: Traded over-the-counter (OTC), directly between buyer and seller.
● Futures Contracts: Traded on organized exchanges, providing liquidity and
transparency.
3. Secondary Market:
● Forward Contracts: Generally do not have a secondary market; terms are binding
between the original parties.
● Futures Contracts: Have a secondary market, allowing contracts to be bought or sold
before expiration.
4. Counterparty Risk:
● Forward Contracts: Expose parties to counterparty risk, as there is no intermediary
ensuring contract performance.
● Futures Contracts: Clearinghouses act as intermediaries, reducing counterparty risk.
5. Standardization of Terms:
● Forward Contracts: Terms can vary widely, allowing for flexibility in size, expiration
date, and other contract details.
● Futures Contracts: Standardized terms, including contract size, expiration date, and
other specifications.
6. Marking to Market:
● Forward Contracts: Typically not marked to market; profits or losses realized at the
contract's expiration.
● Futures Contracts: Marked to market daily, with gains or losses settled daily.
7. Liquidity:
● Forward Contracts: May lack liquidity due to customization and absence of a
centralized exchange.
● Futures Contracts: Generally more liquid due to standardized terms and exchange
trading.
8. Flexibility:
 ● Forward Contracts: Provide high flexibility, allowing parties to tailor terms to specific
needs.
● Futures Contracts: Offer less flexibility due to standardized terms, but this
standardization promotes ease of trading.
9. Duration:
● Forward Contracts: Duration is negotiable and can vary widely.
● Futures Contracts: Have standardized expiration dates.
10. Delivery:
● Forward Contracts: Settlement occurs at the end of the agreed-upon period, and
physical delivery of the asset is common.
● Futures Contracts: Settlement can be through physical delivery or cash settlement,
providing flexibility.
11. Regulation:
● Forward Contracts: Generally subject to fewer regulations as they are private
agreements.
● Futures Contracts: Subject to regulatory oversight to ensure fair and transparent trading.
12. Accessibility:
● Forward Contracts: More accessible to a broader range of participants due to fewer
regulatory constraints.
● Futures Contracts: Access may be restricted by exchange requirements and regulations.
Conclusion:
In summary, derivatives are integral components of financial markets, offering diverse
instruments such as options, futures, swaps, and forwards that empower market participants to
manage risks, speculate on market movements, and customize investment strategies. These
financial contracts derive their value from underlying assets, providing flexibility and
opportunities for hedging against price fluctuations. While derivatives enhance liquidity and
contribute to efficient market functioning, their utilization demands a nuanced understanding of
market dynamics and associated risks. Whether employed by investors, corporations, or financial
institutions, derivatives play a vital role in shaping the landscape of modern finance, offering
avenues for both prudent risk management and strategic financial maneuvering.