FINANCIAL DERIVATIVES

Prepared by K.Logasakthi MBA (Ph.D) Assist.. Professor VSA School of Management, Salem.

OBJECTIVES OF THE LEARING

Derivatives - (Meaning)
Derivatives: derivatives are instruments which include a) Security derived from a debt instrument share, loan, risk instrument or contract for differences of any other form of security and , b) a contract that derives its value from the price/index of prices of underlying securities.

Advanced investors sometimes purchase or sell derivatives to manage the risk associated with the underlying security. bond. equity or currency. Examples of derivatives include futures and options. to protect against fluctuations in value. . typically a commodity. These techniques can be quite complicated and quite risky. or to profit from periods of inactivity or decline.Derivatives (Definition) A financial instrument whose characteristics and value depend upon the characteristics and value of an underlier.

Advantages of Derivative Market .

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Basics Four Parts: 1. Forward 2. Complex 1.Continue…. Swap 2. Exotics . Warrents& Convertibles. Future 3.Option 4.

Forward contract .

expiration date and the asset type and quality. • The contract price is generally not available in public domain. exposed to counterparty risk.The salient features of forward contracts are as follows: • They are bilateral contracts and hence. . and hence is unique in terms of contract sixe. • Each contract is customer designed. the contract has to be settled by delivery of the asset and • If party wishes to reverse the contract. • On the expiration date.

Liquidity and Counterparty risk. Forward markets are afflicted by several problems: 2. • Counterparty risk arises from the possibility of default by any one party to the transaction.Limitations of Forward contract 1. Lack of centralization of trading. the other suffers . 3. • The basic problem in the first two is that they have too much flexibility and generality. When one of the two sides to the transaction declares bankruptcy.

But unlike forward contract. futures contract are standardized and stock ex-changed traded. .FUTURE CONTRACT Future contract Future contract is an agreement between two parties to buy or sell an asset at a certain time in the future. at a certain price.

…. 4. The date/month of delivery. 2. Quality of the underlying.Continue. Quantity of the underlying. 3. Location of settlement. The standardized items in a futures contract are: 1. The units of price quotation and minimum price change and 5. .....

no Forward Contract 1 Traded on an organized stock exchange Standardized contract terms. 1 Over the Counter (OTC) in nature 2 2 Customized contract terms. less liquid No margin payment 3 Requires margin payments 3 4 Follows daily settlement 4 Settlement happens at the end of the period . hence. hence.no Future Contract S.Distinction between futures and forward S. more liquid.

the reason for which a stock is traded over-the-counter is usually because the company is small.Over The Counter(OTC) Trading • In general. these securities are traded by broker-dealers who negotiate directly with one another over computer networks and by phone. making it unable to meet exchange listing requirements. OTC stocks are generally unlisted stocks which trade on the Over the Counter Bulletin Board (OTCBB) . Also known as "unlisted stock".

• Future Price: The price at which the futures contract trade in the future market. . • Contract cycle: The period over which a contract trades.Important terms in future contract • Spot price: The price at which an instrument/asset trades in the spot market. The index futures contract typically have one month. two months and three months expiry cycles that expire on the last Thursday of the month.

• Expiry date: It is the date specified in the futures contract.Continue…... . • Basis: Basis is defined as the future price minus the spot price. In the a normal market. This reflects that futures prices normally exceed spot prices. basis will be positive. There will be different basis for each delivery month for each contract. • Contract size: The amount of asset that has to be delivered under one contract. at the end of which it will cease to exist. This is the last day on which the contract will be traded..

• Initial Margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is the initial margin.Continue…. • Cost of Carry: The relationship between futures prices and spot prices can be summarised in terms of the cost of carry. .

Futures contracts have linear pay off. Linear pay off: “ losses as well as profits for both the buyer and the seller of futures are unlimited” .Pay off for Futures A pay off is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset.

.Pay off for Buyer of Futures: (Long Future) The pay offs for a person who buys a futures contract is similar to the pay off for a person who holds an asset. When the index moves down the short futures position starts making profits and when the index moves up it starts making losses. He has a potentially unlimited upside as well as downside. the underlying asset in this case is the nifty portfolio. e. Take the case of a speculator who sells a two month Nifty index futures contact when the Nifty stands at 1220.g.

he has potentially unlimited upside as well as downside. .Pay off for Seller Futures (short future) • The pay off for a person who sells a futures contract is similar to the pay off for a person who shorts an asset.

In the securities market. but not the obligation to buy or sell something on a specified date at a specified price. . an option is a contract between two parties to buy or sell specified number of shares at a later date for an agreed price.OPTIONS Meaning of options: An option is the right.

. buyer and the broker. There are three parties involved in the option trading. and receives a commission or fee for it.Continue…. the option seller. 1. The securities broker acts as an agent to find the option buyer and the seller. He receives premium on its price. 3. 2. The option seller or writer is a person who grants someone else the option to buy or sell. The option buyer pays a price to the option writer to induce him to write the option. .

Strike price: Price specified in the options contract is known as the strike price or exercise price. Options trade in an organized market but. large percentage of it is traded over the counter (i. Note that this is just an option.Options An option to buy anything is known as a CALL while an option to sell a thing is called a PUT.e. . privately). That means it is a right and not an obligation.

Call option: A call option is a contract giving the right to buy the shares. . Put option is a contract giving the right to sell the shares. • The expiration date. Call option that gives the right to buy in its contract gives the particulars of • The name of the company whose shares are to be bought. the date on which the contract or the option expires. 2. • The number of shares to be purchased. • The purchase price or the exercise price or the strike price of the shares to be bought.Types of Options 1.

The number of shares to be sold. . Put option contract contains: 1. 4. The name of the company shares to be sold. The selling price or the striking price. The expiration date of the option. 2. 3.Put option • Put option gives its owner the right to sell (or put) an asset or security to someone else.

strike price moves • Strike price is fixed. price moves • Price is zero • Price is always positive • Linear payoff • Non linear payoff • Both long and short at risk • Only short at risk . with novation • Same as futures • Exchange defines the product • Same as futures • Price is zero.Distinction between Futures and Options Futures Options • Exchange traded.

The replacement of existing debt or obligation with a new one.Novation 1. or the substitution of one party in a contract with another party. 2. . The substitution of a new contract for an old one.

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.SWAPS (Meaning) • Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts.

• Currency swaps: These entail swapping both principal and interest between the parties.Commonly two kind of swaps • Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. . with the cash flows in one direction being in a different currency than those in the opposite direction.

Currency Swaps.Interest Rate Swaps. .Types Of Swaps There are four types of swaps. (2). (1).Commodity Swaps. (3).Equity Swaps. (4).

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. at a certain price.FUTURES Future contract is an agreement between two parties to buy or sell an asset at a certain time in the future. futures contract are standardized and stock ex-changed traded. But unlike forward contract.

There are commodity futures and financial futures. .Continue…. Future is a financial contract which derives its value from the underlying asset. For example: Sugar cane or wheat or cotton farmers may wish to have contracts to sell their harvest at a future date to eliminate the risk of change in price by that date.

interest rate and market index futures. .. there are foreign currencies. • In the financial futures. • Market index futures directly related with the stock market.Continue…..

The units of price quotation and minimum price change and 5.Continue….. . Quantity of the underlying. 3. Quality of the underlying. The date/month of delivery. The standardized items in a futures contract are: 1. 4. 2. Location of settlement.

• Futures markets are designed to solve the problems of trading..standardized contracts .. futures markets resemble the forward market Three distinct features of the futures markets are: .Continue…. . liquidity and counterparty risk.Settlement through clearing houses to avoid counterparty risk. Basically.centralized trading .