Derivatives

Mishu Agarwal Lecturer-AKGIM

What Are Derivatives?  

A Financial Instrument That Derives Its Value From An Underlying Security. An easy way to think of derivatives is as a ³side bet´ on interest rates, exchange rates, commodity prices, and practically ANYTHING that you can think of.

Why derivatives? 


Not to raise capital Buy or sell to protect against adverse changes in external factors

Conventional Securities Market 
 

Bonds Cash Stocks

The standard market is what most people think of when they think of the market. The truth is that derivatives are the fastest growing sector of the market. In fact, they are the largest section of the market. The mutual funds are not taken into consideration. There are more mutual funds in the market than there are stocks.

Types of Derivatives 
  

Forwards Futures Options Swaps

Forward Contracts 

The agreement to pay for and pick up, ³Something´ at a pre-determined date and or time, for a pre-determined price. Usually traded off of the trading floor between two firms.

An Example   

An agreement on Monday to buy a book, from a bookstore on Friday for $1000.00. On Friday, you return to the bookstore and take delivery of the book and pay the $1000.00. The contract is actually the agreement.

Futures
Similar to forwards in length of time. However, profits and losses are recognized at the close of business daily, ³Mark-to-market.´ Transactions go through a clearinghouse to reduce default risk. 90% of all futures contracts are delivered to someone other than the original buyer.

An Example 

On Monday we enter into a futures contract to buy our book on Friday. We are required to place a deposit for the book of 50% ($500.00). We are told that if the book appreciates in value we may be required to increase the deposit. If the book depreciates in value, we may take back some of the money. Wednesday the book goes to $1500.00. We must deposit another $250.00. On Thursday the book drops to $750.00. We can collect $375.00. On Friday the book value is $800.00, therefore we owe $425.00 on the remaining balance.

Options  

Options come in many flavors. To name a few: collar, cylinder, fence, mini-max, zerocost tunnel and straddle. These are all newer forms of options. The most common options discussed are put and call. An OPTION is the right, not the obligation to buy or sell an underlying instrument.

Calls 

Long a call- Person buys the right (a contract) to buy an asset at a certain price. They feel that the price in the future will exceed the strike price. This is a bullish position. Short a Call- Person sells the right (a contract) to someone that allows them to buy a asset at a certain price. The writer feels that the asset will devalue over the time period of the contract. This person is bearish on that asset. 

Puts 

Long a Put- Buy the right to sell an asset at a predetermined price. You feel that the asset will devalue over the time of the contract. Therefore you can sell the asset at a higher price than is the current market value. This is a bearish position. Short a Put- Sell the right to someone else. This will allow them to sell the asset at a specific price. They feel the price will go down and you do not. This is a bullish position. 

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