Finance as a service industry for many years have been

characterized by tradition, regulation and a relative slow

innovation.
Until …
Financial Innovation of twentieth century i.e.

DERIVATIVE INSTRUMENTS

Derivatives can be friends or foes depending on how we design them,

use them and control the exposure we are assuming with them.

BIMS - MBA III SEM 1

Introduction to
DERIVATIVES

Definition –

A derivative is a FINANCIAL CONTRACT that derive its

value from other underlying instrument / asset.

Or

A derivative is a FINANCIAL CONTRACT whose value is

derived from the value of some basic underlying asset.

BIMS - MBA III SEM 2

A financial instrument or contract
with all of the following
characteristics
 It has one Underlying, and one Notional Amount or both

 It requires no initial net investment or an initial net

investment that is smaller than would be required for
other types of contracts

 Its terms require or permit net settlement in cash or by

physical delivery.

BIMS - MBA III SEM 3

So derivatives can be and on…

DERIVATIVE UNDERLYING NOTIONAL AMOUNT

Stock / Index Stock price /

Index Value Number of shares

Currency Forward Exchange

Rate Number of currency
units

Commodity Commodity Price Number of

commodity units

Swap Interest Index Rupee Amount

BIMS - MBA III SEM 4

Fundamental Building Blocks of
Derivatives
 Forwards
• Physical / Financial

 Futures

 Options
• Calls
• Puts

 Swaps

BIMS - MBA III SEM 5

Forwards Contracts
A contract that obligates one counterparty to buy,
and the other to sell, a specific underlying and notional
amount at a specific date in the future.

 A forward market exists for a multitude of underlying, including

agricultural and physical commodities, currencies and interest rates.
 Buyer
 Seller
 Settlement, Maturity or Expiration
 Contract Size
 Forward Contract Price (Invoice Amount)

BIMS - MBA III SEM 6

Forward Contract -
Characteristics
 Terms and conditions are negotiated

 Illiquid market

 Credit risk

 Unregulated market (not exchange-traded)

BIMS - MBA III SEM 7

Closing Out a Forward
Contract
 Entering into an offsetting transaction

 Making (taking) physical delivery

 Cash settlement

BIMS - MBA III SEM 8

Future Contracts
A contract that obligates one counterparty to buy,
and the other to sell, a specific underlying and notional
amount at a specific date in the future.

 A future market exists for a multitude of underlying, including

Stocks, Indices, Commodities, Currencies & Interest Rates.
 Buyer
 Seller
 Settlement, Maturity or Expiration
 Contract Size
 Future Contract Price (Underlying Asset Price)

BIMS - MBA III SEM 9

Futures Contract is a
Standardized Forward
Contract
Futures Contract - Standardized Terms

 A description of the underlying asset

 Quantity and quality of the underlying asset
 Time and place of delivery
 Method of payment

BIMS - MBA III SEM 10

Option Contract
An option is a contract that gives its owners right to Buy
or Sell some underlying at a fixed price on or before a given
date.
i.e.
“An option Buyer has the right, Seller is under the obligation”

 Call Option – Right to purchase the underlying asset

 Put Option – Right to sell the underlying asset
 Strike Price – The price upon at the time of contract
 Exercise Date – The date on which contracts matures
 Option Premium – the amount buyer pays to seller
 American / European Options

BIMS - MBA III SEM 11

Option Contract
 Call option “Option” to Buy

 Put option “Option” to Sell

 Buyer “Holder” has the right to exercise the option. Buyer pays premium to
acquire right.

 Seller “Writer” is obligated to perform at the buyer’s discretion. Writer is paid

up front a fixed sum (premium) to incur obligation.

 Insurance Buyer (holder) pays a premium for the right to be compensated in the
event of a specified occurrence.

 Seller (writer) receives the premium and is obligated to compensate the policy
holder in the event of a specified occurrence.

BIMS - MBA III SEM 12

Swap Contract

Is an agreement to exchange future cash

flows.

Typically, one cash flow is based on a variable or

floating price and the other on fixed one.

BIMS - MBA III SEM 13

Swap Contract -
Characteristics
 Contractual agreement between two parties

 Exchange of cash flows

 Payments based upon price fluctuations in an underlying

 Notional principal amount - hypothetical principal amount

upon which cash flows are calculated

BIMS - MBA III SEM 14

Q&A

BIMS - MBA III SEM 15