Derivatives

Definition

A derivative is a financial instrument whose value is

“derived from”, or depends on, the price of some
underlying asset.

Used For

Derivatives hedge the risk of owing things that are

subject to unexpected price fluctuations.
 Derivatives (Contd..).

Underlying Assets

 Bonds
 Interest rates
 Stocks
 Forex
 Commodities
 Derivatives - Features
 Manages exposure to price risk.

 Lowers interest expense

 Alters the structure of assets, liabilities, revenues,

and costs

 Arbitrages the price differentials.

 The pay off from these derivative securities is

contingent on the price of underlying securities or
variables.
 Derivatives - Users
Speculators

They think they know the future direction of prices.

They try to profit from their beliefs
Arbitragers

They trade derivatives to take advantage of times where a

considerable difference exists between two currencies

Hedgers
They face the risk that a change in a price will hurt their financial
status. They use derivatives to protect, hedge, or insure themselves
against such harmful movement in prices.
 Derivatives - Advantages
 They allow an investor to benefit from an increase in the
price of an asset at a fraction of the cost of buying the asset
itself.

 One can benefit from market fluctuations.

 Exchange-traded derivatives are distinct because the

terms and conditions for delivery and pricing are
standardized.

 Derivative instruments are flexible tools adapted to fit

many different investment objectives.

 With the help of derivatives one can plan for acquisition

or disposition of securities.

 Derivatives are risk shifting devices.

 Derivatives - Types
Types

• Forward

• Futures

• Options

• Swap
 1. Forward Contract
Definition
An agreement to buy or sell an asset at a certain time in
the future for a certain price (the delivery price)
Features
 It is the most basic derivative contract.
 Forward contracts are privately negotiated and are not
standardized.
 Both the parties must bear each other's credit risk.
 It gives the owner the right and obligation to buy a specified
asset on a specified date at a specified price.
 The buyer is said to have a Long Position & seller is said to
have a Short Position.
 On future specified date ownership of the good is transferred
and payment is made.
 Forward contracts do not trade in organized exchanges.They
are traded in OTC (over-the-counter) market.
 No M-T-M
 Spot and Forward
Differences between Spot and Forward.

1. Forward contract is an agreement to buy or sell an asset

at a certain time in the future for a certain price whereas
Spot contract is an agreement to buy or sell immediately.

2. There is no cost to taking on a long position in a forward

contract but buying commodity in the spot market
requires an initial cash outlay.

3. Buying the good in the spot market will result in storage

and insurance costs bur for buying in Forward market one
does not have to incur the expense of storing and insuring
the commodity.

4. In Forward the Payment for the asset is made at a

specified future date and in Spot the Payment for the
asset is made immediately.
 Forward – Example 1

Mr. X deals in the wholesale business of rice to big business

houses and for hotels every year at a rate of Rs.15/kg.
Suddenly,he comes to know that the price of the rice may
decline in 6 months time to Rs.13/kg, which may result in
heavy loses to X. He wants to avoid the risk of the decline
in the price of the rice.

Hence, he enters into a forward contract at Rs.14/kg. Now

Mr. X can sell the rice at Rs.14 and make a profit of Rs.1/kg
against the spot market.

In the same way as X in the example a buyer can also hedge

against the price fluctuations.
 2. Futures
Definition
An agreement to buy or sell a standard amount of an asset
at a certain time in the future for a certain price.

Features
 Futures contract is traded on an exchange.
 Future contracts are regulated by exchange and are
standardized.
 No credit risk involved.
 Exchange acts as a counterparty to all buyers and sellers. If
there is a default by one party the other party will not be
affected.
 It gives the owner the right and obligation to buy a specified
asset on a specified date at a specified price.
 The buyer is said to have a Long Position (agrees to buy the
underlying asset) & seller is said to have a Short Position
(agrees to sell the underlying asset)
 Futures
Features (contd…)

 On future specified date ownership of the good is

transferred and payment is made.
 Marked to market on a daily basis.
 Margin money is required to absorb loses.
 Profits and losses are computed and settled on a
day-to-day basis, rather than at the end of the contract.
 Most trades are reversed and do not involve actual
delivery.
 Trading strategies in Futures

 Speculation
Short – You believe price will fall
Long - You believe price will rise

 Hedging
Long hedge - Protecting against a rise in price
Short hedge - Protecting against a fall in price.
 Forward Vs Futures
No. Forwards Futures

1 Privately negotiated contract Exchange traded

2 Custom designed Standard contract

3 No cash upfront Margin required

4 Default risk potential No default risk

5 Settle at maturity Marked to market daily

Delivery or final cash Contract usually closed out
6
settlement usually occurs prior to maturity
7 Little regulation Regulated
 3. Options
Definition
A privilege sold by one party to another that offers the buyer the
right, but not the obligation, to buy (call) or sell (put) a security
at an agreed-upon price during a certain period of time or on a
specific date.
Common Example: Stock options

Features
 It trades on an exchange
 It gives the buyer the right and not the obligation.
 Buyer has to pay premium to the seller for the right.
 Used to save transaction costs and avoid tax exposure.
 Options like futures are traded on an exchange
 No credit risk involved.
 The seller of an option is known as Option Writer.
 Types of options
There are 2 basic types of Options:

1. Call Option

2. Put Option

 A call option is an option to buy a certain asset

by a certain date for a certain price (the strike
price)
 A put is an option to sell a certain asset by a
certain date for a certain price (the strike price)
 4. Swaps
Definition
An agreement between two parties to periodically exchange
cash flows over a period in the future.

Features

 Rapidly growing market

 Over the counter deal
 Privately negotiated
 No regulation
 No secondary market
 No guarantor, therefore default risk
 Swaps Vs Future
Differences between Swaps and futures

Swaps Futures
OTC contracts Exchanged traded
Multi-period contracts Single period
agreements
No marking-to-market Marked-to-market daily
Extremely flexible Standardized terms
Default (credit) risk Guaranteed by
clearinghouse
 Types of swaps

1. Interest Rate Swap

2. Currency Swap
3. Equity Swap
4. Commodity Swap