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Daniel McLaury, Ph.D. Student in Mathematics at University of Illinois at

Chicago Whatisaderivativeinlayman'sterms?
WrittenSep9,2013
HowcanCommunismbeexplainedtoatenyearold?
I'd give the example of a put option:
Whatisthemeaningoftorqueandpowerinacarin
"If you pay me $5 right now, I'll agree to buy up to ten pounds of potatoes from you a month laymanterms?
from now at a price of $2/pound."

Whatisthecloud?Canitbeexplainedintermsthata
nontechnicalpersoncanunderstand?
It's called a "derivative" product because its value is derived from the value of the
underlying product -- in this case, potatoes. If, in a month, potatoes are worth only $1/lb, HowcanIexplainlimits(maths)toalayman?
you can buy ten pounds of potatoes for $10, then sell them to me for $20 and make a prot
HowcantheHaltingProblembeexplainedtoa
of $5 (because you made $10 and paid me $5 to start, ignoring the month's worth of interest layman?
on the $5). If, on the other hand, they're worth $3/lb, then your contract will be worthless
since you wouldn't want to sell $3/lb potatoes to me for only $2/lb. Howdoexplaintransferpricingtoalayman?
HowdoIexplainthisequationtoalayman?
Of course we can make more complicated derivatives, too, but it's the same basic idea -- a
product whose value is derived from the value of something else. HowcanIexplaingeneticstoalayman?
3.7kViewsViewUpvotes
Howdoyouexplain2Gnetworktoalayman?
Anirudh Joshi, not all data is good data

WrittenSep9,2013
All derivatives are insurance.
If something goes wrong with an asset whether that's a car, a house or a life, if you pay us X
amount today, we will pay you Y amount when something goes wrong.
The trick is in picking the right X and the right Y.
Amit Pawar
WrittenSep9,2013
DERIVATIVES : In simple term the derivative means you predict and betting on future
weather this will happen or not on the bases of current situation and your own interest.

DERIVATIVES
Derivatives are securities whose value is derived from the underlying security.
Examples of security: Such as bonds, stocks, currencies, commodities, an index or
temperature.

Types of Derivatives.

Forward
Future
Options
Warrants

Necessity of Derivatives
Counterparty
Common Asset
Market
Contractual Agreement

Markets

CBOE-Chicago Board Options Exchange,
CBOT-Chicago Board of Trade, USA
LIFFE-London international nancial futures Exchanges (LIFFE).
BOX - Boston Options Exchange
EDX London - London's Equity Derivatives Exchange, UK

Forward Contracts
Denition:-A forward contract is an agreement between two parties to buy or sell an asset
at a pre-agreed future point in time.

The owner of a forward contract has the obligation to buy the underlying asset at a xed
date in the future for a xed price.
They are traded on, over the counter .
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Whatisaderivativeinlayman'sterms?
Example of how the payo of a forward contract works
A enters a forward contract to buys a house from B $1,04,000 on 1.1.2005
Situation 1: On 1.1.2006, if the value of the house is $1,10,000, (spot price)
laymanterms?
A will gain $6000 and B will loose $ - 6,000.
Situation 2: On 1.1.2006, if the value of the house is $ 1,00,000, (spot price) Whatisthecloud?Canitbeexplainedintermsthata
A will loose $ -4000 and B will gain $4000 nontechnicalpersoncanunderstand?

HowcanIexplainlimits(maths)toalayman?

Example of How Forward Prices Should Be Agreed Upon Considering the Time value layman?

On 1.1.2005, the value of the house is $1,00,000. Howdoexplaintransferpricingtoalayman?
If B sold on 1.1.2005, & deposited in bank, he would earn at least 4% p.a. (i.e.$1,04,000) HowdoIexplainthisequationtoalayman?
If A takes a loan and buys the above house on 1.1.2005 he will have to at least pay 4%
interest to the bank. HowcanIexplaingeneticstoalayman?
Hence it would be ideal for A & B to enter into a one years forward contract (expire date
1.1.2006) for at least $1,04,000

FUTURE CONTRACTS

Denition: Future contract is an obligation to buy or sell a specic quantity and quality of
a commodity or security at a certain price on a specied future date.

They are standardized, and exchange traded

Some futures contracts may call for physical delivery of the asset, while most are settled
in cash.

Example:-
Commodities markets farmers often sell futures contracts for the crops and livestock
they produce to guarantee a certain price, making it easier for them to plan. Similarly,
livestock producers often purchase futures to cover their feed costs, so that they can plan on
a xed cost for feed.

In modern (nancial) markets, "producers" of interest rate swaps or equity derivative
products will use nancial futures or equity index futures to reduce or remove the risk on
the swap.

Specication on a Future Contract

Futures contracts ensure their liquidity by being highly standardized, usually by specifying:
The underlying. This can be anything from a barrel of sweet crude oil to a short term
interest rate.
The type of settlement, either cash settlement or physical settlement.
The amount and units of the underlying asset per contract. This can be the notional
amount of bonds, a xed number of barrels of oil, units of foreign currency, the notional
amount of the deposit over which the short term interest rate is traded, etc.
The currency in which the futures contract is quoted.
The grade of the deliverable. In the case of bonds, this species which bonds can be
delivered. In the case of physical commodities, this species not only the quality of the
underlying goods but also the manner and location of delivery. For example, the NYMEX
Light Sweet Crude Oil contract species the acceptable sulfur content and API specic
gravity, as well as the location where delivery must be made.
The delivery month.
The last trading date.
Margin percentage are specied.
Other details such as the commodity tick, the minimum permissible price uctuation.

Types of Future Contracts
There are many dierent kinds of futures contract, reecting the many dierent kinds of
tradable assets of which they are derivatives.

Foreign exchange market

Bond market

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Money market SignIn

Equity index market
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Soft Commodities market


laymanterms?
Who trades futures? nontechnicalpersoncanunderstand?
Hedgers:-Hedgers, who have an interest in the underlying commodity and are seeking to
hedge out the risk of price changes HowcantheHaltingProblembeexplainedtoa
layman?
Speculators:-Speculators, who seek to make a prot by predicting market moves and
buying a commodity "on paper" for which they have no practical use. Howdoexplaintransferpricingtoalayman?
Arbitragers also trade in future, if they feel that the instrument in over priced, they would
buy in Spot and sell in futures or if they feel that the instrument is under priced , they HowcanIexplaingeneticstoalayman?
would sell in Spot and buy in futures.

Hedgers typically include producers and consumers of a commodity

Margin on Future Contracts
Although the value of a contract at time of trading should be zero, its price constantly
uctuates. This renders the owner liable to adverse changes in value, and creates a credit
risk to the exchange, who always acts as counterparty. To minimize this risk, the exchange
demands that contract owners post a form of collateral, in the US formally called
performance bond, but commonly known as margin.

Initial Margin: While entering into a trade the investor pays an upfront some percentage
of the total contract value as an initial margin money.

Variation Margin: The cash transfer that takes place after each trading day (and
sometimes intraday) in most futures markets to mark long and short positions to the
market. Most contracts are settled daily by the payment of variation margin from the party
who has lost money that day to the party who has made money.

Example: If each point in the price of a contract is worth $1,000, and the futures price
goes up by 1/2 point during a session, the short will pay the long $500 per contract in
variation margin.

Margin requirements are waived or reduced in some cases for hedgers who have physical
ownership of the covered commodity or traders who have osetting contracts

Future v/s Forward Contract

Future

Forward

Exchange traded

Over the counter

Standard contract

Customized contract

Margins

May not require margins

Daily Settlement

End of the period settlement

Liquid

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No counter party risk
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Counter party risk



laymanterms?
Options Contracts
Options - Denition. nontechnicalpersoncanunderstand?

An option is a type of derivative where the buyer has the right, but not the obligation, to
buy (call option) or sell (put option) a commodity or nancial asset at a specied price (the HowcantheHaltingProblembeexplainedtoa
strike price) during a specied period of time in future. layman?

Howdoexplaintransferpricingtoalayman?
Features of an option contract.


Unit of Trading: One option contract gives right over a xed quantity of the underlying HowcanIexplaingeneticstoalayman?
asset, eg. one individual equity option gives right over 1000 shares (in the UK). It is 100
shares in the USA.

Expiration: The rights conferred upon the owner of an option are only valid for a certain
period (until expiration) - after this expiry date they are not legitimate.

Writer: The option seller is also known as the option writer.

Strike / Exercise Price: The price of which the option holder has the right to buy (or sell)
the underlying asset. Most exercise prices gravitate around the current price of the
underlying asset.

Premium: The amount paid by the option buyer to the option writer for the right.
Premium is determined by a intrinsic value and time value

Option Exercise Style

American option: Can be exercised at any time for both stock & indices
European option: Can only be exercised on the expiry date for the underline stock or
indices
Capped-style Option:
The term "capped-style option" means an option contract that is automatically
exercised when the cap price is reached. If this does not occur prior to expiration, it can be
exercised ,(relating to the cuto time for exercise instructions and to the rules of the
clearing corporation), only on its expiration date.
Bermuda Option: A type of option that can only be exercised on predetermined dates,
usually every month.

Call Options

An option contract that gives its holder the right (but not the obligation) to buy a
specied number of shares of the underlying stock at a given strike price, on or before the
expiration date of the contract is known as call option.

CALL OPTION STRATERGY

CALL OPTION (BUY
Long (Right)
Advantage if Price goes up

Price goes up-Prots unlimited
If Price falls /remain same
losses limited to premium paid

Short (Obliged)
Disadvantage if price goes down

Price goes up-Losses are unlimited
If Price falls /remain same
prots are limited to premium received

Put Options
An option contract that gives its holder the right (but not the obligation) to sell a
specied number of shares of the underlying stock at a given strike price, on or before the
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expiration date of the contract is known as put option


PUT OPTION STRATERGY HowcanCommunismbeexplainedtoatenyearold?

PUT OPTION (SELL)
laymanterms?

Long (Right) Whatisthecloud?Canitbeexplainedintermsthata
Advantage if price goes down nontechnicalpersoncanunderstand?

Price goes down-prots unlimited
If Price rises /remain same HowcantheHaltingProblembeexplainedtoa
losses limited to premium paid layman?

Short (Obliged) HowdoIexplainthisequationtoalayman?

Disadvantage if price rises
HowcanIexplaingeneticstoalayman?
Price goes down - losses are unlimited
If Price rises /remain same
prots are limited to premium received

Equity options.
Equity options:-Exchange traded equity options are "physical delivery" options. It gives
the owner the right to receive physical delivery (if it is a call), or to make physical delivery (if
it is a put), of underlying shares when the option is exercised.

Equity Option Trading Example

Equity options allow you to take advantage of share price movements by allowing you to
gain exposure, to larger amounts of shares for less initial cash outlay than would be possible
when trading the actual shares.
If you buy an equity option, you get the right - without the obligation - to buy or sell the
underlying shares at a xed price by an appointed time.
If the market moves in your favour, you gain; if you get it wrong, all you lose is the price
you paid for the option (premium).

Intrinsic Value

In options terminology, intrinsic value is the positive dierence between the current price
for the underlying and the strike price of an option. For a call option the strike price has to
be under the price of the underlying; for a put option the strike price has to be over the price
of the underlying. If an option has intrinsic value, it is also referred to as in-the-money, if it
has no intrinsic value, it is referred to as out-of-the-money.

For example, if the strike price for a call option is USD 1 and the price of the underlying is
USD 1.20, then the option has an intrinsic value of USD 0.20. Options are usually sold for
their intrinsic value plus their time value

In the Money Option

An in-the-money call option is described as a call whose strike (exercise) price is lower than
the present price of the underlying. An in-the-money put is a put whose strike (exercise)
price is higher than the present price of the underlying, i.e. an option which could be
exercised immediately for a cash credit should the option buyer wish to exercise the option.

Example for ITM option

In our Microsoft example, an in-the-money call option would be any listed call option with a
strike price below $65.00 (the price of the stock). So, the MSFT January 60 call option would
be an example of an in-the-money call.
The reason is that at any time prior to the expiration date, you could exercise the option and
prot from the dierence in value: in this case $5.00 ($65.00 stock price - $60.00 call option
strike price = $5.00 of intrinsic value). In other words, the option is $5.00 in-the-money.
Using our Microsoft example, an in-the-money put option would be any listed put option
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with a strike price above $65.00 (the price of the stock). The MSFT January 70 put option SignIn
would be an example of an in-the-money put.
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It is in-the-money because at any time prior to the expiration date, you could exercise the
option and prot from the dierence in value: in this case $5.00 ($70.00 put option strike
price - $65.00 stock price = $5.00 of intrinsic value. In other words, the option is $5.00 in-
the-money. HowcanCommunismbeexplainedtoatenyearold?


laymanterms?
Out of-the-money option

An out-of-the-money call is described as a call whose exercise price (strike price) is higher HowcantheHaltingProblembeexplainedtoa
than the present price of the underlying. layman?
There is no intrinsic value in an out-of-the-money call because the options strike price is Howdoexplaintransferpricingtoalayman?
higher than the current stock price. HowdoIexplainthisequationtoalayman?

Example for OTM option

For example, if you chose to exercise the MSFT January 70 call while the stock was
trading at $65.00, you would essentially be choosing to buy the stock for $70.00 when the
stock is trading at $65.00 in the open market. This action would result in a $5.00 loss.
Obviously, you wouldnt do that.
An out-of-the-money put has an exercise price that is lower than the present price of the
underlying.
There is no intrinsic value in an out-of-the-money put because the options strike price is
lower than the current stock price. For example, if you chose to exercise the MSFT January
60 put while the stock was trading at$65.00, you would be choosing to sell the stock at
$60.00 when the stock is trading at $65.00 in the open market. This action would result in a
$5.00 loss. Obviously, you would not want to do that.

At-the-money-option

An at-the- money option (ATM) option is an option that would lead to a zero cash ow if
it were exercised immediately. An option on the index is at the money when the current
index equals the strike price. (i.e. spot price=strike price).

Example for ATM option
An at-the-money option is described as an option whose exercise or strike price is

approximately equal to the present price of the underlying stock.
For instance, if Microsoft (MSFT) was trading at $65.00, then the January $65.00 call would
an example of an at-the-money call option. Similarly, the January $65.00 put would be an
example of an at-the-money put option.

Dierence between Futures & Options.

Future

Options

Obligation to the buyer & seller to honor the contract.

Gives the buyer the right, but not the obligation to buy (or sell)

Aside from commissions, an investor can enter into a futures contract with no upfront
cost.

Premium upfront (cost) is the maximum that a purchaser of an option can lose.

Are more risky for those investors new to the market

Are less risky, since the holder has the option not to exercise.


RelatedQuestions
Warrants Contracts
Warrants
It is a part of the derivatives family as their value depends on the value of an underlying
security. As such, the warrant investor gains economic exposure to this underlying security
laymanterms?
without actually owning it.
A warrant is the right (but not the obligation) to buy or sell an underlying nancial Whatisthecloud?Canitbeexplainedintermsthata
instrument at a specic price (strike price or exercise price) until a specic time (expiration nontechnicalpersoncanunderstand?
date).
layman?
Divya Vyas, Attempt-Maker,
WrittenOct11,2013 Howdoexplaintransferpricingtoalayman?
Derivatives remain a type of nancial instrument few of us understand and fewer still fully
appreciate, although many of us have invested indirectly in derivatives by investing in
mutual fund whose underlying assets may include derivative products. HowcanIexplaingeneticstoalayman?
Derivatives oer organisations the opportunity to break nancial risks into smaller
components and then to buy and sell those components to best meet specic risk
management objectives.
" A derivative can be dened as a nancial instrument whose value depends on ( or derives
from) the values of other , more basic variables" - John C Hull
Financial Derivatives includes dierent nancial contracts like forward, futures, options,
swaps etc.
Advantages of Financial Derivatives :-
Risk Management
Trading Eciency
Speculation
Anonymous
WrittenSep10,2013
A derivative is a nancial product that price derives from an other nancial product, which
is called the underlying asset. For exemple, the price of an call on s&p500 derives from the
price of the s&p500 index. in this case, the call is a derivative, and the s&p500 index is the
underlying asset. That's why they are called derivatives, ie their price is "derived" from the
price of an other product. it should be noted that other inputs are needed to calculated the
price of the derivative/
Vinay Kumar, I read few non ctions too.

WrittenOct27,2013
Lets say x company`s share value is 10$.
Now either 2 things can happen share value reduces or increases.
If u think d company ll do well in future u can buy `call` options. If share value increases u
make money else u lose Ur money.
If u think d company might not do well then u buy `put` options. If share value goes down u
make money. This just a basic explanation.
This is how future n options work.
If you want to know more bout it watch movies like inside job or wall street.
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2/10/2017 Howwouldyouexplaintoalaymanwhataderivativeinstrumentis?

Daniel McLaury, Ph.D. Student in Mathematics at University of Illinois at

from now at a price of $2/pound."

Anirudh Joshi, not all data is good data

The trick is in picking the right X and the right Y.

Future v/s Forward Contract

Features of an option contract.

Short (Obliged) HowdoIexplainthisequationtoalayman?

higher than the current stock price. HowdoIexplainthisequationtoalayman?

An at-the-money option is described as an option whose exercise or strike price is

Advantages of Financial Derivatives :-

Vinay Kumar, I read few non ctions too.

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