CONCEPT OF DERIVATIVES

PRESENTED BYGEETA SHREE() JYOTI JAIN(57) ABHINAV ANAND(60) ROHIT HENRY() NITESH PRASAD()

INTRODUCTIONA derivative is a financial instrument which derives its value from some other financial price. This other financial price is called the underlying. A wheat farmer may wish to contract to sell his harvest at a future date to eliminate the risk of a change in prices by that date. The price for such a contract would obviously depend upon the current spot price of wheat. Such a transaction could take place on a wheat forward market. Here, the wheat forward is the derivative and wheat on the spot market is the underlying.

A derivative is a financial instrument whose pay-offs is derived from some other asset which is called as an underlying asset.
There are a large number of simple derivatives like futures or forward contracts or swaps. Options are more complicated derivatives. Derivatives are tools to reduce a firms risk exposure.

HEDGING

Hedging is the term used for reducing risk by using derivatives. Its purpose is to reduce the volatility of a portfolio, by reducing the risk. Not maximization of return. Only reduction in variation of return.

Types of Derivatives
Forwards, Futures

Exchange traded products are : Traded on the floor of physical exchange, Standardized Participation of large number of players Less Expensive High liquidity

Swaps

Options

Types of Derivatives Based on Characteristics

Over the Counter (OTC) Traded Derivatives Exchange Traded Derivatives

Difference between OTC & Exchange Traded Derivatives

OTC
Traded on private basis
Prices are less transparent Less Liquid

Exchange Traded
Traded on the floor of physical exchange
Prices are transparent Highly Liquid

Market players known to each other and based on creditworthiness

Settlement by physical delivery. Typical derivative is Forwards

Market players are not known to each other

settlement on cash basis Typical derivative is Futures

Forward Contract

In a forward contract, two parties agree to settle a trade at a future date, for a stated price and quantity.
Suppose- A buyer L and a seller S agree to do a trade in 100 grams of gold on 31 Dec 2005 at Rs.5,000/tola. Here, Rs.5,000/tola is the forward price of 31 Dec 2005 Gold. The buyer L is said to be long and the seller S is said to be short. Once the contract has been entered into, L is obligated to pay S Rs. 500,000 on 31 Dec 2005, and take delivery of 100 tolas of gold. Similarly, S is obligated to be ready to accept Rs.500,000 on 31 Dec 2005, and give 100 tolas of gold in exchange

A forward contract is an agreement between two parties to exchange an asset for cash at a predetermined future date for a price that is specified today.

In case of a forward contract, both the buyer and the seller are bound by the contract. Forward contracts are flexible. They are tailormade to suit the needs of the buyers and sellers.

Future Contract
A future contract is a financial security, issued by an organized exchange to buy or sell a commodity, security or currency at a predetermined future date at a price agreed upon today.

The agreed upon price is called the future price. (Future Price = Spot Price + Cost of Carrying)
In other words Futures are exchange traded contracts to sell or buy financial instruments /physical commodities for future delivery at an agreed price.

Types of Futures Contract: (underlying assets)

Commodity Futures Financial Futures

Mechanism in Future Contracts :

Buy a future Sell a future

Participants in Future Markets

Hedgers Speculators Arbitrageurs

SWAPS

A swap is an agreement between two parties, called counterparties, to trade cash flows over a period of time. Two most popular swaps are currency swaps and interest-rate swaps. Currency swap involves an exchange of cash payments in one currency for cash payments in another currency. The interest rate swap allows a company to borrow capital at fixed (or floating rate) and exchange its interest payments with interest payments at floating rate (or fixed rate).

Options
An option contract gives the holder of the contracts the option to buy or sell shares at a specified price on or before a specific date in the future.

Terminologies used in Options

Buyer

/ Holder / Owner Seller/ Writer Option Premium Strike Price Expiry Date

Call Options : An option acquired to obtain the right to buy/call an underlying in the market.
Buyer Holder Long Has the right but not the obligation to buy underlying at the strike price Seller Writer Short Is obligated on demand to sell underlying at the strike price when the holder exercises Receives the total premium

Pays the total premium

Dr. Ratnesh Chaturvedi, FMS, Session 17-18

Put Option : An option acquired to obtain the right to sell/put an underlying in the market.

Buyer Holder Long Has the right but the obligation to sell underlying at the strike price

Seller Writer Short Is obligated on demand to buy underlying at the strike price when the holder exercises

Pays the total premium

Receives the total premium

Features of Options

The option is exercisable only by the owner namely the buyer of the option. The owner has limited liability Options are popular because they allow the buyer profits from favorable movements in exchange rate.

Flexibility in investors need.

Difference between Futures & Options Futures

1. Both the parties are obliged to

Options 1. Only the seller (writer) is obligated to perform the contract. 2. The buyer pays the seller (writer) a premium. 3. The buyers loss is restricted to downside risk to the premium paid, but retains upward indefinite potentials.

perform the contract.

2. No premium is paid by either parties

3. The holder of the contract is exposed to the entire spectrum of downside risk and has potential for all the up side return.
4,The parties of the contract must perform at the settlement date. They are not obliged to perform before the date.

4. The buyer can exercise option any time prior to the expiry date.

USES OF DERIVATIVES
Most

surveys on the use of derivatives reveal that derivatives are popular among the large listed companies in US. About the half of publicly traded firms uses one or the other form of derivatives.

 The

objective of firms using derivatives is to reduce the cash flow volatility and thus, to diminish the financial distress costs. This is consistent with the theory of risk management through derivatives. firms use derivatives not for for the purpose of hedging risk rather to speculate about futures prices.

Some