01. Introduction to Derivatives

8/17/2019 01. Introduction to Derivatives

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Unit 1 Syllabus

• Introduction to Derivatives:forwards, Futures, options, swaps,trading mechanisms, Exchanges,Clearing house (structure andoperations, regulatory framework,Floor brokers, !nitiating trade,

"i#uidating or Future position, !nitialmargins, $ariation margins, %ypesand orders& future commission

merchant&


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Introduction to

Derivatives

'$! !)


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* e ri + a ti + e s m e a n i n g a n dde - n iti o n

• *eri+ati+es are instruments in respectof which the trading is carried outas a right on an underlying asset.

• In normal trading, an asset isacquired or sold& .hen we deal with*eri+ati+es, the asset itself is not

traded, but a right to buy or sell theasset, is traded.


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• %hus a deri+ati+e instrument does not directlyresult in a trade but gi+es a right to a personwhich may ultimately result in trade&

•

buyer of a deri+ati+e gets a right o+er theasset which after or during a particular periodof time might result in her buying or sellingthe asset&

• deri+ati+e is often de-ned as “ a fnancialinstrument whose value derives romthat o something else”


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• In abstract, a derivative is a price guarantee.

• /early e+ery deri+ati+e out there is 0ust anagreement between a buyer and a future seller&

•

Every derivative specifes a uture price atwhich some time can or must be sold.

• %hus item is an underlier, which might be some physical commodity such as corn or natural gas

or some fnancial security such as stock or agovt. bond or something abstract like priceindex &


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• E+ery deri+ati+e must speci-es a future date on orbefore which the transaction must occur&

• %hese are common elements of all deri+ati+es buyerand seller, underlier, uture price and uture date&

• Some deri+ati+es guarantee something other than aprice&

• Credit *eri+ati+es gi+e performance guarantee notprice guarantees&

• .eather deri+ati+es guarantee things liketemperature or rainfall&

• $ast deri+ati+es guarantee price guarantees&


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• *eri+ati+es are risk transerringinstruments& %hey are called deri+ati+essince they derive their value rom the

value o underlying, which may be eithermay be either

• interest rate, foreign exchange, index,commodity or shares or any securities&

• *eri+ati+es can be classi-ed as 2%C (o+erthe counter and Exchange %raded*eri+ati+es&


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History of derivatives exchange

• Derivatives exchanges have existed for a long

time. The Chicago Board of Trade (CBOT)

was established in 1! to bring farmers and

merchants together.

• "nitially its main tas# was to standardi$e the

%&antities and %&alities of the grains that were

traded. 'ithin a few years the first f&t&restye contract was develoed


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History of derivatives exchange

• "t was #nown as a to-arrive contract. *ec&lators

soon became interested in the contract and fo&nd

trading the contract to be an attractive alternative

to trading the grain itself.• + rival f&t&res exchange, the Chicago -ercantile

xchange (C-), was established in 1/1/.

• 0ow f&t&res exchanges exist all over the world.


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lectronic mar#ets

• Traditionally derivatives exchanges have &sedwhat is #nown as the open outcry system.

• This involves traders hysically meeting on

the floor of the exchange, sho&ting, and &singa comlicated set of hand signals to indicatethe trades they wo&ld li#e to carry o&t.


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lectronic mar#ets

• xchanges are increasingly relacing the oeno&tcry system by electronic trading. Thisinvolves traders entering their desired trades at

a #ey board and a com&ter being &sed tomatch b&yers and sellers.

• The oen o&tcry system has its advocates, b&t,

as time asses, it is becoming less and lesscommon.


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2%C *eri+ati+es

• 2+er3the3counter (2%C derivativesare contracts that are traded (and privately negotiated directly between

two parties, without going through anexchange or other intermediary.

• !roducts such as swaps, orward rate

agreements, exotic options " andother exotic derivatives " are almostalways traded in this way &


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2%C *eri+ati+es

• #he $#% derivative market is the largestmarket or derivatives, and is largelyunregulated with respect to disclosure o

inormation between the parties, since the$#% market is made up o banks and otherhighly sophisticated parties, such as hedgeunds&

•

&eporting o $#% amounts is di'cultbecause trades can occur in private, withoutacti+ity being +isible on any exchange&


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Overtheco&nter mar#ets

The overtheco&nter mar#et is an imortant alternativeto exchanges and meas&red in terms of the total vol&me

of trading, has become m&ch larger than the exchange

traded mar#et."t is a telehone and com&terlin#ed networ# of dealers.

Trades are done over the hone and are &s&ally between

two financial instit&tions or between a financial

instit&tion and one of its clients.


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• Trades in the over theco&nter mar#et are

tyically m&ch larger than trades in theexchangetraded mar#et. + #ey advantage of

the overtheco&nter mar#et is that the terms

of a contract do not have to be thosespecified by an exchange. -ar#et articiants

are free to negotiate any m&t&ally attractive

deal. + disadvantage is that there is usually

some credit risk in an over-the-counter

trade.


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-ar#et si$e • Both the overthe co&nter and the exchange

traded mar#et for derivative are huge.


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Exchange3traded*eri+ati+es

• Exchange3traded deri+ati+es (E%* are thosederi+ati+es instruments that are traded viaspecialied derivatives exchanges or otherexchanges.

• ) derivatives exchange is a market whereindividuals trade standardied contracts thathave been defned by the exchange&

•

deri+ati+es exchange acts as an intermediaryto all related transactions, and takes initialmargin from both sides of the trade to act as aguarantee&


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Exchange-tradedDerivatives

• %he exchange market is sometimes known as the4*isted +arket

• !n the exchange market buyer and seller do noneed to worry about -nding each other&

• -utures and most options are traded on exchange&

• In $#% trade, the two parties have no undamentalassurance that the other side will hold up their endo the deal.

• Exchange trade, the exchange itsel guaranteesthat all counterparties will ulfl theirresponsibilities&


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$anilla and Exotics *eri+ati+es

%ypes

• Simple deri+ati+es are known as 4$anilla5

• Some complex deri+ati+es are known as4Exotics5

• *eri+ati+es are +ariation or combinationsof four basic types

• Forward contract

•Futures contract

• Swap contract

• 2ption contract


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6ow are deri+ati+es used 7

• *eri+ati+es are used primarily for 6edging('isk 8anagement or for Speculation&

• 6edgers used deri+ati+es to reduce

-nancial risk or the prospect that the priceof things might mo+e against them&

• Speculators use deri+ati+es not to reduce-nancial risk but potentially pro-t from it&

• 2ther uses of *eri+ati+es 8arket3makersand arbitrageurs&


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6ow are deri+ati+es used 7 Contd&

• Market Maker a dealer in securities or other assets whoundertakes to buy or sell at speci-ed prices at all times

• 9+arket +aker 9 broker3dealer -rm that accepts the risk ofholding a certain number of shares of a particular security

in order to facilitate trading in that security&• Each market maker competes for customer order :ow by

displaying buy and sell #uotations for a guaranteednumber of shares&

• Arbitrageur9 type of in+estor who attempts to pro-t

from price ine;ciencies in the market by makingsimultaneous trades that o or =ine;ciencies>


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)asic *eri+ati+es %ypes

• Forward contract forward contractis an agreement to buy something ata speci-ed price on speci-ed future

date&• Futures contract futures contract is

a standardised forward contract

executed at an exchange, a forumthat brings buyers and settlerstogether&


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)asic *eri+ati+es %ypes

• Swap contract swap contract is anagreement to exchange cash :ows&

%ypically, one cash :ow is based on a

+ariable or :oating price and other on a-xed one&

• 2ption contract n option contract grantsthe holder the right but not the obligation

to buy or sell something at a speci-edprice, on or before a speci-ed future date&8ost are executed at an exchange&

Documents

01. Introduction to Derivatives