Introduction

Derivatives-a financial product becoming increasingly popular

Derivative is….A derivative is a financial instrument, whose value depends on the value of basic underlying variable The value of derivative is linked to risk or volatility in either financial asset, transaction, market rate, or contingency, and creates a product

Features of DerivativesTraded on exchange10. No compulsory physical trading of underlying assets11. All transactions in derivatives take place in future specific date12. Hedging Device-Reduces risk13. Derivatives has low transaction cost14. Derivatives are often leveraged, such that a small movement in the underlying value can cause a large difference in the value of the derivative.

Types of Derivatives Contracta) Forwards b) Futures c) Swaps d) Options

ForwardsA forward contract is a customized contract between two entities, where settlement takes place as a specific date in the future at predetermined price.

Ex: On 10th Novem, Ram enters into an agreement to buy 100 kgs of wheat on 1st May at Rs.10000 from Shyam, a farmer. It is a case of a forward contract where Ram has to pay Rs.10000 on 1st May to Shyam and Shyam has to supply 100 kgs of wheat. Ram has taken a long position assuming the price of the wheat will rise in the future six months .

Normally traded outside exchangeFutures

A financial contract obligating the buyer to purchase an asset, (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price.Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange.Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very

high leverage relative to stock markets.20. Some of the most popular assets on which futures contracts are available are equity stocks, indices, commodities and currency.

SwapsSwaps are private agreement between two parties to exchange cash flows in the future according to a pre-arranged formula.

The two commonly used Swaps are-i) Interest Rate Swaps: - A interest rate swap entails swapping

only the interest related cash flows between the parties in the same currency.

ii) Currency Swaps: - A currency swap is a foreign exchange agreement between two parties to exchange a given amount of one currency for another and after a specified period of time, to give back the original amount swapped.

Options

Call option - give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a particular date by paying a premium.

Put option - give the buyer the right, but not obligation to sell a given quantity of the underlying asset at a given price on or before a particular date by paying a premium.

American Option An option that may be exercised on any trading day on or before expiry .

European Option An option that may only be exercised on expiry date

Important Concepts of OptionIn-the money

A call option said to be in the money, when Future price> Option’s strike price A put option said to be in the money, when Future price < Option’s strike price

At- the moneyA option is at the price, when Future price = Option’s strike price

Out of the moneyA call option said to be out of the money, when Future price < Option’s strike price A put option said to be out of the money, when Future price > Option’s strike price30. Types of Derivatives Markets

Over-the-Counter derivatives-Contracts that are traded between two parties directly without going through a exchange.

The contract between the two parties are privately negotiated.Over-the-counter markets are uncontrolled, unregulated and

have very few laws. Its more like a freefall.

31. Forward and swap contracts are OTC derivatives.Exchange -traded derivatives-

Contracts that are traded in derivatives exchangesThe world's largest derivatives exchanges (by number of transactions) are the Korea Exchange.There is a very visible and transparent market price for the derivatives.

Traders in Derivatives Market

Hedgers -Transfer of risk component of their portfolio.Speculators - Intentionally taking the risk from the hedgers in pursuit of profit.Arbitrageurs -Operating in different markets simultaneously, in pursuit of profit and eliminate mis-pricing.