Derivatives BasicsBy: Ajay Mishra

JSSGIW faculty of Management,Bhopal

Introduction In business decisions are made in the

presence of RISK A decision maker confront two types of risk

Business Risk

Financial Risk

Business Risks

Uncertainity of future sales.

Cost of Inputs.

Financial Risks

Interest rates Exchange rates Stock prices Commodity prices

Our financial system is replete with risk

It also provides a means of dealing with risk in form of deriavatives.

Derivatves They are the financial instruments whose

returns are derived from those of other financial instruments.

Their performance depends on how other financial instruments performs.

Derivatives serve a valuable purpose in providing a means of managing financial risk.

Derivatives By using derivatives companies and individuals can

transfer, for a price, any undesired risk to other parties.

The vast majority of derivatives, however created in private transactions in over the counter markets.

Derivative can be based on real assets, which are physical assets and include agricultural commodities, metals, and source of energy.

It also be based on financial assets which are Stocks, Bons/Loans and currencies.

Derivative Markets and Instruments What is an Instrument?

Instrument

An asset or an item of ownership Having a positive monetary value

A Liability or an item of ownership having a negative monetary value

Derivative Markets and Instruments A security is a tradable instrument

representing a claim on a group of assets. We know that A contract is an enforceable

legal agreement. For a asset transaction the required asset be

delivered immediately or shortly thereafter. Payment usually is made immediately or

sometime credit arrangements are made.

Derivative Markets and Instruments On the first basis the markets are known as

cash market or spot market. Where: Sale is made

Payment is remitted

Goods or security is delivered

Derivative Markets and Instruments For other type of arrangements which allow

the buyer or seller to choose whether or not to go through with the sale.

These type of arrangements are conducted in derivatives market.

Derivative Markets and Instruments Derivatives markets are market for

contractual instrument whose performance is determined by the way in which another instrument or asset performs.

Like all other contracts they are also agreements between two parties as a buyer and a seller, with a price where the buyers try to buy as cheaply as possible and sellers try to sell as dearly as possible,

Derivative Markets and Instruments Various types of

derivative contracts

OPTIONS, FORWARDS FUTURES AND SWAPS AND RELATED DERIVATIVES

OPTIONS, FORWARDS FUTURES AND SWAPS AND RELATED DERIVATIVES

Option (Introduction) Contract between two parties a buyer and a seller. Gives the buyer the right but not the to obligation,

to purchase or sell something at a later date at a price agreed upon today

Buyer pays a sum of money called price or premium Seller stands ready to sell or buy according to the

terms and when the buyer so desires.

Option (Introduction) An option to buy something is referred to a CALL An option to sell something is called a

PUT. Major options are for the purchase or sale of

financial assets such as stocks and bonds, but there are also options on future contracts, metals, and currencies and even loan guarantees and insurance are forms of options.

Stock itself is equivalent to an option.

Forward Contracts (Introduction) Contract between two Parties to purchase or

sell something at a later date at a price agreed upon today

The two parties in a forward contract incur the obligation to ultimately buy and sell the good

They trade strictly in an over the counter market consisting of direct communication.

Futures Contracts (Introduction) Contract between two parties to buy or sell

something at a future date at a price agreed upon today.

The contract trades on a future exchange and is subject to a daily settlement procedure.

Unlike forward contracts however the future contracts trade on organised exchanges.

The buyer of a future contract who has the obligation to buy the good at the later date, can sell the contract in future market, which relieves him of the obligation. Likewise the seller can buy the contract back relieving him of the obligation to sell the good.

Swaps and other Derivatives A Swap is a contract in which two parties agree to

exchange cash flows. The firm and the dealer in effect swap cash flow

streams. Depending on what later happens to price or interest rates.

In this one party might gain at the expense of others. An option to enter into a swap is called swaption.

Return and Risk

RISKRISK

ReturnReturn