• Derivative is a security whose value depends on the
values of the other underlying variables.
• A derivative is a financial contract which derives its
value from the performance of another entity such as
an asset, index, or interest rate, called the "underlying".
• Derivative securities are available on stocks, stock
indices, bullion, index, currency, bonds, interest
rates, commodities in the world.
• Derivatives are one of the three main categories of
financial instruments, the other two being equities (i.e.
stocks) and debt (i.e. bonds and mortgages).
• Derivatives include a variety of financial
contracts, including futures, forwards, swaps,
options, and variations of these such as
caps, floors, collars, and credit default
• Futures contracts, forward contracts, options
and swaps are the most common types of
• Financial Derivatives can be classified into Futures and
• The derivatives market is the financial
market for derivatives, financial
instruments like futures contracts or
options, which are derived from other
forms of assets.
• The market can be divided into two, that
for exchange-traded derivatives and that
for over-the-counter derivatives.
Economic functions of
• Helps in managing risks
• Helps in the discovery of future prices
• Increases the volume traded in markets
(risk averse people participate in greater
• Increases savings and investment in the
Components of a
ex: stock futures contract on an Index
or options on a security or on a
ii. Trading mechanism
iii. Clearing Facility
iv. Settlement Procedures
Clearing and Settlement
• Clearing and settlement are fundamental
processes in financial markets.
• After the trade is executed, the record is
submitted to the clearing agency, which matches
the buyer and seller record and confirms that the
counterparts agree to the terms.
• The agency reports discrepancies to traders in
case the reports do not match, who then try and
• After the clearing process is performed, through
settlement, agencies fulfill the delivery
requirements of the securities object of a trade.
• The settlement agency receives cash from
buyers and securities from sellers and, at the
end of the process, gives the securities to the
buyer and the cash to the seller. Agencies
perform an important function in case a trader is
not trustworthy or creditworthy.
Participants in a
Advantages of Derivatives
• Can be used as a convenient substitute
for other investments
• Can be used to hedge the risk and can
help manage the risks inherent in a
• Can be used speculatively to increase risk
and reward through leverage.
• Derivatives are also the basis for modern
Stock Index Futures
• Stock market index future is a cash-settled futures
contract on the value of a particular stock market
• Stock index futures are used for hedging, trading, and
Hedging using stock index futures could involve hedging against a
portfolio of shares or equity index options.
Trading using stock index futures could involve, for instance,
volatility trading (The greater the volatility, the greater the likelihood
of profit taking – usually taking relatively small but regular profits).
Investing via the use of stock index futures could involve exposure
to a market or sector without having to actually purchase shares
• Options is a financial derivative that represents a
contract sold by one party (option writer) to another
party (option holder).
• The contract offers the buyer the right, but not the
obligation, to buy (call) or sell (put) a security or other
financial asset at an agreed-upon price (the strike
price) during a certain period of time or on a specific
date (exercise date).
• To acquire the right of option, the buyer pays to the
option seller (option writer) an Option Premium
Futures and Options
• In Futures contract, both parties have obligation to
perform the contract.
• In case of Options, only the seller has the obligation,
while the buyer has the right without the obligation to
exercise the contact.
• Options are contracts giving the holder the right (but not
the obligation) to buy or sell securities. at a predetermined price (known as strike price or exercise
price), within or at the end of a specified period.
FUTURE Vs. OPTION
• FUTURE – Right with obligation to
• OPTION – Right without Obligation to
exercise the contract
Types of Options
• Call Option – gives the buyer a right to
buy the underlying asset
• Put Option – gives the buyer a right to
sell the underlying asset
Risk and Return Profile
of Option Contracts:
• Option Buyer has limited risk and
unlimited return potential
• Option Writer has unlimited risk and
limited return potential (premium received
from the buyer)