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Derivatives

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derivatives market JNTUH Business Environment Topic

derivatives market JNTUH Business Environment Topic

Published in: Business, Economy & Finance

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  • 1. Derivatives
  • 2. Derivatives • 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).
  • 3. Derivatives • Derivatives include a variety of financial contracts, including futures, forwards, swaps, options, and variations of these such as caps, floors, collars, and credit default swaps. • Futures contracts, forward contracts, options and swaps are the most common types of derivatives • Financial Derivatives can be classified into Futures and Options
  • 4. Derivatives Market • 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.
  • 5. Economic functions of Derivatives Market • Helps in managing risks • Helps in the discovery of future prices • Increases the volume traded in markets (risk averse people participate in greater numbers) • Increases savings and investment in the long run.
  • 6. Components of a Derivatives exchange 4 components: i. Product ex: stock futures contract on an Index or options on a security or on a commodity ii. Trading mechanism iii. Clearing Facility iv. Settlement Procedures
  • 7. 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 resolve them.
  • 8. Settlement • 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.
  • 9. Participants in a Derivatives Market 3 types: i. Hedgers ii. Speculators iii. Arbitrageurs
  • 10. 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 business • Can be used speculatively to increase risk and reward through leverage. • Derivatives are also the basis for modern financial engineering.
  • 11. Stock Index Futures • Stock market index future is a cash-settled futures contract on the value of a particular stock market index. • Stock index futures are used for hedging, trading, and investments. • 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 directly.
  • 12. Options • 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
  • 13. Difference between 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.
  • 14. FUTURE Vs. OPTION • FUTURE – Right with obligation to exercise contract • OPTION – Right without Obligation to exercise the contract
  • 15. 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
  • 16. 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)