Derivative

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Notes by rameshwar Patel, pacific institute of management, Udaipur

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Derivative

  1. 1. Derivatives <ul><li>Derivatives are usually broadly categorized by: </li></ul><ul><li>The relationship between the underlying and the derivative (e.g. forward, option, swap) </li></ul><ul><li>The type of underlying (e.g. Equity derivatives, FX derivatives, credit derivatives) </li></ul><ul><li>Examples </li></ul><ul><li>The overall derivatives market has five major classes of underlying asset: </li></ul><ul><li>interest rate derivatives (the largest) </li></ul><ul><li>foreign exchange derivatives </li></ul><ul><li>credit derivatives </li></ul><ul><li>equity derivatives </li></ul><ul><li>commodity derivatives </li></ul><ul><li>The market in which they trade (e.g. exchange traded or over-the-counter) </li></ul><ul><li>Common derivative contract types </li></ul><ul><li>There are three major classes of derivatives: </li></ul><ul><li>Futures/Forwards are contracts to buy or sell an asset on or before a future date at a price specified today. A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold, while a forward contract is a non-standardized contract written by the parties themselves. </li></ul>
  2. 2. <ul><li>Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. The option contract also specifies a maturity date. In the case of a European option, the owner has the right to require the sale to take place on (but not before) the maturity date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity date. If the owner of the contract exercises this right, the counterparty has the obligation to carry out the transaction. </li></ul><ul><li>Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets. </li></ul><ul><li>More complex derivatives can be created by combining the elements of these basic types. For example, the holder of a swaption has the right, but not the obligation, to enter into a swap on or before a specified future date. </li></ul>
  3. 3. <ul><li>A forward contract or simply a forward is an agreement between two parties to buy or sell an asset at a certain future time for a certain price agreed today. </li></ul><ul><li>This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract. The party agreeing to buy the underlying asset in the future assumes a long position , and the party agreeing to sell the asset in the future assumes a short position . The price agreed upon is called the delivery price , which is equal to the forward price at the time the contract is entered into. </li></ul><ul><li>The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party. </li></ul>
  4. 4. Suppose that Mr. A wants to buy a house a year from now. At the same time, suppose that Mr. B currently owns a $100,000 house that he wishes to sell a year from now. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year's time of $104,000 A and B have entered into a forward contract. A, because he is buying the underlying, is said to have entered a long forward contract. Conversely, B will have the short forward contract. At the end of one year, suppose that the current market valuation of B's house is $110,000. Then, because B is obliged to sell to Bob for only $104,000, A will make a profit of $6,000. To see why this is so, one needs only to recognize that A can buy from B for $104,000 and immediately sell to the market for $110,000. A has made the difference in profit. In contrast, B has made a potential loss of $6,000, and an actual profit of $4,000.
  5. 5. <ul><li>A  futures contract is a type of derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. </li></ul><ul><li>So, a futures contract is an agreement between two parties: a short position - the party who agrees to deliver a commodity -  and a long position - the party who agrees to receive a commodity </li></ul><ul><li>A producer of wheat may be trying to secure a selling price for next season's crop, while a bread maker may be trying to secure a buying price to determine how much bread can be made and at what profit. So the farmer and the bread maker may enter into a futures contract requiring the delivery of 5,000 bushels of grain to the buyer in June at a price of $4 per bushel. By entering into this futures contract, the farmer and the bread maker secure a price that both parties believe will be a fair price in June. </li></ul>
  6. 6. <ul><li>It is this contract - and not the grain per se - that can then be bought and sold in the futures market. In the above scenario, the farmer would be the holder of the short position (agreeing to sell) while the bread maker would be the holder of the long (agreeing to buy). In every futures contract, everything is specified: the quantity and quality of the commodity, the specific price per unit, and the date and method of delivery. The “price” of a futures contract is represented by the agreed-upon price of the underlying commodity or financial instrument that will be delivered in the future. For example, in the above scenario, the price of the contract is 5,000 bushels of grain at a price of $4 per bushel. </li></ul>
  7. 7. <ul><li>Fundamentally, forward and futures contracts have the same function: both types of contracts allow people to buy or sell a specific type of asset at a specific time at a given price. However, it is in the specific details that these contracts differ. </li></ul><ul><li>First of all,  futures contracts are exchange-traded and, therefore, are standardized contracts. Forward contracts, on the other hand, are private agreements between two parties and are not as rigid in their stated terms and conditions.  </li></ul><ul><li>Because forward contracts are private agreements, there is always a chance that a party may default on its side of the agreement. Futures contracts have clearing houses that guarantee the transactions, which drastically lowers the probability of default to almost never. Secondly, the specific details concerning settlement and delivery are quite distinct. For  forward contracts , settlement of the contract occurs at the end of the contract. Futures contracts  are marked-to-market daily, which means that daily changes are settled day by day until the end of the contract. Furthermore, settlement for futures contracts can occur over a range of dates. Forward contracts, on the other hand, only possess one settlement date.  </li></ul>
  8. 8. <ul><li>Lastly, because futures contracts are quite frequently employed by speculators, who bet on the direction in which an asset's price will move, they are usually closed out prior to maturity and delivery usually never happens. </li></ul><ul><li>On the other hand, forward contracts are mostly used by hedgers that want to eliminate the volatility of an asset's price, and delivery of the asset or cash settlement will usually take place.  </li></ul>
  9. 9. An option <ul><li>An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. </li></ul><ul><li>An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties. for example, that you discover a house that you'd love to purchase. Unfortunately, you won't have the cash to buy it for another three months. You talk to the owner and negotiate a deal that gives you an option to buy the house in three months for a price of $200,000. The owner agrees, but for this option, you pay a price of $3,000. </li></ul>
  10. 10. <ul><li>Now, consider two theoretical situations that might arise: 1 The market value of the house skyrockets to $1 million. Because the owner sold you the option, he is obligated to sell you the house for $200,000. In the end, you stand to make a profit of $797,000 ($1 million - $200,000 - $3,000). 2. While touring the house, you discover not only that the walls are chock-full of asbestos, Though you originally thought you had found the house of your dreams, you now consider it worthless. On the upside, because you bought an option, you are under no obligation to go through with the sale. Of course, you still lose the $3,000 price of the option. This example demonstrates two very important points. </li></ul><ul><li>First, when you buy an option, you have a right but not an obligation to do something. You can always let the expiration date go by, at which point the option becomes worthless. If this happens, you lose 100% of your investment, which is the money you used to pay for the option. </li></ul><ul><li>Second, an option is merely a contract that deals with an underlying asset. For this reason, options are called derivatives, which means an option derives its value from something else. In our example, the house is the underlying asset. Most of the time, the underlying asset is a stock or an index. </li></ul>
  11. 11. <ul><li>Calls and Puts The two types of options are calls and puts: A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires. A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires. </li></ul>
  12. 12. Contract specifications <ul><li>There are two main types of options: </li></ul><ul><li>American options can be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are of this type. </li></ul><ul><li>European options are different from American options in that they can only be exercised at the end of their lives. </li></ul><ul><li>whether the option holder has the right to buy ( a call option) or the right to sell ( a put option) </li></ul><ul><li>the quantity and class of the underlying asset(s ) (e.g. 100 shares of XYZ Co. B stock) </li></ul><ul><li>the strike price , also known as the exercise price , which is the price at which the underlying transaction will occur upon exercise </li></ul><ul><li>the expiration date , or expiry, which is the last date the option can be exercised </li></ul><ul><li>the settlement terms , for instance whether the writer must deliver the actual asset on exercise, or may simply tender the equivalent cash amount </li></ul><ul><li>the terms by which the option is quoted in the market to convert the quoted price into the actual premium –the total amount paid by the holder to the writer of the option. </li></ul>
  13. 13. <ul><li>There are three types of traders in the derivatives market: </li></ul><ul><li>1. Hedger </li></ul><ul><li>2. Speculator </li></ul><ul><li>3. Arbitrageur </li></ul><ul><li>Hedger : A hedge is a position taken in order to offset the risk associated with some other position. A hedger is someone who faces risk associated with price movement of an asset and who uses derivatives as a means of reducing that risk. A hedger is a trader who enters the futures market to reduce a pre-existing risk. </li></ul><ul><li>Speculators : While hedgers are interested in reducing or eliminating risk, speculators buy and sell derivatives to make profit and not to reduce risk. Speculators willingly take increased risks. Speculators wish to take a position in the market by betting on the future price movements of an asset. </li></ul>
  14. 14. <ul><li>Arbitrageur: An arbitrageur is a person who simultaneously enters into transactions in two or more markets to take advantage of discrepancy between prices in these markets For example, if the futures price of an asset is very high relative to the cash price, an arbitrageur will make profit by buying the asset and simultaneously selling futures. Hence, arbitrage involves making profits from relative mispricing. </li></ul><ul><li>All three types of trades and investors are required for a healthy functioning of the derivatives market. Hedgers and investors provide economic substance to this market, and without them the markets would become mere tools of gambling. Speculators provide liquidity and depth to the market. </li></ul><ul><li>Arbitrageurs help in bringing about price uniformity and price discovery. </li></ul><ul><li>The presence of Hedgers, speculators and arbitrageurs, not only enables the smooth functioning of the derivatives market but also helps in increasing the liquidity of the market. </li></ul>

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