Forward, Futures, Options & Swap Arbitrageurs,Speculators & Hedgers

1. Prof Smruti Ranjan Sahoo
FINANCUAL DERIVATIVES
-TYPES & PARTICIPANTS-

2.  The term “derivatives” is used to refer to financial instruments
which derive their value from some underlying assets.
 The underlying assets could be equities (shares), debt (bonds,
T-bills, and notes), currencies, and even indices of these
various assets, such as the Nifty 50 Index.
 Derivatives contracts are bought and sold by a large number
of individuals, institutions and other’s for a variety of
purposes.
 When the price of the underlying changes, the value of the
derivative also changes.
 E.g. The value of the gold futures contract is derived from the
value of underlying asset i.e. gold.

4.  A forward contract or simply a forward is a contract
between two parties to buy or sell an asset at a certain
future date for a certain price that is pre-decided on the
date of the contract.
 The future date is referred to as expiry date and the
pre-decided price is referred to as Forward Price.
 It is the customized contract, in the sense that the term
of the contract are agreed upon by the individual
parties.
 Hence it is traded on Over The Counter (OTC).
 Default risk, Credit risk & Counter-party risk involved in
this type of contract.

6.  Like a forward contract, a futures contract is an agreement
between two parties in which the buyer agrees to buy an
underlying asset from the seller, at a future date at a price
that is agreed upon today.
 Unlike a forward contract, a futures contract is not a private
transaction but gets traded on a recognized stock exchange.
In addition, a futures contract is standardized by the
exchange.
 Both buyer and seller of the futures contracts are protected
against the counter party risk by an entity called the Clearing
Corporation.

8.  Like forwards and futures, options are derivative
instruments that provide the opportunity to buy or
sell an underlying asset on a future date.
 Options can be divided into two different
categories depending upon the primary exercise
styles associated with options. These categories
are American option & European option.
 There are two types of options—call options and
put options—which are explained below.

10.  Call option gives the buyer the right but not the obligation to
buy a given quantity of the underlying assets, at a given price
on or before a given future date.
 If assets price is higher than the strike price – Option is in the
money.
 If assets price is exactly at the strike price – Option is at the
money.
 If assets price is below the strike price – Option is out of the
money.

11.  Put gives the buyer the right but not obligation to sell a given
quantity of the underlying asset at a given price on or before
a given date.
 If asset price is lower than the strike price – Option is in the
money.
 If asset price is exactly at the strike price – Option is at the
money.
 If asset price is higher than the strike price – Option is out of
the money.

12.  Swaps are private agreement between two parties to
exchange cash flows in the future according to pre arranged
formula. They can be regarded as portfolio’s of forward
contract.
 The two commonly used swaps are:
 Interest rate swaps: This entail swapping only the interest
related cash flows between the parties in the same currency.
 Currency swaps: This entail swapping both principal and
interest between the parties with the cash flows in one
direction being in a different currency than those in the
opposite direction.

13.  Exchange Traded Derivatives: Derivatives which are traded on
an exchange are called exchange traded derivatives. Trades
on an exchange generally take place with anonymity i.e.
buyer and seller do not know each other. Generally go
through the clearing corporation. E.g. S&PCNX nifty futures,
OPTINDX nifty.
 OTC Derivatives: A derivative contract which is privately
negotiated is called the OTC derivative. OTC trades have no
anonymity and they generally do not go through a clearing
corporation. E.g. foreign exchange transaction between banks
and its cliants.

15.  Hedge is the position taken in derivative exchange/markets
for the purpose of reducing risk. A person who takes such
position is called hedger.
 A hedger uses the derivatives market to reduce risk caused by
movement in prices of shares/securities, commodities,
exchange rates, interest rate, indices, etc.
 The position taken by hedger is opposite to the risk he is
exposed.
 Taking an opposite position to the risk exposure is called
hedging strategy.

16.  A speculator may be defined as a investor who is willing to
take a risk by taking derivatives position with the expectation
to earn profits.
 The speculator forecasts the future economic conditions and
decides which position (long or short) to be taken will yield a
profit if his forecast is correct.

17.  An arbitrageur is an intelligent trader who attempts to make
profits in a derivatives market by simultaneously entering into
two transaction at a time in two different markets and takes
advantage of the difference in pricing.
 The arbitrage opportunities available in two markets usually
do not last long because of heavy transaction by arbitrageur
when such opportunity arises.