derivatives and financial derivatives

1. DERIVATIVES
DR SIJI K,
ASSOCIATE PROFESSOR,
GOPALAN COLLEGE OF COMMERCE

2. MEANING
 Derivatives are contracts whose value is dependent
on an underlying asset, which could be anything
from a stock to a bond to a foreign currency, or
something else.
Examples of derivatives include forwards, futures,
and options.

3. Participants in derivatives market
 Hedgers who try to minimize loses of both the parties entering into
a derivative contract. and at the same time, they protect themselves
against price changes in the products that they deal in. They use
options and futures and hedge in both financial derivatives and
commodities derivatives.
 Speculators take high risks for potential gains and participate in
future and option.
 Arbitrageurs are able to make a profit through the difference in
price of the asset in different markets. They make a risk less profit
but they have to analyse the market with speed to ensure
profitability.

4. CLASSIFICATION OF DERIVATIVES
 Commodities derivatives: These are derivatives on commodities like sugar, jute,
paper, gur, castor seeds.
 Financial Derivatives: These derivatives deal in shares, currencies and gilt-edged
securities.
 Basic Derivatives: Futures and Options are basic derivatives.
 Complex Derivatives: Interest rate futures and swaps are classified as complex
derivatives.
 Exchange traded derivatives are standard contracts traded according to the rules
and regulations of a stock exchange. Only members can trade in exchange traded
derivatives and they are guaranteed against counter-party default. Contracts are
settled daily.
 OTC Derivatives are regulated by statutory provisions. Swaps, forward contracts
in foreign exchange are usually OTC derivatives and have a high risk of default.

5. FINANCIAL DERIVATIVES
What is a forward?
 A forward contract are agreements to buy or sell an asset at an agreed-upon
price at a specific date in the future. It is a customised contract, in the sense
the term of contract are agreed upon the individual parties.Hence it is traded
in Over the trade counter market.
 Forward contracts are mainly used by companies to hedge their risks and to
speculate on currencies, commodities, stock exchange, bonds, interest rates....
The party that agrees to buy the commodity, obtain a loan or purchase a
currency, etc. is said to have a long position while the other party is said to
have a short position.

6. Features of Forward Contract
 Over the counter trading
 No down payment
 Settlement at maturity
 Linearity
 No secondary market
 Delivery

7. Formula of forward contract
 At Initiation
At the initiation of the forward contract, no money is
exchanged and the contract at initiation is valueless (V0(T)).
V0(T)=0
The forward price at initiation is the spot price of the
underlying compounded at the risk-free rate over the life of
the contract.
F0(T)=S0(1+r)TF0(T)=S0(1+r)T

8.  During the life of the contract
The value of the forward contract is the spot price of the
underlying asset minus the present value of the forward
price:
VT(T)=ST−F0(T)(1+r)−(T−r)VT(T)=ST−F0(T)(1+r)−(T−r)
i.e. that this is a zero-sum game: The value of the contract to
the short position is the negative value of the long position.
 At Expiration
At expiration, the value of the forward contract (long
position) will be:
VT(T)=ST−F0(T)

9. Future contract
What is future?
A futures contract is a contract between two parties where both parties
agree to buy and sell a particular asset of specific quantity and at a
predetermined price, at a specified date in future.
The payment and delivery of the asset is made on the future date
termed as delivery date.
The underlying asset in a futures contract could be commodities,
stocks, currencies, interest rates and bond. The futures contract is held
at a recognized stock exchange.
Futures can be used to hedge against risk or speculate the prices.

10. Features of future contract
Organised exchange
Standardisation
Making to market
Clearing house
No counter party risk

11. Formula of future contract
 Value at inception
The value of futures contract for the buyer at inception is
zero and the value at expiration equals the difference
between the associated spot rate at the expiration date minus
the futures price i.e. the price at which the futures contract
was purchased.
VT = ST − F0 Where,
VT is the value at expiration,
ST is the spot price at expiration, and
F0 is the futures price looked through the futures contract.

12.  Value after inception but before expiry date
The value of the futures contract equals the difference between the spot price at that
time (denoted as St) minus the present value of the futures price locked at time t. The
value of futures F0 that we expected to get at time T can be worked out by discounting
the futures price (F0) at risk-free rate r for the remaining time period (i.e. T minus t).
The value of the futures contract can be worked out as follows:
 Vt=St-F0/(1+r)(T-t)

13. Option
 Options are financial instruments that are derivatives based on the
value of underlying securities such as stocks. An options contract
offers the buyer the opportunity to buy or sell—depending on the type
of contract they hold—the underlying asset.
 Two types of options :
 Call option:The holder to buy the asset at a stated price within a
specific timeframe.
 Put option:The holder to sell the asset at a stated price within a
specific timeframe.
Each option contract will have a specific expiration date by which the
holder must exercise their option. The stated price on an option is
known as the strike price. Options are typically bought and sold
through online or retail brokers.

14. Features of option
Highly flexible
Down payment
Settlement
Non-linearity
No obligation to buy or sell

15. Terminologies in option
 Expiration date: The date when the options contract becomes void.
 Strike price or exercise price: The price at which you can buy or
sell the stock
 Premium: The per-share price you pay for an option. The premium
consists of:
Intrinsic value: The value of an option based on the difference
between a stock’s current market price and the option’s strike price.
Time value: The value of an option based on the amount of time
before the contract expires.
 American-Style Option - An option contract that may be exercised
at any time between the date of purchase and the expiration date.
Most exchange-traded options are American-style.
 At the Money - When an option's strike price is the same as the
prevailing stock price.

16.  In-The-Money : For call options, this means the stock price
is above the strike price.
 Out-of-The-Money — For call options, this means the stock
price is below the strike price.
 At-The-Money :when the stock price is equal to the strike
price.
 Ask Price- The price at which a potential seller is willing to
sell.
 Bid Price - The price at which a potential buyer is willing to
buy from you.
 Spread:Bid/Ask Spread - The difference between the
prevailing bid and ask price.
 European option - Option may be exercised at its expiration.

17. SWAP
 A swap is a derivative contract where two
parties exchange financial instruments. Most swaps are
derivatives in which two counterparties exchange cash
flows of one party's financial instrument for those of the
other party's financial instrument.
 swaps are not exchange-traded instruments. Swaps
are customized contracts that are traded in the over-the-
counter market between private parties.

18. Types of swap
 Currency swap: An agreements between counter-parties to exchange
interest and principal payments in different currencies Cross-currency
swaps can be used to transform the currency denomination of assets
and liabilities and give companies extra flexibility to exploit their
comparative advantage in their respective borrowing markets.
 . Credit Default Swap: It is a financial instrument for swapping the
risk of debt default.
 Commodity Swap: It is an agreement whereby a floating (or market
or spot) price is exchanged for a fixed price over a specified period.
 Interest Rate Swap: It is an agreement between two parties to
exchange a sequence of interest payments without exchanging the
underlying debt.

19. Uses of swap
 To create either synthetic fixed or floating rate liabilities or
assets,
 To hedge against adverse movements,
 As an asset liability management tool,
 To reduce the funding cost by exploiting the comparative
advantage that each counterparty has in the fixed/floating
rate markets, and
 For trading.

20. Conclusion
The derivatives market is a market where investors come to exchange
risks. In a global economy with divergent risk
exposures, derivatives allow businesses and investors to protect
themselves from rapid price fluctuations and negative events.