Derivatives are the financial instruments which
derive their value from the value of the underlying
Derivatives markets can be traced back to middle ages. They
were developed to meet the needs of farmers and merchants.
First future exchange was established in Japan in 16th century.
The Chicago Board of Trade was established in 1848.The
international Monetary market was established in 1972 for
future trading in foreign currencies
Players in the derivatives market?
A hedger is someone who faces risk associated with
price movement of an asset and who uses derivatives
as means of reducing risk.
short position: an asset which must be delivered to a third party as a
future date, or an asset which is borrowed and sold, but must be
replaced in the future
Hedging risk involves engaging in a financial transaction that
offsets a long position by taking an additional short position,
or offsets a short position by taking an additional long
Speculators use derivatives to bet on the future
direction of the markets. Their objective is to
gain when the prices move as per their
3 types based on duration
i. SCALPERS – hold for very short time (in
ii. DAY TRADERS- one trading day
iii.POSITION TRADERS- long period (week,
month, a year).
Arbitrageurs try to make risk-less profit by
simultaneously entering in to transactions in two or
Arbitrageurs assist in proper price discovery and
correct price abnormalities.
TYPES OF FINANCIAL DERIVATIVE
A forward is an agreement between two counterparties - a
buyer and seller. The buyer agrees to buy an underlying asset
from the other party (the seller). The delivery of the asset
occurs at a later time, but the price is determined at the time of
A futures contract is an agreement that requires a
party to the agreement either to buy or sell something
at a designated future date at a predetermined price.
Futures contracts are categorized as either
Commodity futures involve traditional agricultural
commodities (such as grain and livestock), imported
foodstuffs (such as coffee, cocoa, and sugar), and
WHO DO YOU USE FUTURES
MECHANICS OF FUTURES TRADING
A futures contract is a firm legal agreement between a
buyer and an established exchange or its
clearinghouse in which the buyer agrees to take
delivery of something at a specified price at the end
of a designated period of time.
The price at which the parties agree to transact in the
future is called the futures price.
The designated date at which the parties must transact
is called the settlement date.
LIQUIDATING A POSITION
Most financial futures contracts have settlement dates
in the months of March, June, September, or
The contract with the closest settlement date is called
the nearby futures contract.
The contract farthest away in time from the
settlement is called the most distant futures contract.
Choices of liquidation
A party to a futures contract has two choices on
liquidation of the position.
First, the position can be liquidated prior to the
The alternative is to wait until the settlement date.
DAILY PRICE LIMITS
The exchange has the right to impose a limit on the
daily price movement of a futures contract from the
previous session's closing price.
RISK AND RETURN CHARACTERISTICS OF
Long futures: An investor whose opening position is the
purchase of a futures contract
Short futures: An investor whose opening position is the
sale of a futures contract.
The long will realize a profit if the futures price increases.
The short will realize a profit if the futures price decreases
Option is basically an instrument that is traded at the derivative
segment in stock market. Option is a contract between the buyer
and seller to buy or sell a one or more lot of underlying asset at a
fixed price on or before the expiry date of the contract.
TYPES OF OPTIONS
There are mainly two types of option contact
that you can buy or sell at the stock market.
“ A call gives the holder the right to buy an asset at a certain
price within a specific period of time or certain date of time.”
“A put gives the holder the right to sell an asset at a certain
price within a specific period of time”.
The premium is the price at which the contract trades. The
premium is the price of the option and is paid by the buyer to the
writer, or seller, of the option.
The intrinsic value of an option is the difference between the
actual price of the underlying security and the strike price of
Call option=underlying asset-strike price
Put option=strike price-underlying asset
It is determined by the remaining lifespan of the option, the
volatility and the cost of refinancing the underlying asset
Time value = option price - intrinsic value
CALLS VERSUS PUTS
Call options gives the holder the right, but not the obligation, to
buy a given quantity of some asset at some time in the future, at
prices agreed upon today. When exercising a call option, you “call
in” the asset.
Put options gives the holder the right, but not the obligation, to sell
a given quantity of an asset at some time in the future, at prices
agreed upon today. When exercising a put, you “put” the asset to
STRIKE PRICE TERMINOLOGY
The type of option and the relationship between the spot price of
the underlying asset and the strike price of the option determine
whether an option is in-the-money, at-the-money or out-of-themoney.
In- the Money
TRADING & PARTICIPANTS OF OPTIONS
Trading of option
Options are traded both on exchanges and in the over-the-counter
Participant of options
There are four types of participants in options markets.
Buyers of calls
Seller of calls
Buyer of puts
Seller of puts
Derivatives Market in Pakistan
Commodity futures contracts have recently been
introduced from the platform of National Commodity
Exchange Limited Karachi. Currently they only trade
in Gold futures and plan to expand the contracts on
agricultural commodities and interest rates.
SBP took initiative in 2004 by granting Authorized
Derivative Dealers (ADD) license to five commercial
Need & Scope of Derivatives in Pakistan
Volatile financial markets due to:
1. Political Uncertainty
2. Monetary Policy
3. Fiscal Policy
4. Foreign Investment
5. War On Terror