The document provides an overview of financial derivatives, which are instruments whose value is derived from underlying assets such as stocks, bonds, and commodities. It explains different types of derivatives, including forwards, futures, options, and swaps, as well as their purposes like speculation, arbitrage, and hedging. Additionally, it details the mechanics of various derivative contracts, including examples of their functions and risks involved.

1. DERIVATIVE MARKET

2. e.g.
A forward contract on gold, is the derivative instrument,
while gold is the actual, underlying asset
What are the underlying assets?
• Stocks
• Bonds
• Commodities
• Currencies
• Interest Rates
Which are the Common Financial Derivatives?
• Forwards
• Futures
• Options
• Swaps

3. Denny B Justin : Derivatives are financial instruments whose value is
derived from an underlying asset or a group of assets. These assets range
from stocks, bonds, commodities, currencies, interest rates, or market
indices. These financial instruments allow you to profit by betting on the
underlying asset's future value. As a result, their value is derived from
the underlying asset. This is why they are referred to as 'Derivatives.'

4. WHY DERIVATIVES?
Consider a farmer, whose fresh crop of corn will be harvested in three months from
now. He is unsure about the price he will receive at that time. Will he get a buyer
when he is in the market to sell corn, three months later?
A derivative contract will enable him to enter into a firm contract
today, to sell a fixed quantity of corn, of an agreed upon quality, at a mutually agreed
price, at the time specified (in his case, three months).
The farmer now knows how much demand there is for his corn for
delivery after three months (when he is ready with his harvest) and he also knows
what price he will receive for his produce. Uncertainty removed

5. Financial Derivatives are Used For:
• Speculation: A speculator is one who bets on a price movement, in her/his favor. Ineffect,
speculators use derivatives as a tool of LEVERAGE to enhance returns (or to lose more
money, if they are proved wrong)
• Arbitrage: An arbitrageur takes advantage of a price differential in two markets, for the
same asset, at the same time. Essentially, she/he makes a (theoretically) riskless profit by
buying the asset in the market with a lower price, while simultaneously selling it in the
market with a higher price.
• Hedging: A hedger either owns the asset, or the right to the asset; or she/he is a consumer
of the asset, or a prospective consumer of the asset. Hedgers use F&O (futures & options)
markets to reduce their risk. (A perfect hedge would be one which eliminates risk, entirely)

6. TYPES OF DERIVATIVES
• FORWARD CONTRACT
• FUTURE CONTRACT
• OPTION CONTRACT
• SWAP

7. FORWARD CONTRACT
A forward contract is
• a contract between two parties
• either on a one-on-one basis, or transacted on an
OTC (Over-The Counter) Exchange
• binding on both parties
• completed with one buyer and one seller
• specific in terms of, the price of the underlying to be
exchanged, the quality/type of the underlying, the
date of delivery, the quantity, and where applicable,
the place and mode of delivery
• a customized contract wherein both parties to the
contract must be consensus ad idem

8. e.g.
If “A” agrees to purchase 100 kg of wheat from “B” at Rs. 40/ per kg, after
6months, it is a forward contract. (Note that the quality, specifications, delivery
terms are all clearly specified in the contract)
“A” is assured of a buyer of 100 kg, @ 40/ per kg, 6 months from now.
“B” is assured of supply of 100 kg, @ 40/ per kg, 6 months from now.
Win-Win situation, right?
THERE IS COUNTER- PARTY RISK IN FORWARDCONTRACTS
Counter-party risk is the risk of default by one of the parties to the contract. This may not
be mala fide, but it happens. One person’s gain is another person’s loss. When the price
of wheat becomes 55/ then “A” has every incentive to default on a contract to deliver at
40/. The reverse would hold true, if the price of wheat crashed to 25/...in which case, “B”
would be better off, not honoring the forward contract, but rather, purchasing the required
quantity in the spot market. With the best of intentions also, it is possible that one party is
not able to fulfil her/his commitment as per the forward contract.

9. FUTURES CONTRACT
Futures is a standardized forward contact to buy (long) or sell (short) the
underlying asset at a specified price at a specified future date through a specified
exchange. Futures contracts are traded on exchanges that work as a buyer or seller
for the counterparty. Exchange sets the standardized terms in term of Quality,
quantity, Price quotation, Date and Delivery place (in case of commodity).

10. The features of a futures contract may be specified as follows:
• These are traded on an organised exchange like NSE, BSE, CBOT (Chicago
Board of Trade) etc.
• These involve standardized contract terms viz. the underlying asset, the time
of maturity and the manner of maturity etc.
• These are associated with a clearing house to ensure smooth functioning of
the market.
• There are margin requirements and daily settlement to act as further
safeguard.
• These provide for supervision and monitoring of contract by a regulatory
authority.
• Almost ninety percent future contracts are settled via cash settlement instead
of actual delivery of underlying asset.

11. Eg :
Suppose on November 2007 Ramesh holds 1000shares of ABC Ltd. Current (spot)
price of ABC Ltd shares is Rs 115 at National Stock Exchange(NSE). Ramesh
entertains the fear that the share price of ABC Ltd may fall in next two months
resulting in a substantial loss to him.
Ramesh decides to enter into futures market to protect his position at Rs 115 per
share for delivery in January 2008. Each contract in futures market is of 100
Shares. This is an example of equity future in which Ramesh takes short position
on ABC Ltd. Shares by selling1000 shares at Rs 115 and locks into future price.

13. OPTIONS:
An Option
Gives the Buyer the Right but Not the Obligation,
To Buy or Sell a contracted quantity of the Underlying,
at a pre-determined Price, on or before a specified Date
This is a blatantly, one-sided contract: only one party seems to benefit, hence the
Buyer of the Option pays to the Seller or Writer, an amount upfront, called the
Option Premium.
The Seller (or Writer) of the Option HAS THE OBLIGATION, (BUT NO RIGHT )
to COMPLY WITH THE RIGHT OF THE BUYER OR OPTION HOLDER

14. Call Option
•Definition: A contract that gives the buyer the right (but not the
obligation) to buy an underlying asset (such as a stock, commodity, or
index) at a specified price (strike price) before or on a particular date
(expiration date).
•Example: An investor buys a call option on Stock A with a strike price
of $50, expiring in one month. If Stock A’s price rises to $60, the
investor can buy the stock at $50, potentially making a $10 profit per
share (minus the premium paid for the option). If the stock price stays
below $50, the investor can let the option expire, only losing the
premium.

15. Put Option
Definition: A contract that gives the buyer the right (but not the obligation) to
sell an underlying asset at a specified strike price before or on a particular
expiration date.
Example: An investor buys a put option on Stock B with a strike price of $40,
expiring in one month. If Stock B’s price falls to $30, the investor can sell the
stock at $40, making a $10 profit per share (minus the premium paid). If the
stock price stays above $40, the investor can let the option expire, only losing
the premium.
• There is a buyer & a seller for both, call & put options.
• The Profit of the Buyer is Unlimited, Loss is limited to the Option Premium paid.
• The Profit of the Seller is limited to the Option premium paid, the Loss is Unlimited

16. American Option
•Definition: An option that can be exercised at any time before or
on the expiration date.
•Example: A trader buys an American call option on Stock C with a
strike price of $100, expiring in 3 months. If Stock C's price rises to
$120, the trader can choose to exercise the option at any time before
expiration to buy the stock at $100, maximizing flexibility.

17. European Option
•Definition: An option that can only be exercised on the expiration
date.
•Example: A trader buys a European put option on Stock D with a
strike price of $70, expiring in 2 months. If Stock D’s price falls to
$60, the trader can exercise the option only on the expiration date
to sell the stock at $70, locking in a $10 profit per share (minus the
premium).

18. Covered Option
•Definition: A strategy where the option seller holds a
corresponding position in the underlying asset to cover the
obligation.
•Example: An investor holds 100 shares of Stock G and sells a
call option with a strike price of $120. If the stock price rises
above $120, the investor can fulfill the call option by selling the
shares, reducing risk.

19. Naked Option
•Definition: An option position where the seller does not hold a
corresponding position in the underlying asset, exposing them to
unlimited risk.
•Example: A trader sells a naked call option on Stock H with a
strike price of $50. If Stock H rises to $70, the trader has to buy the
stock at the market price and sell it to the option buyer at $50,
leading to significant losses.

20. • In-the-money call : A call option whose exercise price is less than the current price of the
underlying stock. K < S
• Out-of-the-money call : A call option whose exercise price exceeds the current stock
price. K > S
• At-the-money call : A call option whose exercise price is equal to the current stock price.
K = S
• In-the-money put : A put option whose exercise price is more than the current price of the
underlying stock. K > S
• Out-of-the-money put : A put option whose exercise price is less than the current stock
price. K < S
• At-the-money put : A put option whose exercise price is equal to the current stock price.
K = S

21. SWAPS
A Swap is an agreement between two counterparties to exchange cash
flows on specific dates, based on the terms of the contract entered into.
Types of Swaps
• Currency
• Interest Rate
• Equity
• Commodity
• Others

22. Currency Swap
Definition: An agreement to exchange principal and interest
payments in one currency for equivalent payments in another
currency.
Example: Company A in the U.S. needs euros to expand in Europe,
while Company B in Europe needs U.S. dollars for U.S. operations.
They agree to swap currencies. Company A pays Company B in
euros, while Company B pays Company A in dollars, for a specified
period, based on agreed exchange rates.

23. Interest Rate Swap
•Definition: An agreement where two parties exchange cash flows based
on different interest rates. One party typically pays a fixed rate, while the
other pays a floating rate (like LIBOR).
•Example: Company A borrows at a floating rate but prefers a fixed rate.
Company B borrows at a fixed rate but prefers a floating rate. They agree
to swap interest payments. Company A will pay a fixed rate to Company
B, and Company B will pay a floating rate to Company A, based on the
notional principal amount.

24. Equity Swap
•Definition: A swap where one party’s payments are based on the
performance of an equity index or stock, and the other party's payments
are based on a fixed or floating rate.
•Example: Investor A holds a large position in Company X’s stock and
wants to lock in profits without selling the shares. Investor A enters an
equity swap with Investor B. Investor A pays a fixed rate, while Investor
B pays Investor A the returns based on the performance of Company X’s
stock price.

25. Commodity Swap
•Definition: A swap where cash flows are exchanged based on
the price of a commodity, such as oil, gas, or metals.
•Example: An airline company (Company A) wants to hedge
against rising fuel prices. It enters into a commodity swap with
an oil producer (Company B). Company A agrees to pay a fixed
price for oil, and in return, Company B pays Company A the
floating market price of oil. This stabilizes Company A's fuel
costs.

26. Credit Default Swap (CDS)
•Definition: A swap designed to transfer the credit risk of a reference entity
(such as a corporation or government). One party pays a premium, and the
other party agrees to compensate if a credit event, like a default, occurs.
•Example: Investor A holds bonds of Company C and is worried about
default risk. Investor A enters into a CDS with Investor B. Investor A pays
regular premiums to Investor B, and if Company C defaults on its bonds,
Investor B compensates Investor A for the loss.

27. Inflation Swap
•Definition: A swap where one party’s payments are based on an
inflation index, and the other party's payments are fixed.
•Example: A pension fund wants to hedge against inflation risks. It
enters into an inflation swap where it agrees to pay a fixed rate, and
in return, it receives payments linked to the inflation rate (like the
Consumer Price Index - CPI). If inflation rises, the pension fund
receives higher payments to cover the increasing costs.