The document discusses various types of financial derivatives including futures, forwards, options, and swaps. It explains that derivatives derive their value from underlying assets and are used to hedge risk or profit from price changes. Futures contracts are exchange-traded standardized agreements to buy or sell assets at a future date, while other derivatives like forwards and swaps are customized over-the-counter transactions.

1. FINANCIAL DERIVATIVES
Prepared by
K.Logasakthi MBA (Ph.D)
Assist.. Professor
VSA School of Management,
Salem.

2. OBJECTIVES OF THE LEARING

3. Derivatives - (Meaning)
Derivatives: derivatives are instruments which
include
a) Security derived from a debt instrument
share, loan, risk instrument or contract for
differences of any other form of security and ,
b) a contract that derives its value from the
price/index of prices of underlying securities.

4. Derivatives (Definition)
A financial instrument whose characteristics and value
depend upon the characteristics and value of an
underlier, typically a commodity, bond, equity or currency.
Examples of derivatives include futures and options.
Advanced investors sometimes purchase or sell derivatives
to manage the risk associated with the underlying
security, to protect against fluctuations in value, or to profit
from periods of inactivity or decline. These techniques can
be quite complicated and quite risky.

5. Advantages of Derivative Market

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Basics Four Parts:
1. Forward
2. Future
3.Option
4. Warrents& Convertibles.
Complex
1. Swap
2. Exotics

8. Forward contract

9. The salient features of forward contracts
are as follows:
• They are bilateral contracts and hence, exposed to
counterparty risk.
• Each contract is customer designed, and hence is
unique in terms of contract sixe, expiration date and
the asset type and quality.
• The contract price is generally not available in public
domain.
• On the expiration date, the contract has to be
settled by delivery of the asset and
• If party wishes to reverse the contract.

10. Limitations of Forward contract
1. Forward markets are afflicted by several
problems:
2. Lack of centralization of trading,
3. Liquidity and Counterparty risk.
• The basic problem in the first two is that they
have too much flexibility and generality.
• Counterparty risk arises from the possibility of
default by any one party to the transaction.
When one of the two sides to the transaction
declares bankruptcy, the other suffers

11. FUTURE CONTRACT
Future contract
Future contract is an agreement
between two parties to buy or sell an asset at a
certain time in the future, at a certain price. But
unlike forward contract, futures contract are
standardized and stock ex-changed traded.

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The standardized items in a futures contract are:
1. Quantity of the underlying,
2. Quality of the underlying,
3. The date/month of delivery,
4. The units of price quotation and minimum
price change and
5. Location of settlement.

13. Distinction between futures and
forward
S.no Future Contract S.no Forward Contract
1 Traded on an organized stock 1 Over the Counter (OTC) in nature
exchange
2 Standardized contract terms, hence, 2 Customized contract terms, hence,
more liquid. less liquid
3 3 No margin payment
Requires margin payments
4 4 Settlement happens at the end of the
Follows daily settlement
period

14. Over The Counter(OTC) Trading
• In general, the reason for which a stock is traded
over-the-counter is usually because the company
is small, making it unable to meet exchange listing
requirements.
Also known as "unlisted stock", these
securities are traded by broker-dealers who
negotiate directly with one another over
computer networks and by phone.
OTC stocks are generally unlisted stocks
which trade on the Over the Counter Bulletin
Board (OTCBB)

15. Important terms in future contract
• Spot price: The price at which an
instrument/asset trades in the spot market.
• Future Price: The price at which the futures
contract trade in the future market.
• Contract cycle: The period over which a
contract trades. The index futures contract
typically have one month, two months and
three months expiry cycles that expire on the
last Thursday of the month.

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• Expiry date: It is the date specified in the
futures contract. This is the last day on which
the contract will be traded, at the end of which
it will cease to exist.
• Contract size: The amount of asset that has to
be delivered under one contract.
• Basis: Basis is defined as the future price minus
the spot price. There will be different basis for
each delivery month for each contract. In the a
normal market, basis will be positive. This
reflects that futures prices normally exceed
spot prices.

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• Cost of Carry: The relationship between
futures prices and spot prices can be
summarised in terms of the cost of carry.
• Initial Margin: The amount that must be
deposited in the margin account at the time a
futures contract is first entered into is the
initial margin.

18. Pay off for Futures
A pay off is the likely profit/loss that
would accrue to a market participant with
change in the price of the underlying asset.
Futures contracts have linear pay off.
Linear pay off:
“ losses as well as profits for both the
buyer and the seller of futures are unlimited”

19. Pay off for Buyer of Futures: (Long
Future)
The pay offs for a person who buys a futures
contract is similar to the pay off for a person
who holds an asset. He has a potentially
unlimited upside as well as downside.
e.g. Take the case of a speculator who sells a two
month Nifty index futures contact when the
Nifty stands at 1220. the underlying asset in this
case is the nifty portfolio. When the index moves
down the short futures position starts making
profits and when the index moves up it starts
making losses.

20. Pay off for Seller Futures (short future)
• The pay off for a person who sells a futures
contract is similar to the pay off for a person
who shorts an asset. he has potentially
unlimited upside as well as downside.

21. OPTIONS
Meaning of options:
An option is the right, but not the
obligation to buy or sell something on a
specified date at a specified price. In the
securities market, an option is a contract
between two parties to buy or sell specified
number of shares at a later date for an agreed
price.

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There are three parties involved in the option
trading, the option seller, buyer and the broker.
1. The option seller or writer is a person who grants
someone else the option to buy or sell. He
receives premium on its price.
2. The option buyer pays a price to the option
writer to induce him to write the option.
3. The securities broker acts as an agent to find the
option buyer and the seller, and receives a
commission or fee for it.

23. Options
An option to buy anything is known as a CALL
while an option to sell a thing is called a PUT.
Options trade in an organized market but,
large percentage of it is traded over the
counter (i.e. privately).
Note that this is just an option. That
means it is a right and not an obligation.
Strike price: Price specified in the options
contract is known as the strike price or
exercise price.

24. Types of Options
1. Call option: A call option is a contract giving the
right to buy the shares.
2. Put option is a contract giving the right to sell the
shares.
Call option that gives the right to buy in its contract
gives the particulars of
• The name of the company whose shares are to be
bought.
• The number of shares to be purchased.
• The purchase price or the exercise price or the
strike price of the shares to be bought.
• The expiration date, the date on which the
contract or the option expires.

25. Put option
• Put option gives its owner the right to sell (or
put) an asset or security to someone else.
Put option contract contains:
1. The name of the company shares to be sold.
2. The number of shares to be sold.
3. The selling price or the striking price.
4. The expiration date of the option.

26. Distinction between Futures and
Options
Futures Options
• Exchange traded, with novation • Same as futures
• Exchange defines the product
• Same as futures
• Price is zero, strike price moves
• Strike price is fixed, price moves
• Price is zero
• Price is always positive
• Linear payoff
• Non linear payoff
• Both long and short at risk
• Only short at risk

27. Novation
1. The substitution of a new contract for an old
one; or the substitution of one party in a
contract with another party.
2. The replacement of existing debt or
obligation with a new one.

29. SWAPS (Meaning)
• Swaps: Swaps are private agreements
between two parties to exchange cash flows in
the future according to a prearranged
formula. They can be regarded as portfolios of
forward contracts.

30. Commonly two kind of swaps
• Interest rate swaps: These entail swapping
only the interest related cash flows between
the parties in the same currency.
• Currency swaps: These 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.

31. Types Of Swaps
There are four types of swaps.
(1).Interest Rate Swaps.
(2).Currency Swaps.
(3).Commodity Swaps.
(4).Equity Swaps.

32. UNIT-II

33. FUTURES
Future contract is an agreement between
two parties to buy or sell an asset at a certain
time in the future, at a certain price. But unlike
forward contract, futures contract are
standardized and stock ex-changed traded.

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Future is a financial contract which derives its
value from the underlying asset.
For example:
Sugar cane or wheat or cotton farmers
may wish to have contracts to sell their
harvest at a future date to eliminate the risk
of change in price by that date.
There are commodity futures and financial
futures.

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• In the financial futures, there are foreign
currencies, interest rate and market index
futures.
• Market index futures directly related with the
stock market.

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The standardized items in a futures contract are:
1. Quantity of the underlying,
2. Quality of the underlying,
3. The date/month of delivery,
4. The units of price quotation and minimum
price change and
5. Location of settlement.

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• Futures markets are designed to solve the
problems of trading, liquidity and
counterparty risk. Basically, futures markets
resemble the forward market
Three distinct features of the futures markets
are:
- standardized contracts
- centralized trading
- Settlement through clearing houses to avoid
counterparty risk.