Introduction to
Derivative
Derivative: is a contract or an agreement
for the exchange of payments, whose
value derives from the value of an
underlying asset.
Derivatives are financial instruments that
have no intrinsic value, but derive their
value from something else. They hedge the
risk of owning things that are subject to
unexpected price fluctuations, e.g. foreign
currencies, commodity price, stocks, bonds
etc.
Features of Derivative:
A) Nature of contract:
(i) Forward & Futures
(ii) Option
(iii) Swap.
B) Underlying Assets:
(i) Foreign exchange
(ii) Commodities
(iii) Interest bearing financial assets
(iv) Equities.
Financial Vs. Commodity derivative:
(i) Nature of underlying assets.
(ii) Standardization & quality issue.
(iii) Structure & function.
The basic purpose of these instruments is
to provide protection against adverse
movement in future prices.
It also provides opportunity to earn profit,
who are ready to go for higher risk.
So it facilitate to transfer risk from those
who wish to avoid it to those who are
willing to accept the same.
Financial Forward
Definition: It is simple customized contract between
two parties to buy or sell an asset at a certain time in
future for a certain price.
Basic Features:
1. Bilateral contracts.
2. Custom designed. (contract size, expiration date,
assets type, assets quality).
3. Settled by delivery.
4. Fixed delivery price. (forward price changes).
5. Mostly popular in Forex Market. (Large international
banks quote the forward rate through their forward
desk).
One party agrees to buy the underlying asset is said to
have a long position and the other is short position.
Forward market – fore runner of futures market
Very poor transportation facility.
Counter party of the hedger.
Dealer matches buyers & sellers requirement against a
commission.
Dealer has to bear Price risk, Quality risk & credit risk.
Dealers also bring liquidity in market.
Pay-off for forward buyer & seller.
Futures Contract
Definition: An agreement between
buyer & seller where the seller agrees to
deliver the specific quantity & grade of a
particular asset at predetermined time in
future at an agreed price through a
designated market.
Difference between Forward & Futures
Location
Size of the contract
Maturity
Counterparty
Market place
Valuation
Margin account
Regulation in trade
Credit risk
Settlement
Liquidity
Transaction cost.
OPTION
Definition: An option is a contract,
which gives the buyer (holder) the right
but not an obligation to buy or sell
specified quantity of an underlying
assets, at a specific (strike/exercise)
price on or before the specified time
(expiration date).
The underlying assets may be commodities
like wheat, rice, cotton, gold, oil or
financial instruments like equities, stock
index, bonds etc.
American & European Option:
Call option: An option contract, where
the writer gives the buyer, the right to
purchase the asset, at a predetermined
price, on or before the expiration date.
Put option: An option contract, where
the writer gives the buyer, the right to
sell the asset, at a predetermined price,
on or before the expiration date.
Option Strategies
Elementary investment strategy
Long position: Investor is bullish on the
stock.
Short position: It involves selling the
asset first and buying it back later.
Long call: Purchase a call option. (bullish)
Short call: Writing a call without owning
the stock. (bearish) [Naked call writing].
Long put: Buying a put. (right to sell the
underlying assets at a specific price.
(bearish).
Short put: writing a put. (bullish).
Price Buy Asset Short Sell Buy Call W. Call Buy Put W. Put
0 -100 100 -5 5 95 -95
20 -80 80 -5 5 75 -75
40 -60 60 -5 5 55 -55
60 -40 40 -5 5 35 -35
80 -20 20 -5 5 15 -15
85 -15 15 -5 5 10 -10
90 -10 10 -5 5 5 -5
95 -5 5 -5 5 0 0
100 0 0 -5 5 -5 5
105 5 -5 0 0 -5 5
110 10 -10 5 -5 -5 5
115 15 -15 10 -10 -5 5
120 20 -20 15 -15 -5 5
140 40 -40 35 -35 -5 5
160 60 -60 55 -55 -5 5
180 80 -80 75 -75 -5 5
