DERIVATIVE SECURITY MARKETS

Types of Derivative Markets

There are four types:
(1)Financial Future Markets
(2)Options Markets
(3)Interest Rate Derivative Markets
(4)Foreign Exchange Derivative Markets
 Financial Futures Markets
• A financial futures market deals in future
contracts.
• A financial futures contract is a standardized
agreement to deliver or receive a specified
amount of a specified financial instrument at a
specified price and date.
• The buyer of a futures contract buys the financial
instrument, and the seller of a financial futures
contract delivers the instrument for the specified
price.
• Financial futures contracts are traded on
organized exchanges, which fix and enforce rules
for such trading.
• Exchanges clear, settle, and guarantee all
transactions that take place there.
• Many of the popular financial futures contracts
are on debt securities such as treasury bills and
treasury bonds.
• Futures are settled quarterly. Generally it is
March, June, September, and December.
• Purpose of Trading Financial Futures:
(1)For Speculation:
- Speculators take position to profit from expected changes
in price of future contract over time. They can be classified
as ‘Day Traders’ or ‘Position Traders’.
- Day traders attempt to capitalize on price movements
during a single day. Normally, they close out their futures
positions on the same day the positions were initiated.
- Position Traders maintain their futures positions for longer
periods of time (for weeks or months) and thus attempt to
capitalize on expected price movements over a more
extended time horizon.
(2) For Hedging:
Hedgers take positions in financial futures to
reduce their exposure to adverse movements
in prices.
 Trading Futures
• Futures can be traded on organised exchanges
(biggest being Chicago Mercantile Exchange) or
OTC also.
• Customers who desire to buy or sell futures
contracts open accounts at brokerage firms that
execute futures transactions.
• A customer must establish a margin deposit with
the broker before a transaction can be executed.
This is called initial margin which is normally 5-
18%.
• A customer whose contract values moves in
an unfavourable direction may receive a
margin call from the broker. Margin call
requires additional funds be deposited in the
margin account.
• Margin requirements reduce the risk that
customers will later default on their
obligations.
• Types of Orders:
(1)Market Order: In this a trade is executed
automatically at the prevailing price of future
contract.
(2)Limit Order: In this a trade is executed only if
the price is within the limit specified by the
customer.
• How Orders are Executed:
- Now a days most trading take place
electronically. However some trades are still
conducted on trading floor through ‘outcry’.
- Floor brokers execute orders in the exchange.
They get order through telephone from
brokerage firms. Brokerage firms get orders
from customers.
• Floor brokers receive transaction fees in the
form of a Bid-Ask spread.
• That is, they purchase a given futures contract
for one party at a slightly lower price than the
price at which they sell the contract to
another party.
• For every buyer of a futures contract there
must be a corresponding seller.
• The futures exchange facilitates the trading
process but does not itself take buy or sell
positions on the futures contract.
• Instead, the future exchange acts as a
clearinghouse facilitating the trading process
by recording all transactions and guaranteeing
timely payments.
 Option Markets
• An option can be a ‘call option’ or ‘put option’.
• Call Option
• A call option grants the owner the right to purchase a
specified financial instrument (like stock) for a specified
price (called exercise price or strike price) within a specified
period of time.
• A call option is said to be ‘in the money’ when the market
price of the underlying security exceeds the exercise price.
• It is at the money when the market price is equal to the
exercise price.
• It is out of the money when it is below the exercise price.
• Put Option
• It grants the owner the right to sell a specified
financial instrument for a specified price within a
specified period of time.
• A put option is said to be ‘in the money’ when
the market price of the underlying security is
below the exercise price.
• It is ‘at the money’ when the market price is
equal to the exercise price.
• It is ‘out of money’ when it exceeds the exercise
price.
• To buy option contract a person has to pay price called
‘premium’.
• Premiums paid are determined by the participants
engaged in trading.
• Participants can close out their positions by making an
offsetting transactions.
e.g. purchasers of an option can offset their positions at any
time by selling an identical option. The gain or loss is
determined by the premium paid when purchasing the
option versus the premium received when selling an
identical option. Sellers of options can close out their
positions at any time by purchasing an identical option.
• An option can be an American style option or
European style option.
• An American option can be exercised any time
on or before expiry.
• An European option can be exercised only on
expiry date.
• How Option Trades are Executed?
• Options can be traded on option exchange.
• Each exchange has its own requirements
concerning the financial instruments.
• The decision to list an option is made by each
exchange, not by the parties represented by the
options contracts.
• The exchange itself does not take positions in
option contracts, but provides a market where
the options can be bought or sold.
• Most small, standardized transactions are
executed electronically.
• However, complex transactions are executed
by open outcry among exchange members.
• Like futures, an investor can use either a
market order or limit order.
• Thanks…….