The document discusses various types of financial derivatives, including futures, forwards, options, and swaps. Futures and forwards are contracts that obligate the buyer to purchase an asset at a predetermined price and date in the future. Options provide the right but not the obligation to buy or sell an asset. Swaps involve an agreement between two parties to exchange a series of cash flows over time. Derivatives allow parties to hedge against risk, speculate on price movements, and increase market liquidity.

1. Financial Instruments
Money & Banking
-Derivatives –
PRESENTED BY:-
BABASAB PATIL

2. Content Outline
1. Introduction
2. What is a derivative?
3. Reasons to use derivatives
4. Concepts to understand
5. Futures
6. Forwards
7. Options
8. Swaps
9. Questions

3. Introduction (I)
In the financial marketplace some instruments are regarded as fundamentals,
while others are regarded as derivatives.
Financial Marketplace
Derivatives Fundamentals
Simply another way to catagorize the diversity in the FM*.
*Financial Market

4. Introduction (II)
Financial Marketplace
Derivatives Fundamentals
• Futures • Stocks
• Forwards • Bonds
• Options • Etc.
• Swaps

5. What is a Derivative? (I)
Options
The value of the
derivative instrument is
Futures DERIVED from the Forwards
underlying security
Swaps
Underlying instrument such as a commodity, a stock, a stock index, an exchange
rate, a bond, another derivative etc..

6. What is a Derivative? (II)
Futures The owner of a future has the OBLIGATION to sell or buy
something in the future at a predetermined price.
The owner of a forward has the OBLIGATION to sell or buy
Forwards something in the future at a predetermined price. The difference
to a future contract is that forwards are not standardized.
Options The owner of an options has the OPTION to buy or sell
something at a predetermined price and is therefore more costly
than a futures contract.
Swaps A swap is an agreement between two parties to exchange
a sequence of cash flows.

7. Reasons to use derivatives (I)
Derivative markets have attained an overwhelming popularity for a variety of
reasons...
Hedging: • Interest rate volatility
• Stock price volatility
• Exchage rate volatility
• Commodity prices volatility
VOLATILITY
Speculation: • High portion of leverage
• Huge returns
EXTREMELY RISKY

8. Reasons to use Derivatives (II)
Also derivatives create...
• a complete market, defined as a market in which all identifiable payoffs can be
obtained by trading the securities available in the market*.
• and market efficiency, characterized by low transaction costs and greater
liquidity.

9. Concepts to Understand
Short Selling: • Short selling is the selling of a security that the
seller does not own.
• Short sellers assume the risk that they will be
able to buy the stock at a more favorable price
than the price at which they sold short.
Holding Long Position:
• Investors are legally owning a security.
• Investors are the legal owners of a security.

10. Future Contracts (I)
Futures The owner of a future contract has the OBLIGATION to sell or
buy something in the future at a predetermined price.
Scenario:
You are a farmer and you know that you will harvest corn in three months from
today on. How can you protect yourself from loosing if corn price happens to drop
until March by using corn forward contracts?
t
1/1 3/1
Harvest

11. Future Contracts (II)
You lock into a price by holding a short position in a corn future contract with a
maturity date a little bit longer than the harvest date.
Suppose the price drops...
You close out the corn contract
You either take delivery and and the gain in the futures
lock in a price. market will offset the loss in the
sport market
“A futures contract makes unfavourable price movements less unfavourable and a
favourable price movements less favourable“!

12. Future Contracts (III)
General Rule for Hedgers:
• If you are going to sell something in the near future but want to lock in a
secured price, you take a short position.
• If you are going to receive/buy something in the future but want to lock in a
secured price, you take a long position.

13. Future Contracts (IV)
The Role of Speculators:
• As the name implies, speculators are involved in price betting and take the risk of
price movements against them.
Assume the following:
• You, as hedger, believe that prices will raise. Thus, you are convinced that a long
position will benefit you.
• Key Word: Zero-Sum-Gain
• Large gains due to the concept of leverage

14. Forward Contracts (I)
Forwards The owner of a forward has the OBLIGATION to sell or buy
something in the future at a predetermined price. The difference
to a future contract is that forwards are not standardized.
A Forward Contract underlies the same principles as a future contract, besides the
aspect of non-standardization. Thus, a detail illustration is not necessary as I already
elaborated in the mechanism of the futures contract.

15. Options (I)
Options The owner of an options has the OPTION to buy or sell
something at a predetermined price and is therefore more costly
than a futures.
Some terms to understand:
• Call option
• Put option
• Excersice price / strike price
• Option premium
• Moneyness (in-the-money, at-the-money, out-of-money)
• European vs. American Options

16. Options (II)
The four basic positions:
Write
Call Option
Purchase
Write
Put Option
Purchase

17. Options (III)
Write & Purchase Call Option:
Value
Long Call
x
Stock Price at Expiration
Short Call

18. Options (IV)
Write & Purchase Call Option:
Profit and Loss
Long Call
Zero-Sum-Game
Premium Earned
x
Stock Price at Expiration
Premium Paid
Short Call

19. Options (V)
Write & Purchase Call Option:
Profit and Loss
Long Put
Stock Price at Expiration
Short Put

20. Options (VI)
Write & Purchase Call Option:
Profit and Loss
Long Put
Premium Earned
Stock Price at Expiration
Premium Paid
Short Put

21. Swaps (I)
Swaps A swap is an agreement between two parties to exchange
a sequence of cash flows.
• Counterparties
• Interest rate swaps
• Currency swaps
• Phenomenal growth of the swap market
• Future and Option markets only provide for short term investment horizon
• Traded in OTC markets with little regulations
• No secondary market
• Market limited to institutional investors

22. Swaps (II)
A Plain Vanilla Interest Rate Swap:
An interest rate swap is an agreement between two parties to exchange a sequence
of fixed interest rate payments against floating interest rate payments.
Terms to understand:
• Fixed side
• Receive-fixed side
• Tenor
• Notional amount

23. Swaps (III)
Example:
5 year tenor; notional amount $1 million; Party A is the fixed side paying 9%, Party B
is the receive-fixed side, paying a LIBOR flat rate
Party A Libor*$1m Libor*$1m Libor*$1m Libor*$1m Libor*$1m
0 1 2 3 4 5
$90,000 $90,000 $90,000 $90,000 $90,000
Party B $90,000 $90,000 $90,000 $90,000 $90,000
0 1 2 3 4 5
Libor*$1m Libor*$1m Libor*$1m Libor*$1m Libor*$1m

24. QUESTIONS