This document provides an introduction to financial derivatives. It defines derivatives as contracts that derive their value from an underlying asset such as a commodity, bond, currency, or stock. There are several types of derivatives including futures, forwards, options, and swaps. Futures and options trade on a centralized exchange, while forwards and swaps are over-the-counter instruments arranged between two parties. Derivatives are used for hedging risk, speculating, and generating income. While they provide benefits like risk management, there are also risks associated with their use such as increased volatility and counterparty risk.
2. INTRODUCTION
• Risk/ uncertainty in life accident, calamity,
theft, unexpected change in demand,
government policy, labour rates,interest rates,
economic conditions, foreign exchange rates
etc.
• Insurance accidents, life, theft etc.
• Derivatives change in value due to change
in market conditions
3. DERIVATIVES
A derivative is a contract between two parties
which derives its value/price from an underlying
asset. The most common types of derivatives
are futures, options, forwards and swaps.
Principle: Risk-averse and risk taking individual
4. MEANING
• It derives its value from “something else” aka underlying asset/ underlying’s
/bases
• From verb ‘To Derive’ No independent value Ex: Curd (Price depends upon
milk)
• Right to buy or sell is traded
• It gives a right to a person to buy/sell of an asset after or during a specified
period
• Deferred delivery instruments/ deferred payment instruments
5. CHARACTERISTICS
• Underlying asset
• No independent value
• Predefined period
• Contract fulfillment
• Instruments for hedging risk
• Minimal initial investments
• Off-balance sheet instrument
• Secondary market instruments
6. TYPES / CLASSIFICATION OF DERIVATIVES
Nature of
Payoff/Contract
• Forwards
• Futures
• Options
• Swaps
Underlying Assets
• Commodity
• Financial
Trading Mechanism
• Over The Counter
• Exchange Traded
7. FORWARDS
• A forward contract is a customizable derivative contract between two parties to
buy or sell an asset at a specified price on a future date.
• Forward contracts can be tailored to a specific commodity, amount and delivery
date.
• Forward contracts do not trade on a centralized exchange and are considered
over-the-counter (OTC) instruments.
8.
9. FUTURES
• Futures contracts are financial derivatives that oblige the buyer to purchase some
underlying asset (or the seller to sell that asset) at a predetermined future price
and date.
• A futures contract allows an investor to speculate on the direction of a security,
commodity, or a financial instrument, either long or short, using leverage.
• Futures are also often used to hedge the price movement of the underlying asset
to help prevent losses from unfavorable price change.
10.
11.
12. OPTIONS
• Options are contracts giving the buyer the right, but not the obligation, to buy or
sell a particular asset on or before a specified date.
• An option is a contract giving the buyer the right, but not the obligation, to buy (in
the case of a call) or sell (in the case of a put) the underlying asset at a specific
price on or before a certain date.
• People use options for income, to speculate, and to hedge risk.
• Options are known as derivatives because they derive their value from an
underlying asset.
• A stock option contract typically represents 100 shares of the underlying stock, but
options may be written on any sort of underlying asset from bonds to currencies to
commodities.
13. SWAPS
• Two parties agree to exchange cash flows at future dates according to a
prearranged formula
• Most swaps involve cash flows based on a notional principal amount such as a
loan or bond, although the instrument can be almost anything. Usually, the
principal does not change hands.
14. OVER THE COUNTER DERIVATIVES
• An over the counter (OTC) derivative is a financial contract that is arranged between
two counterparties but with minimal intermediation or regulation.
• OTC derivatives do not have standardized terms and they are not listed on an asset
exchange.
• As an example, a forward and a futures contract both can represent the same
underlying, but the former is OTC while the latter is exchange-traded.
• Over the counter derivatives are instead private contracts that are negotiated
between counterparties without going through an exchange or other type of formal
intermediaries, although a broker may help arrange the trade. Therefore, over the
counter derivatives could be negotiated and customized to suit the exact risk and
return needed by each party. Although this type of derivative offers flexibility, it poses
credit risk because there is no clearing corporation.
15. EXCHANGE TRADED DERIVATIVES
• An exchange-traded derivative is a standardized financial contract, traded on an
exchange, that settles through a clearinghouse, and is guaranteed.
• A key feature of exchange-traded derivatives that attract investors is that they are
guaranteed by clearinghouses, such as the Options Clearing Corporation (OCC)
or the CFTC, reducing the product's risk.
• Intermediary Exchange Takes initial margin from both sides to act as a
guarantee, Specify the terms of trade, Standardise the contracts, Less
counterparty risk
• Ex: Futures, Stock options…
19. DIFFERENCE BETWEEN COMMODITY AND
FINANCIAL DERIVATIVES
Commodity Derivatives Financial Derivatives
Underlying asset Commodity *U.A Financial instruments
Wheat, Corn, Pepper, Crude oil etc. Stocks, Bonds, Currencies etc.
Quality of U.A matters No quality issues
*U.A Bulky Not bulky
Physical settlement Cash-settlement
Need warehouses for storage No need of storage facility
*U.A Underlying Asset
22. LIMITATIONS
1. Increased volatility
2. Increased bankruptcies
3. Increased regulatory burden
4. Enhancement of risk
5. Speculative and gambling motives
6. Instability of the financial system
7. Contract life
