Derivatives in Financial Management.

1. Derivatives
Presentation by.
Mohd Nazim Hussain
Mohd Qasim
Nabeel Ahmad
Neeraj Gautam
Neha Vishwakarma

2. Definition of derivatives
A derivative is a contract designed in such a way
that its price is derived from the price of an
underlying asset.
Example- the price of a gold futures contract for
October maturity is derived from the price of
gold.

3. Features of derivatives
 Future contract between two parties.
 It is always derived from the value of an
underlying asset.
 Underlying asset can be physical or non
physical.
 Counter parties have specified obligation
under the derivative contract.
 It is secondary market instrument.

4. Three types of participants in derivative
market:
1. Hedgers:- hedgers are those person who face
risk associated with the price of an asset.
2. Speculators:- speculators are those who bet on
future movement in price of an asset.
3. Arbitrageurs:- arbitrageurs are one who trades
only to realise profit from discrepancies in the
market.

5. Forward Contracts
• Agreement to buy an asset on a specified date
for a specified price
• Normally traded outside stock exchanges
• Traded on OTC markets

6. Features :-
• Bilateral contracts
• Contract is customer designed
• Contract price generally not available in public
domain
• On expiration date, contract has to be settled by
delivery of assets

7. The Advantage/Disadvantage of A forward
Contract
Advantage
• Both parties have limited
their risk
Disadvantage
• You must make or take
delivery of the commodity
and settle on the deliver
date and honor the
contract as agreed upon
• The buyer and seller are
dependent upon each
other.
• In a forward contract, any
profits or losses are not
realized until the contract
"comes due" on the
predetermined date.

8. Futures Contract
A futures contract is an agreement between two
parties to buy or sell an asset at a certain time in
future, at a certain price.
Traded on an organised stock exchange.

9. Pricing Futures
When the deliverable asset exists in plentiful
supply then the price of a futures contract is
determined via arbitrage arguments. This is typical
for stock index futures, treasury bond futures, and
futures on physical commodities when they are in
supply (e.g. agricultural crops after the harvest).

10. Contd...
However, when the deliverable commodity is not in
plentiful supply or when it does not yet exist - for
example on crops before the harvest - the futures
price cannot be fixed by arbitrage. In this scenario
there is only one force setting the price, which is
simple supply and demand for the asset in the
future, as expressed by supply and demand for the
futures contract.

11. Arbitrage arguments
Arbitrage arguments apply when the deliverable asset
exists in plentiful supply.
Assuming constant rates, for a simple, non-dividend
paying asset, the value of the future price, F(t,T), will
be found by compounding the present value S(t) at
time t to maturity T by the rate of risk-free return r.
F(t,T) = S(t)*(1+R)^{(T-t)}

12. Pricing via expectation
When the deliverable commodity is not in plentiful
supply (or when it does not yet exist) rational
pricing cannot be applied, as the arbitrage
mechanism is not applicable. Here the price of the
futures is determined by today's supply and
demand for the underlying asset in the future.
In a liquid market, supply and demand would be
expected to balance out at a price which
represents an unbiased expectation of the future
price of the actual asset

13. Options (finance)
In finance, an option is a contract which gives the
buyer (the owner) the right, but not the obligation, to
buy or sell an underlying asset or instrument at a
specified strike price on or before a specified date.
The seller has the corresponding obligation to fulfil the
transaction – that is to sell or buy – if the buyer (owner)
"exercises" the option.

14. Contd...
The buyer pays a premium to the seller for this
right. An option which conveys to the owner the
right to buy something at a specific price is referred
to as a call; an option which conveys the right of
the owner to sell something at a specific price is
referred to as a put.

15. Types
1. According to the option rights
• Call option
• Put option
2. According to the underlying assets
• equity option
• bond option
• future option
• index option
• commodity option

16. Terminology
1. Credit spread - It involves simultaneously
buying and selling (writing) options on the
same security/index in the same month, but
at different strike prices. (This is also a
vertical spread)
2. Debit spread - results when an investor
simultaneously buys an option with a higher
premium and sells an option with a lower
premium. The investor is said to be a net
buyer and expects the premiums of the two
options

17. Options Payoffs
A pay off for derivative contracts is the likely
profit/loss that would occur for the market participant
with change in the price of the underlying asset.

18. Pricing options
An option buyer has the right but not the obligation
to exercise on the seller. The worst that can
happen to a buyer is the loss of the premium paid
by him.

19. Pricing stock options
The factors that affect option prices are as follows:
1- The stock price
2- Time to expiration
3- Volatility
4- Risk free interest rate
5- Dividends

20. Derivative market in India
Proprietary traders contribute to the major proportion
of trading volumes in the derivative segment. Foreign
Institutional investors and mutual funds are relatively
small players in this segment and so are corporate
clients.

21. Thank you