2. DERIVATIVES
• A security whose price is dependent upon one or
more underlying assets. The derivative itself is
merely a contract between two or more parties.
Its value is determined by fluctuations in the
underlying asset. The most common underlying
assets
include stocks, bonds, commodities, currencies, i
nterest rates and market indexes. Most
derivatives are characterized by high leverage
3. Continue….
• Derivatives are contracts and can be used as an
underlying asset.
• Derivatives are generally used as an instrument
to hedge risk, but can also be used
for speculative purposes
4. EXAMPLE
• Bombay stock exchange share index calls
sensex, is a derivative whose value depends upon
the price of underlying 30 shares.
6. FORWARD CONTRACT
• Forwards are the oldest of all the derivatives.
Forwards are contracts to buy or sell an asset on
or before a future date at a price specified today
• or an agreement between two parties to
exchange an agreed quantity of an asset for cash
at a certain date in future at a predetermined
price specified in that agreement.
7. Example of forward
• The promised asset may be
currency, commodity, instrument etc
• Eg.- On January 1, Mr. X enters into an
agreement to buy 5 pkts. of basmati rice
on June 1 at Rs. 3000/- per pkt from Mr.
Y, a wholesaler. It is a case of a forward
contract where Mr. X has to pay Rs.
15,000/- on June 1 to Mr. Y and Mr. Y has
to supply 5 pktss of basmati rice.
8. The primary reason for the
classification of a forward contract
as a derivative is that in many cases
its price can be derived through a
no-arbitrage argument that relates
the forward price of an asset to its
spot price
9. In a forward contract, a user (holder)
who promises to buy the specified
asset at an agreed price at a fixed
future date said to be in the ‘Long
position’. On the other hand, the user
(holder) who promises to sell at an
agreed price at a future date is said to
be in ‘Short position’. Thus, ‘long
position, and ‘short position, take the
form of ‘buy’ and ‘sell’ in a forward
contract.
10. FEATURES OF FORWARD
1.Over the Counter Trading (OTC): These
contracts are purely privately arranged
agreements and hence, they are not at all
standardized ones. They are traded ‘over the
counter’ and not in exchanges. There is much
flexibility since the contract can be modified
according to the requirements of the parties to
the contract. Parties enter into this kind of
contract on the basis of the custom, and hence, it
is also called ‘customised contract’.
11. 2. No Down Payment: There must be a
promise to supply or receive a specified
asset at an agreed price at a future date.
The contracting parties need not pay
any down payment at the time of
agreement
3. Settlement at Maturity: The
important feature of a forward contract
is that no money or commodity
changes hand when the contract is
signed. Invariably, it takes place on the
date of maturity only as given in the
contract ement.
12. 4. Linearity: Another special feature of a
forward rate contract is linearity. It means
symmetrical gains or losses due to price
fluctuation of the underlying asset. When the
spot price in future exceeds the contract
price, the forward buyer stands to gain. The gain
will be equal to spot price minus contract price.
If the spot price in future falls below the contract
price, he incurs a loss
.
5.No Secondary Market: A forward rate
contract is a purely private contract, and
hence, it cannot be traded on an organized
stock exchange. So, there is no secondary
market for it.
13. 6. Necessity of a Third Party: There is a
need for an intermediary to enable the parties
to enter into a forward rate contract. This
intermediary may be any financial institution
like bank or any other third party.
7.Delivery: The delivery of the asset which
is the subject matter of the contract is
essential on the date of the maturity of the
contract.
14. SWAP
• A swap is a contract in which two parties agree
to exchange their respective cash flows. This is
a private agreement between the parties to
exchange cash flow according to some
prearranged formula.
• The parties to the swap contract are known as
counter parties.
15. • The cash flow can be swapped with the help of a
swap dealer.
• Swap arrangement are tailor made to the
needs of counter parties.
• Swap are not subject to regulation as the future
and option are.
16. TYPES OF SWAP
• 1. Currency swap- it is a transaction
between two parties in which one promises to
make a series of payments to other party at a
specific dates in exchange for a payment from
the another party in different currency. So in
currency swap the cash flows of different
currency are swapped.
17. • This can be used by the firms that operate in one
currency but need to borrow in another
currency.
Example-
• A ltd. and B ltd. want to borrow in $ and Euro
respectively. But A ltd. Can borrow Euro at a
cheaper rate than B ltd. And vice versa.
Then they entry into a currency swap to share
advantage of the cheaper borrowing capacity of
the other company.
18. 2. INTEREST RATE SWAP
• Interest rate swap is an agreement between two
parties in which each party make a series of
interest payment to the another party at
predetermined dates at different rates.
• At least one of the interest is variable i.e floating
rate .
• The most common type of interest rate swap is
known as plain vanilla swap in which one
rate is fixed and another is floating.
19. Important points
• In this swap, there is no exchange of principle
amount either on maturity or initially.
• On each payment date, only the interest
payments or the net payment will be exchanged.
Why parties enter into interest rate swap??
-The reason in comparative advantage.
