derivatives

Derivatives

Instruments can be called derivatives since they derive their value form an underlying asset. For example, equity share itself is a derivative, since, it derives its value from the firms underlying asset.

Kinds of financial derivatives.

i. Forwards

ii. Futures

iii. Options

iv. Swaps

Forwards : are the oldest of all the derivatives. A forward contract refers to 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. The promised asset may be currency, commodity, instrument etc

Eg:- on 30^th January X enters into and agreement to buy 5000 kg of sugar on May 30^th at Rs 50 per kg from Y, a sugar merchant.

Ie…

· A contract

· to buy/ sell

· An asset

· At a specified price

· A t a specified future date

Futures :- A futures contract is very similar to a forward contract in all respects excepting the fact that it is completely a standardized one. So it is said that futures contract is nothing but a standardized forward contract. It is legally enforceable and it is always traded on an organized exchange.

Features

1. Standardized and legally enforceable

2. No Down payment but to deposit a certain percentage of the contract price called initial margin.

3. Secondary market- dealt in organized exchanges.

4. Non- delivery of assed – generally, parties simply exchange the difference between the future and spot prices on the date of maturity.

Types of futures- commodity futures and financial futures

A commodity futures is a futures contract in commodities like agricultural products, metals and minerals etc

Financial future refers to a futures contract in foreign exchange or financial instruments like Treasury bill, commercial paper, stock market index or interest rate etc.

Forward Vs Futures

Nature of contract- not standardized standardized

secondary market not exists exist

settlement on date of maturity settled daily

Down payment no down payment deposit certain

percentage as margin money

Delivery of asset delivery on maturity merely exchange difference of

Future price and spot prices

Exchange traded in organized SE are private bilateral contract

Duration and price SE fixes the value Parties decide these mutually

and duration

Regulation Regulated by SE,SEBI, RBI self regulatory.

Options:- An option contract gives the buyer an option to buy or sell and underlying asset(stock, bond, currency, commodity etc..) at a predetermined price on or before a specified date in future. The price so predetermined is called the strike price or exercise price

· A contract

· Giving a right to buy/ sell

· A specified asset

· At a specified price

· Within a specified time period

Types of option

American option and European option

· If the option can be exercised at any time between writing of the contract and its expiration- American option

· If it can be exercised only at the time of maturity – europian option

Call option, put option, double option

· A call option is one which gives the option holder the right to buy underlying asset at a predetermined price called exercise price on or before a specified date in future

· A put option is one which gives the option holder the right to sell underlying asset at a predetermined price called exercise price on or before a specified date in future

· A double option is one which gives the option holder either the right to buy or sell underlying asset at a predetermined price called exercise price on or before a specified date in future.

SWAPS:- It is a combination of forwards by two counter parties. It is a contract in which two parties agree to exchange their respective future cash flows based on an underlying instrument.

Features:-

1. Basically a combination of forwards

2. Double coincidence of wants

3. Necessity of an intermediary

4. Settlement – there is no exchange o principal(eg. exchange of fixed and floating rate of interest)

5. Long term agreement (forwards are generally short period)

Types

1. Currency swap:- a swap in which two currencies are exchanged is called cross currency swap

2. Interest rate swap:- in which fixed rate of interest is exchanged for a floating rate .

Advantages

· Borrowing at lower cost

· Access to new financial market

· Hedging of risk

· Tool to correct asset- liability mismatch