2. • The term ‘Derivative’ stands for a contract whose price is
derived from or is dependent upon an underlying asset.
• The underlying asset could be a financial asset such as
currency, stock and market index, an interest bearing
security or a physical commodity.
• The derivative itself is merely a contract between two or
more parties. Its value is determined by fluctuations in the
underlying asset.
What is a “Derivative Market”?
3. The derivatives market performs a number of economic
functions. They help in :
• Transferring risks
• Discovery of future as well as current prices
• Lower Transaction costs
• Increasing saving and investments in long run.
Need for Derivatives
4. • Hedgers are those who buy or sell in derivatives market in
order to reduce their risk of their portfolio.
• Speculators are those who enter into the market purely for
making profit by buying or selling the derivatives, their only
aim is to make profit based on their judgment about the
stock or market.
• Arbitrage refers to obtaining risk free profits by
simultaneously buying and selling similar instruments in
different markets.
Participants in Derivative markets
5. • Over the Counter (OTC) derivatives are those which are
privately traded between two parties and involves no
exchange or intermediary.
• Non-standard products are traded in the so-called over-the-
counter (OTC) derivatives markets.
• The Over the counter derivative market consists of the
investment banks and include clients like hedge funds,
commercial banks, government sponsored enterprises etc.
What is OTC (Over the counter)??
6. • A derivatives exchange is a market where individuals trade
standardized contracts that have been defined by the
exchange.
• A derivatives exchange acts as an intermediary to all related
transactions, and takes initial margin from both sides of the
trade to act as a guarantee.
Exchange Traded Derivatives Market
7. • Spot Contract: An agreement to buy or sell an asset today.
• Spot Price: The price at which the asset changes hands on
the spot date.
• Spot date: The normal settlement day for a transaction
done today.
• Long position: The party agreeing to buy the underlying
asset in the future assumes a long position.
• Short position: The party agreeing to sell the asset in the
future assumes a short position
• Delivery Price: The price agreed upon at the time the
contract is entered into.
Basic Terminologies
9. • Forward is a non-standardized contract between two
parties to buy or sell an asset at a specified future time at a
price agreed today.
• For Example: If A has to buy a share 6 months from now.
and B has to sell a share worth Rs.100. So they both agree
to enter in a forward contract of Rs. 104. A is at “Long
Position” and B is at “Short Position” Suppose after 6
months the price of share is Rs.110. so, A overall gained
Rs. 4 but lost Rs. 6 while B made an overall profit of Rs. 6.
Forward Contract
10. The derivative in which counterparties exchange certain
benefits of one party's financial instrument for those of the
other party's financial instrument. The benefits in question
depend on the type of financial instruments involved. The
types of Swaps are:
• Interest rate swaps
• Currency swaps
• Commodity swaps
• Equity Swap
• Credit default swaps
11. • Futures contract is a standardized contract between two
parties to exchange a specified asset of standardized
quantity and quality for a price agreed today (the futures
price or the strike price) with delivery occurring at a
specified future date, the delivery date.
• Since such contract is traded through exchange, the
purpose of the futures exchange institution is to act as
intermediary and minimize the risk of default by either party.
Thus the exchange requires both parties to put up an initial
amount of cash, the margin.
Futures Contract
12. • Contracts that give the holder the option to buy/sell specified
quantity of the underlying assets at a particular price on or
before a specified time period.
• The word “option” means that the holder has the right but
not the obligation to buy/sell underlying assets.
Options
13. • Options are of two types – call and put
• Call option give the buyer the right but not the obligation to
buy a given quantity of the underlying asset, at a given price
on or before a particular date by paying a premium.
• Put option give the buyer the right, but not obligation to sell
a given quantity of the underlying asset at a given price on
or before a particular date by paying a premium.
Types of options