Understand the basic concepts of derivative instruments and their functions on the stock market. www.koffeefinancial.com

2. Derivatives
• Derivative is a product whose value is derived
from the value of the underlying asset.
• Underlying asset can be equity, forex,
commodity, or any other asset. Derivatives
include a contract which derives its value from
prices, or index of prices, of underlying
securities.

3. Functions of Derivatives Market
• Derivatives help in discovery of future as well
as current prices.
• The derivatives market helps to transfer risks
from those who have them but may not like
them in comparison to those who have an
appetite for them.
• Speculative trades shift to a more controlled
environment of derivatives market.
• Act as a catalyst for new entrepreneurial
activity.

4. Uses of Derivatives
• Hedging
– Done by parties who seek to offset their existing risks
by entering into a derivatives transaction.
– Existing risks could be an investment portfolio, price
changes in oil for a petroleum mining company or
perhaps investments in a foreign country.
• Speculating
– Speculation is more commonly used by hedge funds
or traders who aim to generate profits with only a
marginal investment.

5. Uses of Derivatives (Contd.)
• Arbitrage
– Models to price derivative products have been
developed by researchers and practitioners.
– Upon finding price discrepancies, one can make use
of a specific combination of derivatives in order to
make a riskless profit.

6. Growth Driving Factors
• Increased volatility in asset prices in Financial Markets
• Increased integration between International Markets
• Exponential improvement in communication at exceptionally
reduced costs
• Development of more sophisticated Risk Management tools,
providing economic agents a wider choice of Risk
Management strategies
• Innovations in the derivatives markets, which optimally
combine the risks and returns over a large number of
financial assets leading to higher returns, reduced risk as well
as transactions cost as compared to individual financial
assets

7. Types of Derivatives
• Forwards
– A forward contract is a customized contract between two
entities, where settlement takes place on a specific date in the
future at today’s pre-agreed price.
• Futures
– A future contract is an agreement between two parties to buy
or sell an asset at a certain time in the future at a certain price.
Futures are special types of forward contracts in the sense that
futures are standardized exchange-traded contracts.
• Warrants
– Longer-dated options are called warrants and are generally
traded over-the-counter (OTC).

8. Types of Derivatives (Contd.)
• LEAPS
– Long-Term Equity Anticipation Securities. These are options having a
maturity of up to three years.
• Baskets
– Basket options are options on portfolios of underlying assets. The
underlying asset is usually a moving average of a basket of assets.
Equity index options are a form of basket options.
• Swaps
– These are private agreements between two parties to exchange cash
flows in the future Agreement on formula to be used for exchange of
cash-flows is determined in advance

9. Common Terms
• Spot price: The price at which the asset trades in the
spot market.
• Futures price: The price at which the futures contract
trades in the futures market.
• Contract Cycle: The period over which a contract trades.
• Expiry Date: It is the date specified in the futures
contract. This is the last day on which the contract will be
traded. At the end of this date the contract shall cease to
exist.
• Contract size: The amount of the asset that has to be
delivered under one contract. For instance, the contract
size of NSE’s futures market is 50 Nifties.

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