Derivatives

derivative is a fnancial instrument whose value is based on one or more underlying

assets. In practice, it is a contract between two parties that specifes conditions
(especially the dates, resulting values of the underlying variables, and notional
amounts) under which payments are to be made between the parties. The most
common types of derivatives are: forwards, futures, options, and swaps. The most
common underlying assets include: commodities, stocks, bonds, interest rates and
currencies.
Hedger
n investor who takes steps to reduce the risk of an investment by making
an o!setting investment. There are a large number of strategies that a hedger can
use. "edgers may reduce risk, but in doing so they also reduce their proft potential.
Speculator
#ne who attempts to anticipate price changes and, through buying and
selling contracts, aims to make profts. speculator does not use the marketin
connection with the production, processing, marketing, or handling of a product.
$ee: Trader.
Arbitrageur
#ne who profts from the di!erences in price when the same, or e%tremely
similar, security, currency, or commodity is traded on two or moremarkets. The
arbitrageur profts by simultaneously purchasing and selling these securities to take
advantage of pricing di!erentials (spreads) created by market conditions. $ee: &isk
arbitrage, convertible arbitrage, inde% arbitrage, and international arbitrage.
Types of Derivative Instruments:
'erivative contracts are of several types. The most common types are forwards,
futures, options and swap.
Forward Contracts
forward contract is an agreement between two parties ( a buyer and a seller to
purchase or sell something at a later date at a price agreed upon today. )orward
contracts, sometimes called forward commitments , are very common in everyone
life. ny type of contractual agreement that calls for the future purchase of a good or
service at a price agreed upon today and without the right of cancellation is a
forward contract.
Future Contracts
futures contract is an agreement between two parties ( a buyer and a seller ( to
buy or sell something at a future date. The contact trades on a futures e%change and
is sub*ect to a daily settlement procedure. )uture contracts evolved out of forward
contracts and possess many of the same characteristics. +nlike forward contracts,
futures contracts trade on organi,ed e%changes, called future markets. )uture
contacts also di!er from forward contacts in that they are sub*ect to a daily
settlement procedure. In the daily settlement, investors who incur losses pay them
every day to investors who make profts.
Options Contracts
#ptions are of two types ( calls and puts. -alls give the buyer the right but not the
obligation to buy a given .uantity of the underlying asset, at a given price on or
before a given future date. /uts give the buyer the right, but not the obligation to sell
a given .uantity of the underlying asset at a given price on or before a given date.
Swaps
$waps are private agreements between two parties to e%change cash 0ows in the
future according to a prearranged formula. They can be regarded as portfolios of
forward contracts. The two commonly used swaps are interest rate swaps and
currency swaps.
1. Interest rate swaps: These involve swapping only the interest related cash
0ows between the parties in the same currency.
2. Currency swaps: These entail swapping both principal and interest between
the parties, with the cash 0ows in one direction being in a di!erent currency
than those in the opposite direction.