Introduction

Derivatives-a financial product becoming increasingly

popular
Derivative is.
A derivative is a financial instrument, whose value
depends on the value of basic underlying variable
The value of derivative is linked to risk or volatility in
either financial asset, transaction, market rate, or contingency,
and creates a product
Features of Derivatives
Traded on exchange
10. No compulsory physical trading of underlying assets
11. All transactions in derivatives take place in future
specific date
12. Hedging Device-Reduces risk
13. Derivatives has low transaction cost
14. Derivatives are often leveraged, such that a small
movement in the underlying value can cause a large difference in
the value of the derivative.
Types of Derivatives Contract
a) Forwards b) Futures c) Swaps d) Options
Forwards
A forward contract is a customized contract between
two entities, where settlement takes place as a specific date in
the future at predetermined price.
Ex: On 10th Novem, Ram enters into an agreement to buy
100 kgs of wheat on 1st May at Rs.10000 from Shyam, a farmer. It
is a case of a forward contract where Ram has to pay Rs.10000 on
1st May to Shyam and Shyam has to supply 100 kgs of wheat.
Ram has taken a long position assuming the price of the wheat
will rise in the future six months .
Normally traded outside exchange
Futures
A financial contract obligating the buyer to purchase an
asset, (or the seller to sell an asset), such as a physical
commodity or a financial instrument, at a predetermined future
date and price.
Futures contracts detail the quality and quantity of the
underlying asset; they are standardized to facilitate trading on a
futures exchange.
Some futures contracts may call for physical delivery of
the asset, while others are settled in cash. The futures markets
are characterized by the ability to use very high leverage relative

to stock markets.
20. Some of the most popular assets on which futures
contracts are available are equity stocks, indices, commodities
and currency.
Swaps
Swaps are private agreement between two parties to
exchange cash flows in the future according to a pre-arranged
formula.
The two commonly used Swaps arei) Interest Rate Swaps: - A interest rate swap entails swapping
only the interest related cash flows between the parties in the
same currency.
ii) Currency Swaps: - A currency swap is a foreign exchange
agreement between two parties to exchange a given amount
of one currency for another and after a specified period of
time, to give back the original amount swapped.
Options
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.
American Option An option that may be exercised on any trading
day on or before expiry .
European Option An option that may only be exercised on expiry
date
Important Concepts of Option
In-the money
A call option said to be in the money, when Future price>
Options strike price A put option said to be in the money, when
Future price < Options strike price
At- the money
A option is at the price, when Future price = Options strike
price

Out of the money

A call option said to be out of the money, when Future price
< Options strike price A put option said to be out of the money,
when Future price > Options strike price
30. Types of Derivatives Markets
Over-the-Counter derivativesContracts that are traded between two parties directly
without going through a exchange.
The contract between the two parties are privately
negotiated.
Over-the-counter markets are uncontrolled, unregulated and
have very few laws. Its more like a freefall.
31. Forward and swap contracts are OTC derivatives.
Exchange -traded derivativesContracts that are traded in derivatives exchanges
The world's largest derivatives exchanges (by number of
transactions) are the Korea Exchange.
There is a very visible and transparent market price for the
derivatives.
Traders in Derivatives Market
Hedgers -Transfer of risk component of their portfolio.
Speculators - Intentionally taking the risk from the
hedgers in pursuit of profit.
Arbitrageurs -Operating in different markets
simultaneously, in pursuit of profit and eliminate mis-pricing.