Derivatives

Financial Derivatives
INTRODUCTION
A derivative is a financial instrument - or more simply, an agreement between two
people or two parties - that has a value determined by the price of something else
(called the underlying).
It is a financial contract with a value linked to the expected future price movements of
the asset it is linked to - such as a share or a currency.
The history of derivative is quite colourful, it starts from Bible and believed to be
about year 1700 b.c.
The first exchange-traded financial derivatives emerged in response to the collapse of

the Bretton Woods system of exchange rates established in 1944. Under this system,
most governments agreed to fix the exchange rate of their currencies relative to the
U.S. dollar, which was convertible into gold
Financial Derivatives
A derivative is an instrument whose value depends on the values of other more
basic underlying variables.
More specifically, a derivative is a contract about buying or selling a specific

asset or portfolio for a specific price (K) at a time tT, where T is the duration of
the contract.
The asset can contain

•stock,
•currency,
•Products (commodities)
•Real estate, etc.
There are many kinds of derivatives, with the most notable being swaps, forward,
futures, and options. However, since a derivative can be placed on any sort of security,
the scope of all derivatives possible is nearly endless.
Need for Derivative
•To insure against changes or risk (hedgers).
•To get a high profit from a certain market behavior (speculators).
•To get a quick low-risk profit (arbitrageurs).
•To change the nature of an investment without the costs of selling one
portfolio and buying another.
In 1971, the U.S. Treasury abandoned the gold standard for the dollar, causing
the breakdown of the fixed-exchange system, which was replaced by a
floating-rate exchange system. The need to hedge against adverse exchange-
rate movements provided an impetus for currency futures to emerge. Foreign
currency futures were introduced in 1972 at the Chicago Mercantile Exchange
("Mere"). In 1973, the Chicago Board of Trade (CBOT) created the Chicago
Board Options Exchange (CBOE) to facilitated the trade of options on selected
stocks.
Types of Derivatives
Forward Contract - A forward contract or simply a 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. This is in contrast to a spot contract, which is an agreement to buy or sell an asset
today. It costs nothing to enter a forward contract.
Future contract - A futures contract is a standardized contract between two parties to buy
or sell a specified asset of standardized quantity and quality at a specified future date at a
price agreed today. The contracts are traded on a futures exchange.
The party agreeing to buy the underlying asset in the future assumes a long position, and the
party agreeing to sell the asset in the future assumes a short position.
Option contract - The right, but not the obligation, to buy (for a call option) or sell (for a put
option) a specific amount of a given stock, commodity, currency, index, or debt, at a
specified price (the strike price) during a specified period of time.
There are different type of option contract: Call option, Put option, European Option,
American Option.
Example of Forward Contract
On January 20, 2009 a trader (long position) enters into an agreement to buy
£1 million in three months at an exchange rate of 1.6196.
This obligates the trader to pay $1,619,600 (=K) for £1 million on April 20,
2009
If the exchange rate rose to 1.65, the spot price ST is $1,650,000 and the
payoff is
ST – K = $1,650,000 - $1,619,600 = $30,400
The Trader in above case is able to save a net amount of $30,400.

Future Contract
To minimize credit risk to the exchange, traders must post a margin or a
performance bond, typically 5%-15% of the contract's value.
To minimize counterparty risk to traders, trades executed on regulated futures
exchanges are guaranteed by a clearing house.
There are three different type of margin:
Initial Margin: This is minimum equity required to get into future contract. The
initial margin requirement is calculated based on the maximum estimated change
in contract value within a trading day.
Maintenance Margin: The margin to be maintained through out the life of the
contract.
Variation Margin: The margin to be remitted promptly is the variation margin.
Contango and backwardation

The situation where the price of a commodity for future delivery is higher than
the spot price, or where a far future delivery price is higher than a nearer future
delivery, is known as contango. The reverse, where the price of a commodity for
future delivery is lower than the spot price, or where a far future delivery price is
lower than a nearer future delivery, is known as backwardation.
Option Contract
Option writer: The option writer is the person or institution that sells the option.
Option Premium: Is the option price, it is what the buyer pays, upfront, for the right to
Buy/Sell currency in the future at a set price.
Maturity Date: also call the Expiration Date or Expiry. This is the date when the option
expires.
Exercise: If the option holder decides to execute the option and buy or sell currency at the
contract price, then the option is said to be exercised.
Early Exercise: Refers to an American option being exercised before the maturity date
Strike Price: The FX rate specified in the contract that the option holder can buy or sell
currency at.
Option Type:
1.Call Option: Gives the holder the right to BUY the specified currency at the strike price on
or before the maturity date.
2.Put Option: Gives the option holder the right to sell the specified currency at the strike
price, on or before the maturity date
3.European Option: Gives the option holder the right to buy/sell the currency at but not
before the maturity date.
4.American Option: Gives the option holder the right to buy/sell currency any time before or
on the maturity date.
Types of Option American Call
Options
American
Options
American Put
Options
Options
Contracts
European Call
Options
European
Options
European Put
Options
Derivatives in India
In the exchange-traded market, the biggest success story has been derivatives on
equity products. Index futures were introduced in June 2000, followed by index
options in June 2001, and options and futures on individual securities in July
2001 and November 2001, respectively. As of 2005, the NSE trades futures and
options on 118 individual stocks and 3 stock indices. All these derivative
contracts are settled by cash payment and do not involve physical delivery of the
underlying product.
NSE launched interest rate futures in June 2003 but, in contrast to equity
derivatives, there has been little trading in them. Exchange-traded commodity
derivatives have been trading only since 2000, and the growth in this market has
been uneven. The number of commodities eligible for futures trading has
increased from 8 in 2000 to 80 in 2004.
In India, financial institutions have not been heavy users of exchange-traded
derivatives so far, with their contribution to total value of NSE trades being less
than 8% in October 2005. However, market insiders feel that this may be
changing, as indicated by the growing share of index derivatives (which are used

Derivatives

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Financial Derivatives

The first exchange-traded financial derivatives emerged in response to the collapse of

More specifically, a derivative is a contract about buying or selling a specific

The asset can contain

The Trader in above case is able to save a net amount of $30,400.

Contango and backwardation

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