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Module I (Derivatives)

Derivatives are financial instruments whose values are derived from underlying assets. There are several types of derivatives classified by the nature of the contract or underlying asset, including forwards, futures, options, and swaps. Derivatives can be traded over-the-counter between parties or on organized exchanges. While derivatives provide benefits like risk management and price discovery, they also pose risks such as counterparty risk, market risk, and basis risk that must be managed.

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115 views4 pages

Module I (Derivatives)

Derivatives are financial instruments whose values are derived from underlying assets. There are several types of derivatives classified by the nature of the contract or underlying asset, including forwards, futures, options, and swaps. Derivatives can be traded over-the-counter between parties or on organized exchanges. While derivatives provide benefits like risk management and price discovery, they also pose risks such as counterparty risk, market risk, and basis risk that must be managed.

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Gokz
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© © All Rights Reserved
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FINANCIAL DERIVATIVES (B.

com-Finance)
Module I (Derivatives)
Derivatives
Derivatives are financial instruments or contracts whose values are
derived from some other assets which are called underlying assets.
Characteristics of derivatives
1. Underlying assets
2. No independent value
3. Predefine period
4. Contract fulfillment
5. Instrument for hedging risk
6. Minimal initial investment
7. Off balance sheet instrument
8. Secondary market instrument
Classification of derivatives (Types)
 On the basis of nature of contract
 Forward
It is an agreement between two parties to buy or sell an asset at a
future date at a price agreed today.
 Future
It is a contract between buyer and seller to buy or sell an asset at
certain time in future at a certain price.
 Option
Option is a special type of contract which gives its holder the right, but
not the obligation to buy or sell an asset at a fixed price at some future
date.
 Swap
Swap is an agreement between two parties to exchange a series of cash
flows over a period in the future.
 On the basis of underlying assets
 Commodity derivatives
Commodity derivatives are those derivative, where the underlying
assets are commodities.
 Financial derivatives
Financial derivatives are those derivative, where the underlying asset is
financial instruments or products.
 On the basis of trading mechanism
 Over the counter derivatives
These are the contracts that are traded outside the exchanges. These
are traded between two traders that know each other personally.
Merits of OTC derivatives
1. There is limitless flexibility in contract design
2. These are customized contract
Demerits of OTC derivatives
1. It is difficult to find matching parties
2. It involves credit risk
3. Transaction cost is high
 Exchange trade derivatives
It is a type of derivative, these are traded on the organized or regulated
exchanges. The buyers and sellers need not know each other.
Merits of exchange traded derivatives
1. These are free from counter party risk
2. Transaction cost is normal
3. Investors can enter and exit conveniently from derivative position
Demerits of exchange traded derivatives
1. They are less flexible
2. These are not customized contract
Difference between exchange traded and OTC derivatives
Exchange traded derivatives OTC derivatives
No counter party risk Counter party risk
Less transaction cost Transaction cost is more
Prices are publically available Prices are not available
Market traders don’t know each Market traders know each other
Traded on organized exchanges Traded on outside an exchange
Financial Derivatives
It is a financial contract that derives its value from an underlying
financial asset.
Features of financial derivatives
1. It is a financial instrument
2. It is a financial contract
3. It is a future contract between two parties.
4. Its value depends upon the financial instruments
5. It can be undertaken directly between two parties.
6. These are off balance sheet in nature.
Types of financial derivatives
 Currency derivatives
Exchange rate between various currencies can form the basis of
derivatives is called currency derivatives.
 Interest rate derivatives
In this type of derivatives, the underlying asset is interest rate.
 Equity derivatives
Equity derivatives are those derivatives where the underlying asset is
equity stocks.
 Stock indices derivatives
These are mostly future contracts where the underlying assets are
market index.
 Credit derivatives
These are derivatives that are based on credit rating or credit risk.
 LEAPS
LEAPS means long term equity anticipation securities. These are options
having a maturity of up to three years.
 Baskets
These are the option portfolios of underlying assets. These underlying
assets usually a moving average of a basket of assets.
 Convertibles
These are hybrid securities. They combine the basic attributes of fixed
interest and variable return securities.
Need / Importance / Uses of derivatives
1. It can be used to hedge risks.
2. They helps to enhance liquidity of underlying assets.
3. They make future cash flows more predictable.
4. They can used to make profits through speculation.
5. They helps to act as catalyst for new entrepreneurial activities.
Economic functions of derivative contracts
1. Risk management
2. Price discovery
3. Liquidity
4. Economic development
5. Portfolio management
6. Transaction efficiency
Criticism / Misuses / Limitations of derivatives
1. Increase volatility
2. Increased bankrupts
3. Increased regulatory burden
4. Enhancement of risks
5. Speculation and gambling motives
6. Instability of the financial system
7. Limited contract life
Risks involved with derivatives
1. Counter party risk
2. Market risk
3. Basis risk
4. Interconnection risk
5. Operation risk
6. Liquidity risk

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