20-Jul-15 1 Financial Derivatives : A Recap Financial Derivatives - An Overview 2 Spot Transactions • In any market transaction, there are three components: Price Negotiation Settlement (Calculating the amount due from each party),and Clearing (Payment of price in exchange of goods) • If the three steps takes place with ‘no or minimal delay’ i.e. ‘ on the spot ’, we call it a Spot transaction carried out in Spot or Cash Market.
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20-Jul-15
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Financial Derivatives : A Recap
Financial Derivatives - An Overview 2
Spot Transactions
• In any market transaction, there are three components:
� Price Negotiation
� Settlement (Calculating the amount due from each party),and
� Clearing (Payment of price in exchange of goods)
• If the three steps takes place with ‘no or minimal delay’ i.e. ‘on the spot’, we call it a Spot transaction carried out in Spot or Cash Market.
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Financial Derivatives - An Overview 3
Financial Derivatives
• Financial derivative is a financial instrument whose
value is dependent on (derived from) the value of
some other underlying asset or some other financial
price (Interest rate or Index).
• Common Underlying Assets are:
» Stocks » Commodities
» Stock Indices » Foreign Exchange
» Interest rates
• Financial Derivatives may broadly be classified as:
▪ Forward Contracts ▪ Options
▪ Futures Contracts ▪ Swaps
Financial Derivatives - An Overview 4
Forward Contracts
• In a Forward Contract, two parties irrevocably agree to buy or sell at a future date at a pre-determined price.
• No exchange of goods or money takes place at the time of entering into a Forward Contract.
• Buyer is obligated to pay for the goods and take delivery on the expiry date and Seller is obligated to deliver goods and receive the payment, irrespective of
the price of the goods on the expiry date.
• Buyer of goods is said to have a “Long” position while the seller has a “Short” position .
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Financial Derivatives - An Overview 5
Forward Contracts
• Each Forward Contract is a Unique Contract,
customised to the requirements of the contracting
parties.
• Such contract are Over-the-Counter (OTC) products &
not traded freely.
• Forward Contracts are mostly settled on maturity with
the seller delivering the underlying assets and the
buyer paying the specified price.
• Problems with Forward Contracts:
• Poor Liquidity
• Counter-party Risk
Financial Derivatives - An Overview 6
Futures Contract
• Futures contract is an agreement to buy or sell an
asset for a certain price at a certain future date.
• A Futures contract IS a forward contract, except that it
is standardized and hence traded on an Exchange.
• It is characterized by the following:
� Standardization of the Contract
� Traded on Exchange means:� Centralization of Trading on Price-time priority
� Enhanced Liquidity
� Novation by Clearinghouse
� Mark-to-Market (MTM) margining system
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Pay-off from a Forward / Futures Contract
Long Position
Market price
Pro
fit/
loss
-6
-4
-2
0
2
4
6
100 101 102 103 104 105 106 107 108 109 110
Short Position
-6
-4
-2
0
2
4
6
100 101 102 103 104 105 106 107 108 109 110
Market priceP
rofi
t/lo
ss
Financial Derivatives - An Overview 8
Options Contracts
• Options contract is an agreement between the buyer (holder)& the seller (writer) of the contract, which gives the buyer the right to buy (or sell) without the obligation to buy (or sell) the underlying asset from (to) the seller of the option for a specified price at a specified future date.
• The seller is obligated, under the contract, to perform.
• An option contract, thus, defines the rights of the buyerand the obligations of the seller.
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Calls and Puts
Financial Derivatives - An Overview
Buyer Seller
Call
Option
Has the right to buy the
Asset
Has the Potential
obligation to sell the
Asset, if exercised against
Put
Option
Has the right to sell the
Asset
Has the Potential
obligation to buy the
Asset, if exercised against
• Call Option-, which gives the holder thereof the right to buy an asset for a certain price at a certain future date.
• Put Option-, which gives the holder thereof the right
to sell an asset for a certain price at a certain future
date.
Financial Derivatives - An Overview 10
Types of Options
• American Options can be exercised at any time up to
the Expiration date.
• European Options can be exercised only on the
Expiration date.
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Financial Derivatives - An Overview 11
Pay-off & Profit(loss) on Long position on Call Option