DERIVATIVE MARKETS

FORWARDS OPTIONS
SWAPS
DERIVATIVE MARKETS

So far the focus has been on cash markets but

with some contracts we have an option to
buy or see a financial asset at some
FUTURE DATE .The price of such contract is
derived from the value of the underlying
asset these contracts are called
DERIVATIVE INSTRUMENTS
DEFINITION

 A DERIVATIVE IS A FINANACIAL
INSTUMENT WHOSE VALUE DEPENDS
ON ITS DERIVED FROM ie THE VALUE OF
SOME OTHER FINANCIAL
INSTUMENTCALLED THE UNDERLYING
ASSET, some common examples are stocks
bonds wheat stock market indexes
example
 Contractual agreement between two investors that obligates one to
make a payment to the other, depending on the movement in interest
rates over the next year this is called INTEREST RATE FUTURES
OPTIONS
 This provides an easy way for investors to profit from price declines
,one persons loss is always another persons gain. Derivatives can also
be used to speculate. Farmers use this to insure themselves against
fluctuation of market prices of crops. Risk can be bought and sold by
the use of derivatives. The purpose of derivatives is to transfer risks
from one person or firm to another .Derivatives provide insurance ,it
shifts risks to those who are willing to bear it so in this way they
increase the risk bearing capacity of the economy as a whole
improving the allocation of resources and increasing the level of
output.
MAJOR CATEGORIES OF
DERIVATIVES

 FORWARDS AND FUTURES

 OPTIONS
 SWAPS
FORWARDS AND FUTURES
 EASIEST TO UNDERSTAND
 A forward or forward contract is an agreement between the buyer and
seller to exchange a commodity or financial instrument for a specified
amount of cash on a prearranged future date.
 A future or futures contract is a is a forward contract that has been
standardized and sold through an organized exchange. Seller has a
SHORT POSITION and the buyer has LONG POSITION. On a specific
date called the settlement or delivery date. No payments are made
initially when the contract is agreed upon. The seller benefits from
decline in the price of the underlying asset while the buyer benefits
from the increase.
Cont.
 Future contracts allow the transfer of risk between buyer and
seller .This is done through a process called HEDGING OR
SPECULATION.
 The practice of simultaneously buying and selling financial
instruments in order to benefit from temporary price differential
is called ARBITRAGE and the people who engage in these are
called arbitrageurs. Arbitrage means that two Financial
instruments with the same risk and promised future payments
will sell for the same price.
OPTIONS
 Options are agreements between two parties. There is a seller called the
OPTION WRITER and the buyer called the OPTION HOLDER. Option writers
incur obligation while option holders obtain rights .
 There are two basic options PUTS AND CALLS.
 A CALL OPTION is the right to buy or call away a given quantity of an
underlying asset at a predetermined price . This is called the STRIKE PRICE,
ON OR BEFORE A SPECIFIC DATE.
 A put option gives the holder the right BUT not the obligation to sell the
underlying asset at a predetermined price on or before the fixed date.
 Options transfer risks from the buyer to the seller or they can be used for both
hedging and speculation. Remember that hedger is always buying insurance
.For someone who wants to purchase an asset such as a bond or stock in the
future, a call option ensures that the cost of buying the asset will not rise ,for
someone who plans to sell the asset in the future the put options ensures that
price at which the asset can be sold will not go down.
SWAPS
 In swaps two parties agree to swap something generally
obligations to make specified payments. Most swaps today
involve either interest payments or currencies.
 If companies swapped their payment obligations an INTEREST
RATE SWAP would occur .Currency swaps are similar to
interest rate swaps.
 Originally swaps were arranged between companies by money
centre banks which would match up counterparties. But today
most swaps are between companies and banks.