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Derivatives Essay

4735 words - 19 pages

Study Material on
Derivatives, Options & Futures

No. | Contents | Page No. |
Section 1: Derivatives | |
1.1 | Derivatives: History, Meaning and Definition | 3 |
1.2 | Classification of Derivatives | 4 |
1.3 | Features, Types and Players in Derivatives | 4 |
1.4 | Forwards: Meaning, Definition & Limitations | 6 |
Section 2: Futures | |
2.1 | Meaning | 8 |
2.2 | Terminologies | 8 |
2.3 | Payoff Profile | 10 |
2.4 | Numerical Examples | 11 |
Section 3: Options | |
3.1 | Meaning | 13 |
3.2 | Terminologies | 13 |
3.3 | Payoff Profile | 15 |
3.4 | Numerical Examples | 18 |

1.0 Derivatives
...view middle of the document...

Currently, there are 275 stocks on which derivative trading are allowed.
Derivate – “Derives its value from an asset” - What the phrase means is that the derivative on its own does not have any value. It is considered important because of the importance of the underlying. When we say an Infosys future or an Infosys option, these carry a value only because of the value of Infosys.

A derivative is a financial instrument that derives its value from an underlying asset. This underlying asset can be stocks, bonds, currency, commodities, metals and even intangible, pseudo assets like stock indices.

1.2 Classification of Derivatives

Financial Derivatives
Financial derivatives are instruments that derive their value from financial assets. These assets can be stocks, bonds, currency etc. These derivatives can be forward rate agreements, futures, options swaps etc. As stated earlier, the most traded instruments are futures and options.

1.3 Features of Derivatives
* Hedging: To minimize risk arising due to volatility of the market.
* Price Discovery: To have better price discovery in terms of huge no. of players.
* Liquidity Function: To infuse liquidity in the market by way of lot size trading.
* Trading Volumes: To generate huge trading volumes by way of mass trading.

Types of Derivatives
The most commonly used derivatives contracts are forwards, futures and options. Lets take a brief look at various derivatives contracts that have come to be used.

Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today's pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts.

Options: Options are of two types - calls and puts. Calls 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 given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:
* Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.
* Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.
Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges having a...

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