Derivative Market - 15 Minutes Seminar Notes

 Derivative Market - 15 Minutes Seminar Notes

Description:

The Derivative markets refer to the financial market for financial instruments such as futures contracts or options that are based on the values of their underlying assets.

Example:

A future contracts a contract to buy or sell a commodity or security at a predetermined price and at a present date in the future.

Underlying Assets:

• Stocks
• Bonds
• Currency
• Commodities
• Interest rate

Definition:

A derivative is a contract between two parties which derives its value or price from an underlying asset.

The most common types of derivatives are,

• Forwards
• Futures
• Options
• Swaps

 

History of the Market:

Derivatives are not new financial instruments. For example, the emergence of the first futures contracts can be traced back to the second millennium BC in Mesopotamia. However, the financial instrument was not widely used until the 1970s. The introduction of new valuation techniques sparked the rapid development of the derivatives market. Nowadays we con not imagine modern finance without derivatives.

Types of Derivatives:

Forward:

A forward contract is a contractual agreement between two parties to buy or sell an underlying asset at a certain future date at a particular price that is pre decided at the time of contract and is traded over the counter.

Example:

Large food manufacturers may purchase a farmer’s wheat forward contract to lock in the price and control their manufacturing cost. The buyer assumes a long position and the seller assumes a short position when the forward contract is executed. The agreed upon price is called the delivery price.

• A forward is traded between two parties directly without using an exchange.
  
• The absence of the exchange results in negotiable terms on delivery, size and price of the contract.
  

Future contract:
A future contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future and traded on exchange.
 
For example:
You have purchased a single futures contract of ABC Ltd., consisting of 200 shares and expiring in the month of July. At that time, the ABC share’s price was Rs1000. If on the last Thursday of July, ABC Ltd closes at a price of Rs1050 in the cash market, your futures position will be settled at that price. You will receive a profit of Rs50 per share (the settlement price of Rs1050 less your cost price of Rs1000), which adds up to a neat little sum of Rs10000 (Rs50×200 shares). This amount is adjusted with the margins you have maintained in your account. If you receive profits, they will be added to the margins that you have deposited. If you made a loss, the amount will be deducted from the margins.

Futures contracts can be broadly classified into two categories,

• Commodities futures
• Financial futures

Features of Future contract:

• Expiry date
• Standardization
• Clearing house
• Settlement price

Margin:

• Initial Margin Trader deposit 10% of contract size.
• Maintenance Margin above 75% o initial Margin
• Variation Margin Addition margin required to bring to required level
• Margin call it is made to fill the gap in margin if it falls below margin level

 
Options contracts:

Options contracts are agreements between a buyer and seller which give the buyer the right but not the obligation to buy or sell an underlying instrument at a predetermined price over a certain period of time. For this a premium is paid by the buyer.

Important terms in options:

• Premium
• Strike price
• Contract size in lots
• Expiration date
• Settlement of an option
• No obligation to buy

Types of options: 

Call option:

Gives the options buyer the right, but not the obligation, to purchase the underlying asset at a predetermined price, by a specified date

Put options:

Gives the options buyer the right, but not the obligation, to sell the underlying asset at a predetermined price, by a specified date

Over the counter:

Individually tailored options traded between two private parties (generally an investor and an investment bank). They are not listed on an exchange.

 
Vanilla options:

A normal option with no special features, terms or conditions
– just the right to buy or sell a security during a certain time at a set strike price European and American style options, which make up the majority of options traded, are considered to be “plain” vanilla options

European:

A “plain” vanilla option that can be exercised only on the expiration date

American:

A “plain” vanilla option that can be exercised at any time before the expiration date

Exotic:

Any style of option that includes complex structures, terms or conditions or has a complicated formula to calculate the payoff, it is the opposite of a “plain” vanilla option

Swaps contract:

Swaps are derivative contracts that allow the exchange of cash flows between two parties. The swaps usually involve the exchange of a fixed cash flow for a floating cash flow. The most popular types of swaps are Interest Rate Swaps, Commodity Swaps, and Currency Swaps.

Advantages of Derivatives:

Unsurprisingly, derivatives exert a significant impact on modern finance because they provide numerous advantages to the financial markets:

 

1. Hedging risk exposure:

Since the value of the derivatives is linked to the value of the underlying asset, the contracts are primarily used for hedging risks. For example, an investor may purchase a derivative contract whose value moves in the opposite direction to the value of an asset the investor owns. In this ways, profits in the derivative contract may offset losses in the underlying asset.

2. Underlying asset price determination:

Derivatives are frequently used to determine the price of the underlying asset. For example, the spot prices of the futures can serve as an approximation of a commodity price.

3. Market efficiency:

It is considered that derivatives increase the efficiency of financial markets. By using derivative contracts, one can replicate the payoff of the asset and the assets derivatives tend to be in equilibrium to avoid arbitrage opportunities.

4. Access to unavailable assets or markets:

Derivatives can help organizations get access to otherwise unavailable assets or markets. By employing interest rate swaps, a company may obtain a more favorable interest rate relative to interest rates available from direct borrowing.

Disadvantage of Derivatives:

Despite the benefits that derivatives bring to the financial markets, the financial instruments come with some significant drawbacks. The drawbacks resulted in disastrous consequences during the Global Financial Crisis of 2007 – 2008. The rapid devaluation of mortgage – backed securities and credit – default swaps led to the collapse of financial institutions and securities around the world.

 
1. High risk:

The high volatility of derivatives exposes them to potentially huge losses. The sophisticated design of the contracts makes the valuation extremely complicated or even impossible. Thus, they bear a high inherent risk.

2. Speculative features:

Derivatives are widely regarded as a tool of speculation. Due to the extremely risky nature of derivatives and their unpredictable behavior, unreasonable speculation may lead to huge losses.

3. Counter party risk:

Although derivatives traded on the exchanges generally go through a thorough due diligence process, some of the contracts traded over the counter do not include a benchmark for due diligence. Thus, there is a possibility of counter party default.

 

 

Presented by 

Dhivya.J 

Banking student

Magme School of Banking 

Hosur.