Financial Derivatives

Financial derivatives are contracts that are based on or derived from some underlying assets, reference rate or index. Derivatives are securities where payment dates and amounts may vary according to maturity and/or amount. Derivatives are standard products. It is, in fact, not a very new concept. Derivatives transactions involve transferring risks from entities less willing or able to manage them to those more willing or able to do so. Derivatives helps to improve market efficiency because risks can be isolated and sold to those who are willing to accept them at the less cost. Economic benefits of derivatives are not dependent on the size of the institution trading them. It is an important tool that can help organizations to meet their specific risk-management objectives.

Users of Derivatives
Banks Fund managers Insurance companies Non-financial firms, and Central bank (issues bonds)

Major Types of Derivatives

Forward Futures Options, and Swaps

Forwards and Futures

Forward contract is an individually negotiated agreement made between two parties (trading take place in OTC market). In a forward contract, one party agrees to enter into a financial transaction (such as sale and delivery of an asset) with another, on a set date in the future at a fixed price. Contracts accounted at a date of maturity in Forward contract. A futures contract is an agreement to buy or sell some commodity at a fixed price on a fixed date. A future contract is made through a regulated exchange rather than being a bilaterally negotiated agreement. Although trading is initially done between two counter parties, contracts are typically 'novated' where one of the counter parties for each transaction is the exchange itself. Future transaction dates for settlement and delivery are usually standardized.

In future contract, contract terms are highly specified, uniform with specified commitments at all stock exchange. Trading of futures is subject to price limit to restrict volatility. In Future, contract is an obligation not right; all market partners have to fulfill it.

Similarities between Forward and Future

1. Both Forward trade and Future contracts will share certain key elements that describe the basic economic attributes of a trade. 2. Delivery is prescribed for Future contracts; some have physical settlements, some are cash settlements, and others have a cash or physical options.

Differences between Forward and Future

S. N. 1 2 Subjects Terms of Future Transaction Settlement Dates Forward A Forward transaction can be customized A forward transaction will have a single date at which the future transaction can take place Forward transactions generate credit risk for the two sides of transactions. Future A future contract has standardized terms. Many future contracts have a range of possible future settlement dates. It is not uncommon for possible settlement to take place during a whole month following the of trading in a contract. Most future contracts require that some 'margin' be paid to the exchange when a trade is initiated. This margin will change as the future prices changes. The margin system reduces the credit risk associated with default. Future contracts are openly traded on a recognized exchange. The requisite exchange is generally a legal counterparty in every futures transaction.

Location

Legal counterparty

Forward transactions are privately negotiated between two counterparties Most OTC forward transactions are bilateral contracts between two appropriate counterparties. It is difficult to extinguish exposure for an OTC transaction unless the transaction is unwound with the original counterparty, an agent will be left with the settlement obligation. Contracts are right, not obligation.

The vast majority of futures transactions are offset before the settlement date a buyer of a contract simply sells the contract before expiry.

Contract is an obligation, all market partners have to fulfill it.

Option
These contracts can be either customized and privately negotiated or standardized. An option is a derivative. That is, its value is derived from something else. In the case of a stock option, its value is based on the underlying stock. In the case of an index option, its value is based on the underlying index. They give purchaser the right to buy (call option) or sell (put option) a specified quantity of a commodity or financial asset at a particular price on or before a certain future date. In option, no purchase or sale of underlying asset is done. Options allow you to participate in price movements without committing the large amount of funds needed to buy stock outright. Options can also be used to hedge a stock position, to acquire or sell stock at a purchase price more favorable than the current market price, or, in the case of writing options, to earn premium income. When market price is going up than the delivery price, buyers start to make profit and vice-versa. It is traded only at organized exchange. In option, buyer has to pay for the instrument (option premium). There are two fundamental kinds of options: American option permits the owner to exercise at any time before or at expiration of contract. This option allows a higher degree of variations and more possibilities to gain profits. European option permits owner to exercise only at date of expiration. Option cannot be bought on credit, buyer of the options (both put or call) has to pay full price at the morning of the next working day.

Some benefits of options:

You can protect stock holdings from a decline in market price. You can increase income against current stock holding. You can prepare to buy a stock at a lower price. You can position yourself for a big market move even when you don' t know which way prices will move. You can benefit from a stock price rise without incurring the cost of buying the stock outright.

Swaps
A derivative in which two parties agree to exchange one stream of cash flows against another is called Swaps. Swap contract is individually designed for needs of two parties. In swap, there is significant reduction of transaction cost. Calculation of these payments is based on agreement upon amount, called National Principal Amount. There are various types of swaps in financial market. They are: Interest rates swaps Currency swaps Credit default swaps.