A derivative is a financial instrument or contract between two parties that derives its value from some other underlying

asset. Application of Derivatives: Hedging Speculation Arbitrage

Types Of Derivatives
Forwards Futures Options Swaps Credit Derivatives Weather Derivatives

Forwards and Futures

They are agreements between two parties to buy or sell an asset at a predetermined future date and price Forwards are OTC based whereas futures are exchange traded

Comparison
Forward
Private contract between two parties Not standardized Usually one specified delivery date Settled at end of contract Delivery of final cash settlement takes place Some credit risk

Futures
Traded on a exchange Standardized contract Range of delivery dates Settled daily Contract is closed out prior to maturity Virtually no credit risk

Pay-off

Forward Pricing
Fn = S ( 1 + c )n Where Fn = the forward price of an asset n years into the future S = the current spot price for the asset c = the annual cost of carry, expressed as a fraction of the assets spot price n = years to maturity The cost of carry is composed of F = s (1 + rf + s i v )n Where rf = the riskless rate of return s = storage costs i = cash yield v = convenience yield

Options
It is a contract that offers the buyer the right, but not the obligation, to buy or sell a security or other financial asset at an agreed-upon price during a certain period of time or on a specific date. In order to claim the rights an upfront payment is required which is the Option Premium.

OPTIONS

CALL (Right to Buy)

PUT ( Right to Sell)

American Option Can be exercised any time till maturity European Option Can be exercised only on maturity

Pay-off
Total Payoff on a Call Option
$ Profit P O -P $ Loss Call sellers position K B St Call buyers position

Total Payoff on a Put Option

$ Profit K-P P O -P - ( K P) $ Loss B St Put buyers position K Put sellers position

Pricing Methods
Binomial Model Black - Scholes Model

Call Option Asset Price Exercise Price Interest Rates Volatility of the asset price Time to maturity Cash distribution + + + + Put Option + + + +

Swaps
It is an agreement between two parties to exchange cash flows in the future. Types of swaps : Interest Rate Swaps Currency Swaps

Example
A Corp. and B Corp. both want to borrow $ 10 million for 5 years
FIXED A Corp B Corp Difference 4.0% 5.2% 1.2% FLOATING 6-month LIBOR-0.1% 6-month LIBOR + 0.6% 0.7% REQUIRED Floating Fixed

A Corp. has an absolute advantage whereas B Corp. has comparative advantage in Floating Rate

Quality Spread Differential = 1.2 0.7 = 0.5 %

4.33 % 4%

4.37 %

AAA Corp
LIBOR

Financial Institution
LIBOR

BBB Corp

LIBOR + 0.6%

Indian Scenario
Started in late 1890s, where it was basically futures based market Banned in 1952 to prevent speculation on agricultural commodities Trading restarted in late 1990s and early 2000 Currently, index futures, index options, stock futures, stock options, currency futures, interest rate futures are traded