Financial Derivatives

A derivative= A financial instrument

Forward, futures, options and swaps markets

• There are two groups of derivative contracts,
the privately traded Over-the-counter (OTC)
derivatives that do not go through an
exchange or other intermediary and
exchange-traded derivatives (ETD) that are
traded through specialized derivatives
exchanges or other exchanges.
A derivative can be define as a financial
instrument whose value depends on (or derives
from) the values of other, more basic, underlying
variables.

Very often the variables underlying derivatives

are the prices of traded assets. However,
derivatives can be dependent on almost any
variable.
 Definition of Financial Derivatives

• A financial derivative is a contract between

two (or more) parties where payment is
based on (i.e., "derived" from) some agreed-
upon benchmark.

• Since a financial derivative can be created by

means of a mutual agreement, the types of
derivative products are limited only by
imagination and so there is no definitive list
of derivative products.
 Repayment of Financial Derivatives
• In creating a financial derivative, the means for, basis
of, and rate of payment are specified.
• Payment may be in currency, securities, a physical
entity such as gold or silver, an agricultural product
such as wheat, a transitory commodity such as
communication bandwidth or energy.
• The amount of payment may be tied to movement of
interest rates, stock indexes, or foreign currency.
• Financial derivatives also may involve leveraging, with
significant percentages of the money involved being
borrowed. Leveraging thus acts to multiply (favorably
or unfavorably) impacts on total payment obligations
of the parties to the derivative instrument.
 Forward Contracts

• In a Forward Contract, both the seller and the

purchaser are obligated to trade a security or
other asset at a specified date in the future. The
price paid for the security or asset may be agreed
upon at the time the contract is entered into or
may be determined at delivery.
• Forward Contracts generally are traded OTC.
 Forward Contracts

• Customized:
• Long Obligated to buy
• Short Obligated to sell
• Specified assets (Currency, Stock, Index Bonds)
• Specified date in Future
• Long gains if asset price is above forward price
• Short gains if asset price is below forward Price
 Futures
• A Future is a contract to buy or sell a
standard quantity and quality of an asset or
security at a specified date and price.

• Futures are similar to Forward Contracts, but

are standardized and traded on an exchange,
and are valued daily. The daily value
provides both parties with an accounting of
their financial obligations under the terms of
the Future.
 Futures

• Unlike Forward Contracts, the counterparty

to the buyer or seller in a Futures contract is
the clearing corporation on the appropriate
exchange. (No counter party Default Risk)
• Futures often are settled in cash or cash
equivalents, rather than requiring physical
delivery of the underlying asset.
• Require Margin Deposit.
Forwards Vs Futures
 Options
• The purchaser of an Option has rights (but not
obligations) to buy or sell the asset during a given
time for a specified price (the "Strike" price). An
Option to buy is known as a "Call," and an Option to
sell is called a "Put. "
• The seller of a Call Option is obligated to sell the
asset to the party that purchased the Option. The
seller of a Put Option is obligated to buy the asset.
• Options are traded on organized exchanges and
OTC.
 Options

• For example, a trader believes that the price of a

stock will rise from its current price of $40 to a
level nearing $100. Rather than purchasing the
stock itself, she can purchase a call option for a
fraction of the price at a strike anywhere
between $40 and $100. If the stock does indeed
rise to $100, and assuming the call option was
bought at a strike of $75, the holder stands to
gain $25 per share on the contract, minus any
premiums paid for the option itself.
 Types of an Option
• In the case of a European option, the owner
has the right to require the sale to take place
on (but not before) the maturity date;
• In the case of an American option, the owner
can require the sale to take place at any time
up to the maturity date.
• If the owner of the contract exercises this
right, the counter-party has the obligation to
carry out the transaction.
 Swaps
• A Swap is a simultaneous buying and selling
of the same security or obligation. Perhaps
the best-known Swap occurs when two
parties exchange interest payments based
on an identical principal amount, called the
"notional principal amount."
Swaps
 Swaps

• Think of an interest rate Swap as follows:

Party A holds a 10-year $10,000 home equity
loan that has a fixed interest rate of 7
percent, and Party B holds a 10-year $10,000
home equity loan that has an adjustable
interest rate that will change over the "life"
of the mortgage. If Party A and Party B were
to exchange interest rate payments on their
otherwise identical mortgages, they would
have engaged in an interest rate Swap.
 Swaps
• Interest rate swaps occur generally in three
scenarios. Exchanges of a fixed rate for a floating
rate, a floating rate for a fixed rate, or a floating
rate for a floating rate.
• The "Swaps market" has grown dramatically.
Today, Swaps involve exchanges other than
interest rates, such as mortgages, currencies,
and "cross-national" arrangements. Swaps may
involve cross-currency payments (U.S. Dollars vs.
Mexican Pesos) and cross market payments, e.g.,
U.S. short-term rates vs. U.K. short-term rates.