 The attitude here is that derivatives have, on the whole, been a tremendously

positive force around the world. In all these countries, they impose market
discipline and force supervision to rethink and regulation.
David Folkents-Landan
 Financial Derivatives are Risk management tools.
 Practice of derivative securities have been growing rapidly for over 4 decades in the
developed countries like USA, UK, Canada and so on. In the US, the financial derivative
was first started in 1972 trading future contracts in seven foreign currencies through
Chicago Mercantile Exchange.
 Increasing market of derivative securities has positioned them as sizeable force in the
global economy.
 Financial Derivatives have become integral part of the world of finance and investment.
 NRB has recently allowed the commercial banks to engage in derivatives trading
without its prior permission.
 Commodities and Metal Exchange Limited and Leaders Nepal Private Limited are the
initiators of trading of derivatives in Nepal.
 Nepalese Universities have also included Derivatives in their courses of Finance.
 Financial Contracts or Underlying Assets?
 Assets
Gives benefits in future

Financial
Assets
Real Assets
Used to produce goods
&services

Primary Derivative
Securities Securities
 Positions in Derivatives

Forward/Future Option Contract

Contracts

Long
Position/Short Calls Puts
Position

Long Long
Position/Short Position/Short
Position Position
 Organized Exchange and Over the Counter Market.
 Created through the contract between two parties rather than issued by the firm as
in the case of bond and shares.
 To manage financial risk.
 Financial Risk- Uncertainty about interest rates, exchange rates, stock prices and
commodity prices.
 Used to transfer risk to other parties, to assume risk or to neutralize risk.
 Derive value from underlying assets
 Two parties
 Legally binding contract
 Predetermined Life
 Involves Forward Transactions
 Zero Sum Game
Options
 Features:- Predetermined Price, Pre-specified underlying assets, Transaction Period- On
or before predetermined time.
 Types: Call Option and Put Option

Forward Contracts
 Features: Financial Contracts, Rights and Obligations, Pre-determined Price, Pre-specified
Place, Pre-specified underlying Assets, Delivery Period: On the due date.
 Traded in OTC market.

Futures Contracts
 Features: Created and Traded in Organized Future Exchange, Standardized underlying
assets, performance guaranteed by clearing house. Based on marked to market
settlement process.
Swaps
 A series of Cash flow payment
 Cash Flow Payment is based on random factors, such as interest rate, exchange rate, stock
price or commodity price.
 Notional Principal Amount
 Traded in the over the counter market.

Example of Swaps
 Notional Principal Amount: Rs. 100 million.
 Involved Party: Mr. A and Mr. B
 Mr. A fixed 10 % interest to pay to Mr. B at the end of Dec 31 each year for 3 years
 Mr. B agreed to pay on the basis of market interest rate to Mr. A. at the end of Dec 31 each
year for 3 years.
 The notional principal amount is not exchanged, but parties pay interest to each other as
agreement.
 Market for Forward Transactions.
 Colorful Financial Market:
 Future contracts
 Forward Contracts.
 Option Contracts
 Swaps and
 Other highly complex assets

 Types of Derivative Market:- Organized Exchange or Over the Counter Market

 Newest market as compared to stocks and bond markets.
 Growth of derivative market occurred mainly in the 1970s,1980s and 1990s
(Saunders, and Cornett)
 Risk management
 Hedging/Hedgers
 Speculation/Speculator

 Price Discovery\
 Operational Advantage
 Lower Transaction Cost
 Greater Liquidity
 Short Selling.
 Risk Preference
 Short Selling
 Repurchase Agreement
 Risk and Return
 Market Efficiency and Theoretical Fair Value
 Example 1: A Soybean farmer buys a future contract to deliver a certain amount of
soybean at a specified future date and at a specified price, and hence avoids exposure
to unfavorable price movement.
 Example 2: You can purchase a fire insurance policy to avoid the exposure to fire occur
on your assets.
 Example 3: You assume that dollar price will depreciate in future. You purchase future
agreement to provide dollar at the specified exchange rate of Rs. 100 for one dollar. At
present the exchange rate of dollar is Rs. 110 for 1 dollar.
 Example 4: Instead of depreciation in dollar rate, you assume it will appreciate in
future. You purchase future agreement that will provide you dollars at Rs. 120 for 1
dollar. At present the dollar rate is Rs. 110 for 1 dollar.
 Example 5: Assume that NEPSE and KHPSE are two stock exchanges of Nepal. You buy
one share of EBL from NEPSE at Rs. 650 and Sell one share of EBL at Rs. 750 in KHPSE.
SPOT MARKET
 Cash market
 Ownership on asset is immediately transferred between market participants.

DERIVATIVE MARKET
 Financial contracts between two or more parties.
 Agreement to buy or sell an underlying asset or its stocks at predetermined price and
with in specified time.
Share of Company A Share of Company B
Overvalued Undervalued

Investor
 Financial
Market

Arbitrage comes
into place by
buying and
Irrational Rational
selling different
Amateur Professional
but substitute
Trader
securities

Take a larger
Take Risk for Market efficiency, risk on certain
smaller sum when professional assets
dominates
amateurs
 A security must have a single price, no matter how the security is created. Law of
one price requires that equivalent combinations of assets, meaning those that offer
the same outcomes in future must sell for a single price, or else there would be an
opportunity of profitable arbitrage that quickly eliminate the price differential.
 Arbitrage and the Law of One Price
Current State Future States

Stock A =Rs. 45 Stock A= Rs.60

Stock B= Rs. 21 Stock B=Rs. 30

Stock A=Rs. 40
Stock B=Rs.20