Prepared by:

Nishank Gonsalves (16)

Nayantara Gore (17)
Mansingh Gorkha (18)
Krishna Gosavi (19)
Mukesh Gupta (20)
 What is a Financial Derivative?
 A derivative is a contract between two parties
which derives its value from an underlying
asset.

 The different underlying assets are:

 Currency
 Exchange rate
 Interest rate
 Equity
 Commodities
 FEATURES OF A DERIVATIVE

 A derivative instrument relates to the future

contract between two parties

 The derivative instruments have the value

which derived from the values of other
underlying assets.

 In general the counter parties have specified

obligation under the derivative contract.
 Why derivative is so important today?-Growth
Driving Factors

Increased volatility in asset prices in Financial

Markets

 Increased integration between International

Markets

One of the most important services provided by the

derivatives is to control, avoid, shift and manage
efficiently different types of risks through various
strategies like hedging, arbitraging, spreading, etc.
 Why derivatives are used?
• To insure against changes or risk (hedgers).

• To get a high profit from a certain market

behavior (speculators).

• To get a quick low-risk profit (arbitrageurs).

• To change the nature of an investment
without the costs of selling one portfolio and
buying another.
 What are the different types of traders/participants in
derivatives market ?

                                                     
Hedgers:
They are in the position where they face risk associated
with the price of an asset. They use derivatives to reduce
or eliminate risk.

For example: A farmer may use futures or options to establish

the price for his crop long before he harvests it. Various factors
affect the supply and demand for that crop, causing prices to
rise and fall over the growing season. The farmer can watch the
prices discovered in trading at the CBOT and, when they
reflect the price he wants, will sell futures contracts to assure
him of a fixed price for his crop.
Speculators:
Speculators wish to bet on the future movement in the
price of an asset. They use derivatives to get extra leverage.
A speculator will buy and sell in anticipation of future
price movements, but has no desire to actually own the
physical commodity.  

Arbitrators:
They are in the business to take advantage of a discrepancy
between prices in two different markets. If, for example,
they see the future prices of an asset getting out of line
with the cash price, they will take offsetting positions in
the two markets to lock in a profit.
 Types of Derivatives

Forwards :
A Forward is an agreement between two
parties to purchase or sell an instrument
at a fixed time in the future and at a
certain price.
 Example of a forward
contract
• On January 20, 2009 a trader (long
position) enters into an agreement to
buy £1 million in three months at an
exchange rate of 1.6196
• This obligates the trader to pay
$1,619,600 (=K) for £1 million on April 20,
2009
• If the exchange rate rose to 1.65, the spot
price ST is $1,650,000 and the payoff is
What is `Offsetting the Forward Contract’

One cannot unilaterally back out from the

obligation arisen in the forward contract, but he can

certainly enter into another forward position

exactly opposite the original position. This strategy

is popularly known as `offsetting the forward

contract’.
EXAMPLE:

January 01, 2005, a party X enters into a

forward contract with another party Y, in
which he agrees to buy one kg of gold on April
01, 2005 for Rs.5,000 per 10 grams of gold. On
February 01, 2005, X decides to get out of his
position, and hence, enters into another
forward contract with Z which he agrees to sell
one kg of gold on April 01, 2005 for Rs.5,200/-
per 10 gram of gold.
The Advantage/Disadvantage of A
forward Contract
Advantage Disadvantage

• You must make or take delivery

• Both parties of the commodity and settle on
have limited the deliver date and honor the
their risk. contract as agreed upon.
• The buyer and seller are
dependent upon each other.
• In a forward contract, any
profits or losses are not realized
until the contract "comes due"
on the predetermined date.
 FUTURES CONTRACTS

A future is a standardized derivative contract

between two parties: a buyer and a seller.

Futures are similar to forwards but they are

traded on exchanges and their terms are
standardized.
When the market is bullish
Take a long position
 When Reliance Futures is at Rs. 480
 Market rises and Reliance Futures goes to Rs. 500
 Sell Reliance Futures
 Profit is = Rs 20/-
Take a short position
 When Reliance Future is at 480
Sell Reliance Futures
 Market falls and Reliance Futures goes to 460/-
Buy Reliance Futures
 Profit = Rs.20/-
 WHAT IS OPTIONS?

An option is a particular type of a contract

between two parties where one person gives

the other person the right to buy or sell a

specific asset at a specified price within a

specific time period.

 TYPES OF OPTIONS

Call and Put Options

American and European Options

 TYPES OF OPTIONS

Call Options : The option to buy

Put Options : The option to sell

American Options : The option can be exercised

anytime prior tomaturity.

European Options : The option can be exercised at

maturity.
 Example of Call Option

An investor buys a European call option on

satyam will exercise price at RS 280 for a
premium of RS.10.If the price of the share
rises and current market price is RS 350 ,
the owner of the option may exercise his
option to buy the shares at Rs 280.
 Example of Put Option

The investor buys a European put option on

ONGC share with a strike price of Rs 850 and
expiration in June, by paying a premium of
RS 25.The investor has the right to sell ONGC
share at RS 850 before the expiry date of the
option. If the current market price of share
is RS 950.The investor should not exercised
his option.
 SWAPS
Swaps have been termed as private agreements
between the two parties to exchange stream of cash
flows against one another.

Why?
• To hedge risks like floating
interest rate, Currency
fluctuations, equity returns.
 Characteristics

• Two parties involved

• Private agreement
• Cannot be traded
• Termination by mutual consent
 Types of Swaps

• Interest Swaps
• Currency Swaps
• Equity Swaps
• Commodity Swaps
• Credit Swaps
 Interest Swap

• Parties hedge interest rate

like fixed to floating
• Also called vanilla swaps
• Principal is not exchanged
• Most commonly used.
 Example of Interest Rate Swap

A borrows $10 million with a floating interest

rate of 11% and B borrows $10 million with a
fixed interest rate of 10%. A and B can enter
into an interest rate swap arrangement
under which A will pay a fixed rate of
interest of 10 percent and B will pay a
floating interest rate of 11%.
 Currency Swap
• Parties hedge on currency
fluctuations
• Across two different currencies
• Actual exchange of currency
• Interest rates/variations
swapped
• Transactions are reversed later
 Example of Currency Swap

Company A raises 1 million by issuing 10%

German mark bonds and the company B
raises 2 million by issuing 13% dollar bonds.
Both the company Swap the transaction.

In the beginning company A receives 2

million and company B receives 1 million.
Both the companies re-exchange the
principal amounts at the time of maturity.
Company A pays, 2,60,000 to company B and
company B in turn pays 1,10,000 to company
A as interest during the currency of loan.
 Equity Swap

• Parties hedge returns on equity with

Fixed interest
• Generally entered to avoid tax
• Portfolio is not exchanged
• Can be hedged against currency
fluctuations.
 Credit Swap

• Debt is transferred from one

Party to other
• Seller guarantees credit
worthiness
• Buyer will make money
if credit is recovered properly