5/16/2022
• There are two types of derivatives.
Commodity derivatives and financial
Introduction to Financial
derivatives. It can be agricultural commodity
Derivatives like wheat, soybeans, rapeseed, cotton etc. or
precious metals like gold, silver etc.
Module1
• A derivative is a financial instrument that • The term financial derivative denotes a variety
derives its value from the value of another of financial instruments including stocks,
basic underlying instrument or variable. bonds, treasury bills, interest rate, foreign
• The term ‘derivative’ indicates that it has no currencies and other hybrid securities
independent value, i.e., its value is entirely
derived from the value of the underlying
asset. The underlying asset can be securities,
commodities, bullion, currency, livestock or
anything else.
1
, 5/16/2022
Features of Financial Derivatives Forwards
• It is a contract • A forward contract is a simple customized
• Derives value from underlying asset contract between two parties to buy or sell an
• Specified obligation asset at a certain time in the future for a
• Direct or exchange traded certain price. Unlike future contracts, they are
• Delivery of underlying asset not involved not traded on an exchange, rather traded in
• Secondary Market Instruments the over-the-counter market, usually between
two financial institutions or between a
• Exposure to risk
financial institution and its client.
• Off balance sheet item
Types of Financial Derivatives Example
• An Indian company buys Automobile parts
from USA with payment of one million dollar
due in 90 days. The importer, thus, is short of
dollar that is, it owes dollars for future
delivery. Suppose present price of dollar is Rs
48. Over the next 90 days, however, dollar
might rise against Rs 48. The importer can
hedge this exchange risk by negotiating a 90
days forward contract with a bank at a price
Rs 50.
2
, 5/16/2022
Example
• According to forward contract in 90 days the • A silver manufacturer is concerned about the
bank will give importer one million dollar and price of silver, since he will not be able to plan
importer will give the bank 50 million rupees for profitability.
hedging a future payment with forward • Given the current level of production, he
contract. On the due date importer will make expects to have about 20000 ounces of silver
a payment of Rs 50 million to bank and the ready in next two months. The current price of
bank will pay one million dollar to importer, silver on May 10 is Rs 1052.5 per ounce, and
whatever rate of the dollar is after 90 days. So July futures price at FMC is ` 1068 per ounce,
this is a typical example of forward contract which he believes to be satisfied price.
on currency.
Futures
• Like a forward contract, a futures contract is • But he fears that prices in future may go
an agreement between two parties to buy or down. So he will enter into a futures contract.
sell a specified quantity of an asset at a He will sell four contracts at MCX where each
specified price and at a specified time and contract is of 5000 ounces at Rs 1068 for
place. Futures contracts are normally traded delivery in July.
on an exchange which sets the certain
standardized norms for trading in the futures
contracts.
3
, 5/16/2022
Option Contracts Example
• Options are the most important group of derivative • Suppose the current price of CIPLA share is Rs 750 per
securities. Option may be defined as a contract, share. X owns 1000 shares of CIPLA Ltd. and
between two parties whereby one party obtains the apprehends in the decline in price of share. The option
right, but not the obligation, to buy or sell a particular (put) contract available at BSE is of Rs 800, in next two-
asset, at a specified price, on or before a specified month delivery. Premium cost is Rs 10 per share. X will
date. buy a put option at 10 per share at a strike price of `
• The person who acquires the right is known as the 800. In this way X has hedged his risk of price fall of
option buyer or option holder, while the other person stock. X will exercise the put option if the price of stock
(who confers the right) is known as option seller or goes down below Rs 790 and will not exercise the
option writer. The seller of the option for giving such option if price is more than Rs 800, on the exercise
option to the buyer charges an amount which is known date. In case of options, buyer has a limited loss and
as the option premium. unlimited profit potential unlike in case of forward and
futures.
Warrants and Convertibles
• Options can be divided into two types: calls and • Warrant is just like an option contract where
puts. A call option gives the holder the right to the holder has the right to buy shares of a
buy an asset at a specified date for a specified
price whereas in put option, the holder gets the specified company at a certain price during
right to sell an asset at the specified price and the given time period.
time. • In other words, the holder of a warrant
• The specified price in such contract is known as instrument has the right to purchase a specific
the exercise price or the strike price and the date number of shares at a fixed price in a fixed
in the contract is known as the expiration date or
period from an issuing company.
the exercise date or the maturity date.
4
• There are two types of derivatives.
Commodity derivatives and financial
Introduction to Financial
derivatives. It can be agricultural commodity
Derivatives like wheat, soybeans, rapeseed, cotton etc. or
precious metals like gold, silver etc.
Module1
• A derivative is a financial instrument that • The term financial derivative denotes a variety
derives its value from the value of another of financial instruments including stocks,
basic underlying instrument or variable. bonds, treasury bills, interest rate, foreign
• The term ‘derivative’ indicates that it has no currencies and other hybrid securities
independent value, i.e., its value is entirely
derived from the value of the underlying
asset. The underlying asset can be securities,
commodities, bullion, currency, livestock or
anything else.
1
, 5/16/2022
Features of Financial Derivatives Forwards
• It is a contract • A forward contract is a simple customized
• Derives value from underlying asset contract between two parties to buy or sell an
• Specified obligation asset at a certain time in the future for a
• Direct or exchange traded certain price. Unlike future contracts, they are
• Delivery of underlying asset not involved not traded on an exchange, rather traded in
• Secondary Market Instruments the over-the-counter market, usually between
two financial institutions or between a
• Exposure to risk
financial institution and its client.
• Off balance sheet item
Types of Financial Derivatives Example
• An Indian company buys Automobile parts
from USA with payment of one million dollar
due in 90 days. The importer, thus, is short of
dollar that is, it owes dollars for future
delivery. Suppose present price of dollar is Rs
48. Over the next 90 days, however, dollar
might rise against Rs 48. The importer can
hedge this exchange risk by negotiating a 90
days forward contract with a bank at a price
Rs 50.
2
, 5/16/2022
Example
• According to forward contract in 90 days the • A silver manufacturer is concerned about the
bank will give importer one million dollar and price of silver, since he will not be able to plan
importer will give the bank 50 million rupees for profitability.
hedging a future payment with forward • Given the current level of production, he
contract. On the due date importer will make expects to have about 20000 ounces of silver
a payment of Rs 50 million to bank and the ready in next two months. The current price of
bank will pay one million dollar to importer, silver on May 10 is Rs 1052.5 per ounce, and
whatever rate of the dollar is after 90 days. So July futures price at FMC is ` 1068 per ounce,
this is a typical example of forward contract which he believes to be satisfied price.
on currency.
Futures
• Like a forward contract, a futures contract is • But he fears that prices in future may go
an agreement between two parties to buy or down. So he will enter into a futures contract.
sell a specified quantity of an asset at a He will sell four contracts at MCX where each
specified price and at a specified time and contract is of 5000 ounces at Rs 1068 for
place. Futures contracts are normally traded delivery in July.
on an exchange which sets the certain
standardized norms for trading in the futures
contracts.
3
, 5/16/2022
Option Contracts Example
• Options are the most important group of derivative • Suppose the current price of CIPLA share is Rs 750 per
securities. Option may be defined as a contract, share. X owns 1000 shares of CIPLA Ltd. and
between two parties whereby one party obtains the apprehends in the decline in price of share. The option
right, but not the obligation, to buy or sell a particular (put) contract available at BSE is of Rs 800, in next two-
asset, at a specified price, on or before a specified month delivery. Premium cost is Rs 10 per share. X will
date. buy a put option at 10 per share at a strike price of `
• The person who acquires the right is known as the 800. In this way X has hedged his risk of price fall of
option buyer or option holder, while the other person stock. X will exercise the put option if the price of stock
(who confers the right) is known as option seller or goes down below Rs 790 and will not exercise the
option writer. The seller of the option for giving such option if price is more than Rs 800, on the exercise
option to the buyer charges an amount which is known date. In case of options, buyer has a limited loss and
as the option premium. unlimited profit potential unlike in case of forward and
futures.
Warrants and Convertibles
• Options can be divided into two types: calls and • Warrant is just like an option contract where
puts. A call option gives the holder the right to the holder has the right to buy shares of a
buy an asset at a specified date for a specified
price whereas in put option, the holder gets the specified company at a certain price during
right to sell an asset at the specified price and the given time period.
time. • In other words, the holder of a warrant
• The specified price in such contract is known as instrument has the right to purchase a specific
the exercise price or the strike price and the date number of shares at a fixed price in a fixed
in the contract is known as the expiration date or
period from an issuing company.
the exercise date or the maturity date.
4
