FRM Individual BMS2025

FRM assignment ROLL NO.
BMS2025
NAME. Juzer Jiruwala
What Is Price Discovery?
Price discovery is the overall process, whether explicit or inferred, of setting
the spot price or the proper price of an asset, security, commodity, or
currency. The process of price discovery looks at a number of tangible and
intangible factors, including supply and demand, investor risk attitudes, and
the overall economic and geopolitical environment. Simply put, it is where a
buyer and a seller agree on a price and a transaction occurs.
KEY TAKEAWAYS
• Price discovery is the process of finding out the price of a given asset
or commodity.
• Price discovery is the central function of a marketplace
• It depends on a variety of tangible and intangible factors, from market
structure to liquidity to information flow.
At its core, price discovery involves finding where supply and demand meet.
In economics, the supply curve and the demand curve intersect at a single
price, which then allows a transaction to occur.
The shape of those curves is subject to many factors, from transaction size to
background conditions of previous or future scarcity or abundance. Location,
storage, transaction costs, and buyer/seller psychology also play a role.
Price discovery in derivatives:

Different types of derivatives have different pricing mechanisms. A derivative
is simply a financial contract with a value that is based on some underlying
asset (e.g. the price of a stock, bond, or commodity).
The most common derivative types are futures contracts, forward
contracts, options and swaps.
More exotic derivatives can be based on factors such as weather or carbon
emissions.
KEY TAKEAWAYS
• Derivatives are financial contracts used for a variety of purposes,
whose prices are derived from some underlying asset or security.
• Depending on the type of derivative, its fair value or price will be
calculated in a different manner.
• Futures contracts are based on the spot price along with a basis
amount, while options are priced based on time to expiration, volatility,
and strike price.
• Swaps are priced based on equating the present value of a fixed and a
variable stream of cash flows over the maturity of the contract.
Futures Pricing Basics
Futures contracts are standardized financial contracts that allow holders to
buy or sell an underlying asset or commodity at a certain price in the future,
which is locked in today. Therefore, the futures contract's value is based on
the commodity's cash price.
For example, consider a corn futures contract that represents 5,000 bushels
of corn. If corn is trading at $5 per bushel, the value of the contract is
$25,000. Futures contracts are standardized to include a certain amount and
quality of the underlying commodity, so they can be traded on a
centralized exchange. The futures price moves in relation to the spot price for
the commodity based on supply and demand for that commodity.
Forwards are priced similarly to futures, but forwards are non-standardized

contracts that arranged instead between two counterparties and transacted
over-the-counter with more flexibility of terms.
Options Pricing Basics

Options are also common derivative contracts. Options give the buyer the
right, but not the obligation, to buy or sell a set amount of the underlying
asset at a pre-determined price, known as the strike price, before the contract
expires.1
Aside from a company's stock and strike prices, time, volatility, and interest
rates are also quite integral in accurately pricing an option. The longer that an
investor has to exercise the option, the greater the likelihood that it will be
ITM at expiration. Similarly, the more volatile the underlying asset, the greater
the odds that it will expire ITM. Higher interest rates should translate into
higher option prices.
The best-known pricing model for options is the Black-Scholes method.
This method considers the underlying stock price, option strike price, time
until the option expires, underlying stock volatility and risk-free interest rate to
provide a value for the option.
Other popular models exist such as the binomial tree and trinomial
tree pricing models.
We learned above how derivatives are used as price discovery and the role
of different types of derivative contracts in price discovery.
Now lets learn about how derivatives are used as a tool for risk management,
In the stock market, hedging is a way to get portfolio protection—and
protection is often just as important as portfolio appreciation.
Hedging is often discussed more broadly than it is explained. However, it is
not an esoteric term. Even if you are a beginning investor, it can be beneficial
to learn what hedging is and how it works.
The best way to understand hedging is to think of it as a form of insurance.
When people decide to hedge, they are insuring themselves against a
negative event's impact on their finances. This doesn't prevent all negative
events from happening. However, if a negative event does happen and you're
properly hedged, the impact of the event is reduced.
individual investors, and corporations use hedging techniques to reduce their
exposure to various risks. In financial markets, however, hedging is not as
simple as paying an insurance company a fee every year for coverage.
Hedging against investment risk means strategically using financial
instruments or market strategies to offset the risk of any adverse price
movements.
For instance, if you are long shares of XYZ corporation, you can buy a put
option to protect your investment from large downside moves. However, to
purchase an option you have to pay its premium.
Example of hedging:
Suppose you own shares of TATA MOTORS Although you believe in the
company for the long run, you are worried about some short-term losses in
the auto industry. To protect yourself from a fall in CTC, you can buy a put
option on the company, which gives you the right to sell CTC at a specific
price (also called the strike price). This strategy is known as a married put. If
your stock price tumbles below the strike price, these losses will be offset by
gains in the put option.

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FRM assignment ROLL NO.

Price discovery in derivatives:

Forwards are priced similarly to futures, but forwards are non-standardized

Options Pricing Basics

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