UNIT-1 (Financial Derivatives)

What Is a Derivative?
The term derivative refers to a type of financial contract whose value is dependent on
an underlying asset, group of assets, or benchmark. A derivative is set between two or more
parties that can trade on an exchange or over-the-counter (OTC). These contracts can be used to
trade any number of assets and carry their own risks. Prices for derivatives derive from
fluctuations in the underlying asset. These financial securities are commonly used to access
certain markets and may be traded to hedge against risk.
KEY TAKEAWAYS
 Derivatives are financial contracts, set between two or more parties, that derive their
value from an underlying asset, group of assets, or benchmark.
 A derivative can trade on an exchange or over-the-counter.
 Prices for derivatives derive from fluctuations in the underlying asset.
 Derivatives are usually leveraged instruments, which increases their potential risks and
rewards.
 Common derivatives include futures contracts, forwards, options, and swaps.

Understanding Derivatives
A derivative is a complex type of financial security that is set between two or more
parties. Traders use derivatives to access specific markets and trade different assets.
The most common underlying assets for derivatives are stocks,
bonds, commodities, currencies, interest rates, and market indexes. Contract values
depend on changes in the prices of the underlying asset.
Derivatives can be used to hedge a position, speculate on the directional movement of
an underlying asset, or give leverage to holdings. These assets are commonly traded
on exchanges or over-the-counter (OTC) and are purchased through brokerages.
The Chicago Mercantile Exchange (CME) is among the world's largest derivatives
exchanges.1
OTC-traded derivatives generally have a greater possibility of counterparty risk, which
is the danger that one of the parties involved in the transaction might default. These
contracts trade between two private parties and are unregulated. To hedge this risk,
the investor could purchase a currency derivative to lock in a specific exchange rate.
Derivatives that could be used to hedge this kind of risk include currency
futures and currency swaps.

Exchange-traded derivatives are standardized and more heavily regulated than those
that are traded over the counter.

Special Considerations

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Derivatives were originally used to ensure balanced exchange rates for internationally
traded goods. International traders needed a system to account for the differing values
of national currencies.
Assume a European investor has investment accounts that are all denominated in
euros (EUR). Let's say they purchase shares of a U.S. company through a U.S.
exchange using U.S. dollars (USD). This means they are now exposed to exchange
rate risk while holding that stock. Exchange rate risk is the threat that the value of the
euro will increase in relation to the USD. If this happens, any profits the investor
realizes upon selling the stock become less valuable when they are converted into
euros.
A speculator who expects the euro to appreciate compared to the dollar could profit by
using a derivative that rises in value with the euro. When using derivatives to speculate
on the price movement of an underlying asset, the investor does not need to have a
holding or portfolio presence in the underlying asset.
Many derivative instruments are leveraged, which means a small amount of capital is
required to have an interest in a large amount of value in the underlying asset.
Types of Derivatives
Derivatives are now based on a wide variety of transactions and have many more
uses. There are even derivatives based on weather data, such as the amount of rain or
the number of sunny days in a region.
There are many different types of derivatives that can be used for risk
management, speculation, and leveraging a position. The derivatives market is one
that continues to grow, offering products to fit nearly any need or risk tolerance. The
most common types of derivatives are futures, forwards, swaps, and options.
Futures
A futures contract, or simply futures, is an agreement between two parties for the
purchase and delivery of an asset at an agreed-upon price at a future date. Futures are
standardized contracts that trade on an exchange. Traders use a futures contract to
hedge their risk or speculate on the price of an underlying asset. The parties involved
are obligated to fulfill a commitment to buy or sell the underlying asset.
For example, say that on Nov. 6, 2021, Company A buys a futures contract for oil at a
price of $62.22 per barrel that expires Dec. 19, 2021. The company does this because
it needs oil in December and is concerned that the price will rise before the company
needs to buy. Buying an oil futures contract hedges the company's risk because the
seller is obligated to deliver oil to Company A for $62.22 per barrel once the contract
expires. Assume oil prices rise to $80 per barrel by Dec. 19, 2021. Company A can
accept delivery of the oil from the seller of the futures contract, but if it no longer needs
the oil, it can also sell the contract before expiration and keep the profits.
In this example, both the futures buyer and seller hedge their risk. Company A needed
oil in the future and wanted to offset the risk that the price may rise in December with a

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long position in an oil futures contract. The seller could be an oil company concerned
about falling oil prices and wanted to eliminate that risk by selling or shorting a futures
contract that fixed the price it would get in December.
It is also possible that one or both of the parties are speculators with the opposite
opinion about the direction of December oil. In that case, one might benefit from the
contract, and one might not. Take, for example, the futures contract for West Texas
Intermediate (WTI) oil that trades on the CME and represents 1,000 barrels of oil. If the
price of oil rose from $62.22 to $80 per barrel, the trader with the long position—the
buyer—in the futures contract would have profited $17,780 [($80 - $62.22) x 1,000 =
$17,780].2 The trader with the short position—the seller—in the contract would have a
loss of $17,780.
Cash Settlements of Futures
Not all futures contracts are settled at expiration by delivering the underlying asset. If
both parties in a futures contract are speculating investors or traders, it is unlikely that
either of them would want to make arrangements for the delivery of several barrels of
crude oil. Speculators can end their obligation to purchase or deliver the underlying
commodity by closing (unwinding) their contract before expiration with an offsetting
contract.
Many derivatives are in fact cash-settled, which means that the gain or loss in the trade
is simply an accounting cash flow to the trader's brokerage account. Futures contracts
that are cash-settled include many interest rate futures, stock index futures, and more
unusual instruments like volatility futures or weather futures.
Forwards
Forward contracts or forwards are similar to futures, but they do not trade on an
exchange. These contracts only trade over-the-counter. When a forward contract is
created, the buyer and seller may customize the terms, size, and settlement process.
As OTC products, forward contracts carry a greater degree of counterparty risk for both
parties.
Counterparty risks are a type of credit risk in that the parties may not be able to live up
to the obligations outlined in the contract. If one party becomes insolvent, the other
party may have no recourse and could lose the value of its position.
Once created, the parties in a forward contract can offset their position with other
counterparties, which can increase the potential for counterparty risks as more traders
become involved in the same contract.
Swaps
Swaps are another common type of derivative, often used to exchange one kind of
cash flow with another. For example, a trader might use an interest rate swap to switch
from a variable interest rate loan to a fixed interest rate loan, or vice versa.
Imagine that Company XYZ borrows $1,000,000 and pays a variable interest rate on
the loan that is currently 6%. XYZ may be concerned about rising interest rates that will

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increase the costs of this loan or encounter a lender that is reluctant to extend more
credit while the company has this variable rate risk.
Assume XYZ creates a swap with Company QRS, which is willing to exchange the
payments owed on the variable-rate loan for the payments owed on a fixed-rate loan of
7%. That means that XYZ will pay 7% to QRS on its $1,000,000 principal, and QRS will
pay XYZ 6% interest on the same principal. At the beginning of the swap, XYZ will just
pay QRS the 1% difference between the two swap rates.
If interest rates fall so that the variable rate on the original loan is now 5%, Company
XYZ will have to pay Company QRS the 2% difference on the loan. If interest rates rise
to 8%, then QRS would have to pay XYZ the 1% difference between the two swap
rates. Regardless of how interest rates change, the swap has achieved XYZ's original
objective of turning a variable-rate loan into a fixed-rate loan.
Swaps can also be constructed to exchange currency exchange rate risk or the risk of
default on a loan or cash flows from other business activities. Swaps related to the
cash flows and potential defaults of mortgage bonds are an extremely popular kind of
derivative. In fact, they've been a bit too popular in the past. It was the counterparty risk
of swaps like this that eventually spiraled into the credit crisis of 2008.
Options
An options contract is similar to a futures contract in that it is an agreement between
two parties to buy or sell an asset at a predetermined future date for a specific price.
The key difference between options and futures is that with an option, the buyer is not
obliged to exercise their agreement to buy or sell. It is an opportunity only, not an
obligation, as futures are. As with futures, options may be used to hedge or speculate
on the price of the underlying asset.

In terms of timing your right to buy or sell, it depends on the "style" of the option. An
American option allows holders to exercise the option rights at any time before and
including the day of expiration. A European option can be executed only on the day of
expiration. Most stocks and exchange-traded funds have American-style options while
equity indices, including the S&P 500, have European-style options.

Imagine an investor owns 100 shares of a stock worth $50 per share. They believe the
stock's value will rise in the future. However, this investor is concerned about potential
risks and decides to hedge their position with an option. The investor could buy a put
option that gives them the right to sell 100 shares of the underlying stock for $50 per
share—known as the strike price—until a specific day in the future—known as
the expiration date.
Assume the stock falls in value to $40 per share by expiration and the put option buyer
decides to exercise their option and sell the stock for the original strike price of $50 per
share. If the put option cost the investor $200 to purchase, then they have only lost the

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cost of the option because the strike price was equal to the price of the stock when
they originally bought the put. A strategy like this is called a protective put because it
hedges the stock's downside risk.
Alternatively, assume an investor doesn't own the stock currently worth $50 per share.
They believe its value will rise over the next month. This investor could buy a call
option that gives them the right to buy the stock for $50 before or at expiration. Assume
this call option cost $200 and the stock rose to $60 before expiration. The buyer can
now exercise their option and buy a stock worth $60 per share for the $50 strike price
for an initial profit of $10 per share. A call option represents 100 shares, so the real
profit is $1,000 less the cost of the option—the premium—and any brokerage
commission fees.
In both examples, the sellers are obligated to fulfill their side of the contract if the
buyers choose to exercise the contract. However, if a stock's price is above the strike
price at expiration, the put will be worthless and the seller (the option writer) gets to
keep the premium as the option expires. If the stock's price is below the strike price at
expiration, the call will be worthless and the call seller will keep the premium.
Advantages and Disadvantages of Derivatives
Advantages
As the above examples illustrate, derivatives can be a useful tool for businesses and
investors alike. They provide a way to do the following:
 Lock in prices
 Hedge against unfavorable movements in rates
 Mitigate risks
These pluses can often come for a limited cost.
Derivatives can also often be purchased on margin, which means traders use borrowed
funds to purchase them. This makes them even less expensive.
Disadvantages
Derivatives are difficult to value because they are based on the price of another asset.
The risks for OTC derivatives include counterparty risks that are difficult to predict or
value. Most derivatives are also sensitive to the following:
 Changes in the amount of time to expiration
 The cost of holding the underlying asset
 Interest rates
These variables make it difficult to perfectly match the value of a derivative with the
underlying asset.
Since the derivative has no intrinsic value (its value comes only from the underlying
asset), it is vulnerable to market sentiment and market risk. It is possible for supply and
demand factors to cause a derivative's price and its liquidity to rise and fall, regardless
of what is happening with the price of the underlying asset.

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 Finally, derivatives are usually leveraged instruments, and using leverage cuts both
ways. While it can increase the rate of return, it also makes losses mount more quickly.
Pros
 Lock in prices
 Hedge against risk
 Can be leveraged
 Diversify portfolio
Cons
 Hard to value
 Subject to counterparty default (if OTC)
 Complex to understand
 Sensitive to supply and demand factors
What Are Derivatives?
Derivatives are securities whose value is dependent on or derived from an underlying
asset. For example, an oil futures contract is a type of derivative whose value is based
on the market price of oil. Derivatives have become increasingly popular in recent
decades, with the total value of derivatives outstanding currently estimated at over
$600 trillion.3
What Are Some Examples of Derivatives?
Common examples of derivatives include futures contracts, options contracts,
and credit default swaps. Beyond these, there is a vast quantity of derivative contracts
tailored to meet the needs of a diverse range of counterparties. In fact, since many
derivatives are traded over the counter (OTC), they can in principle be infinitely
customized.
What Are the Main Benefits and Risks of Derivatives?
Derivatives can be a very convenient way to achieve financial goals. For example, a
company that wants to hedge against its exposure to commodities can do so by buying
or selling energy derivatives such as crude oil futures. Similarly, a company could
hedge its currency risk by purchasing currency forward contracts.

Derivatives can also help investors leverage their positions, such as by buying equities
through stock options rather than shares. The main drawbacks of derivatives include
counterparty risk, the inherent risks of leverage, and the fact that complicated webs of
derivative contracts can lead to systemic risks.
Related Terms
Underlying
Underlying, used in both equities and derivatives, is the security that must be delivered
when a contract or warrant is exercised. It can be a stock, bond, or another financial
instrument.

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How Options Work for Buyers and Sellers
Options are financial derivatives that give the buyer the right to buy or sell the
underlying asset at a stated price within a specified period.

How Do Futures Contracts Work?

A futures contract is a standardized agreement to buy or sell the underlying commodity
or other asset at a specific price at a future date.

STIR Futures & Options Definition

STIR is an acronym for "short-term interest rate," meaning STIR futures and options
are derivatives based on short-term interest rates.

What Is a Stock Option?

A stock option gives an investor the right, but not the obligation, to buy or sell a stock at
an agreed-upon price and date.

What Is a Call Option?

A call option is a contract that gives the option buyer the right to buy an underlying
asset at a specified price within a specific time period.

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 Features of Derivative Market
Following are the distinguishing features of this market:
1. It is a massive market with traders all around the globe. Its volume and traded value are
almost greater than 3 to 15 times of the routine market volumes and values.
2. The OTC trades are more popular with a total market value of about $600 trillion.
The derivative market attracts lots of speculators and hedgers, as they can earn higher profits with
lesser capital investments.
3. Trading in a derivative market requires the participant to know the market and the economy
well.

Participants in the Derivatives Market

Primarily there are four types of participants in a derivative market:
Hedgers
These are the investors that enter the derivative market to reduce their risk or to hedge their risk. In
fact, hedging is the biggest motive that drives investors to the derivative market. The option route is
preferred by the hedgers to reduce their risks.
Speculators
It is the most common market activity in any financial market. This basically involves betting against
the future price movement and taking positions accordingly. It is a risky activity as it involves buying
the underlying asset and then betting on its price. Earning a big profit is the driving force for
speculative activities.
For example, an investor expects the price of a share to drop going ahead. Thus, to profit from this,
the investor will short sell the share now and buy later when the price drops.
Arbitrageurs
Arbitrage is also a profit-making activity by taking advantage of the price volatility in the different
financial markets. Arbitrageurs earn a profit using the price difference resulting in investment
between the two markets. Or, we can say they buy an asset at less price in one market and sell in
another at a higher price. For example, buying a share for $100 in the cash market and selling it at
$102 in the future market.
Margin traders
Another derivative market participant is margin traders. The margin is the initial deposit that an
investor makes at the time of entering into a contract.
Drawbacks
Following are the drawbacks of a derivative market:
Over the years, many have criticized the market for being too risky for investors. Those who criticize
this market cite the role of CDS, a derivative tool, in triggering the 2008 financial meltdown.
The derivative market also sees a high level of volatility, enough to erase the full investment of an
investor. Also, the financial instruments in the derivatives market are extremely sensitive to even
small changes in the interest rate, maturity, any political, medical, or economy-related issues, and
more.

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 Financial instruments in the derivatives market are not as simple as the ones you will see in the
primary and secondary markets. Because of this, new and occasional investors avoid this market.
They, however, have an option to take the services of brokers and trading agents to invest in the
derivatives market.
Another criticism against the market is that their activities are similar to gambling but legal. This is
because the activities in the derivative markets are similar in nature to gambling.
Differences – Cash vs Derivative Market
The key differences between the cash and derivative markets are as follows:
1. In the cash market, investors can buy in any quantity, while in a derivative market, the
buying and selling are in pre-fixed lots.
2. Only tangible assets trade in the cash market. In the derivative market, both tangible
and intangible assets trade.
3. Investors use the cash market to invest, while traders use the derivative market for
hedging, arbitrage, or speculation.
4. To trade in a cash market, the investor needs to have a trading and Demat account. For
investing in futures, an investor needs only a future trading account.
5. In the cash market, all funds are invested upfront. However, in the futures market, only
the margin money is paid in advance. Balance money, rather the difference money is
paid on exiting or expiry, only if the trade goes negative. Otherwise, if it is favorable, no
more money needs to be paid.
6. When an investor buys a share in the cash market, they own a part of that firm.
However, as derivaties are based on some underlying asset, the investor or holder of
the derivative instrument has no ownership. Need to note that even the right or
obligation or option bought or sold has a maturity/expiry. Therefore, it is a very short
term trading contract only and does not give ownership rights even on expiry or
maturity.
7. In the cash market, the investor may get dividends, but there are no such things as a
dividend in the derivative market.

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Hedging with forwards:
The Forward Contract is an agreement between two parties wherein they agree to buy or sell
the underlying asset at a predetermined future date and a price specified today. The Forward
contracts are the most common way of hedging the foreign currency risk.
The foreign exchange refers to the conversion of one currency into another, and while dealing
in the currencies, there exist two markets: Spot Market and Forward Market. The Spot market
means where the delivery is made right away, while in the forward market the payment is
made at the predetermined date in the future.
In the spot market, the rate is the current rate, which is prevailing at the time the currencies
are being exchanged. Whereas, the rate in the forward market is the rate which has been fixed
today or at the time the transaction is agreed to but the actual delivery takes place at a
specified date in the future. Thus, forward currency contracts enable the parties to the contract
to lock the exchange rate today, to buy or sell the currency on the predefined future date.
The party who agrees to buy the underlying asset at a specified future date assumes the long
position, whereas the seller who promises to deliver the asset at a rate locked today assumes
the short position. In a forward currency contract, the buyer hopes the currency to appreciate,
while the seller expects the currency to depreciate in the future. Thus, the gain and loss of the
buyer can be calculated as follows:
Gain = Spot Rate– Contract Rate
Loss = Contract Rate – Spot Rate
Where, the spot rate is the actual rate prevailing at the future date while the contract rate is
the rate which was locked at the time transaction was agreed upon.
The forward contracts are similar to the options in hedging risk, but there is a significant
difference between these two. The parties to the forward contracts are obliged to buy or sell
the underlying securities at a specified date in the future, whereas in the case of the options,
the buyer has the right to whether exercise the option or not. The other difference is that the
forward contracts do not require any upfront payment in the form of premium which is very
much required when buying the options contracts.

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