Unit 1- Introduction

Contents
• Concept of Financial Derivatives
• Features of Financial Derivatives
• Types of Financial Derivatives
• Economic Benefits of Financial Derivatives
• Participants in Derivative Markets
• Functions/Importance of Derivative Markets
• Danger of Derivatives
What is Financial Derivatives?
• A derivative can be defined as a financial
instrument whose value depends on (or
derives from) the values of other, more basic,
underlying assets.
• Underlying assets can be bonds, stocks, gold,
silver, etc.
• Financial derivative is also known as derivative
security and its value changes as per the
change in the price of underlying assets.
• Examples of derivative securities are options,
forward, futures, swaps, etc.
Features/Characteristics of Financial Derivatives
1. Contract between two parties
 It is the agreement between two parties to buy or sell certain assets on
certain future date at price agreed today.
 All the terms and conditions are fixed today and written on a contract
paper.
2. Value depends on underlying assets
 The value of derivative securities are derived from other underlying
assets.
 The price of underlying assets changes so the value of the derivative
securities also changes.
3. Predetermined Life
 Derivative securities have certain time period for expiration.
4. Future transaction
 Derivatives are agreement for future transaction.
5. Zero Sum Game
 It is the game in which one party’s gain always equal to the loss of other
party.
 Here one party makes profit in the expense of another party.
E.g. Mr. Ram and Mr. Shyam enter into a
contract today to exchange one tola of gold at
Rs. 25,000 one year from today. Mr. Ram
agrees to buy one tola gold for Rs. 25,000 one
year from today from Mr. Shyam and Mr.
Shyam agrees to sell the same for Rs. 25,000
one year from today to Mr. Ram.
This financial contract is forward contract.
If the price of gold after 1 year turns out to be
Rs. 30,000 then Ram will have profit of Rs.
5,000 and Shyam will have loss of Rs. 5,000.
 Types of Financial Derivatives
1. Options
 It is a contract that gives its buyer (owner) the right but not an obligation
to buy or sell an asset at a fixed price on or before a given date.
 Two types of options; Call and Put Option. Call option is the right to buy
and put option of the right to sell an underlying assets.
2. Forward Contracts
 It is a contract today to buy or sell an asset at a certain future date at a
stated price.
 Such contract creates both right and obligation to both the parties.
3. Futures Contracts
 It is a form of contractual agreement between a buyer and seller for a
specified asset on a fixed date in the future.
4. Swap
 It is a contract in which two parties agree to make a series of payments to
each other at specific intervals over a specified period of time.
 The swap payments are based on an agreed principal amount which is
known as notional principal.
Economic Benefits of Financial Derivatives
• Reduces risk
• Enhance liquidity of the underlying asset
• Lower transaction costs
• Enhances the price discovery process.
• Portfolio Management
• Provides signals of market movements
• Facilitates financial markets integration
Participants in Derivative Markets
1. Hedger
 A hedger is someone who faces risk associated with price
movement of an asset and who uses derivatives as means of
reducing risk. They provide economic balance to the market.
2. Speculator
 A trader who enters the futures market for pursuit of profits,
accepting risk in the endeavor. They provide liquidity and
depth to the market.
3. Arbitrager
 A person who simultaneously enters into transactions in two
or more markets to take advantage of the discrepancies
between prices in these markets.
 Arbitrage involves making profits from relative mispricing.
Arbitrageurs also help to make markets liquid, ensure
accurate and uniform pricing, and enhance price stability.
 They help in bringing about price uniformity and discovery.
Functions/Importance of Financial Derivatives
1. To minimize risk through hedging
 Hedging is the process of reducing the financial risks.
 It eliminates the risk of price fluctuations of financial
assets or commodities.
2. To gain from financial engineering
 An investor can benefit by creating the portfolio of
different derivatives and underlying assets.
3. To make riskless profit from market inefficiencies
 Arbitragers attempt to take advantage of discrepancy
between prices of same asset in two different markets.
4. To explore new investment opportunities
 Financial derivatives serve as an alternative investment
opportunities for the investors.
 Danger of Derivatives
1. Derivatives are very powerful instruments and
they contain a high degree of leverage. Small
change in price could lead large gains and
losses.
2. Derivatives should only be used by
knowledgeable persons for an intended
purpose.
3. Risk limits should be set and activities of
traders should be monitored frequently to
ensure that there is no misuse of derivative
instruments.