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Actions Shares. Embeds 0 No embeds. No notes for slide. The book begins with an introduction to 3. This is followed by a study of topics such as options - 4.
You just clipped your first slide! The underlying assets could be equities shares , debt bonds, T-bills and notes , currencies and indices of these various assets, such as the Nifty 50 index. Derivatives derive their names from their respective underlying assets. The basic purpose of derivatives is to transfer the price risk from one party to another; they facilitate the allocation of risk to those who are willing to take it.
In so doing, derivatives help mitigate the risk arising from the future uncertainty of prices. They range from the very simple to the most complex products. The following are the three basic forms of derivatives. The future date is referred to as expiry date and the pre- decided price is referred to as Forward Price.
A forward is thus an agreement between two parties in which one party, the buyer, enters into an agreement with the other party, the seller that he would buy from the seller an underlying asset on the expiry date at the forward price. Therefore, it is a commitment by both the parties to engage in a transaction at a later date with the price set in advance.
This is different from a spot market contract, which involves immediate payment and immediate transfer of asset. The party that agrees to buy the asset on a future date is referred to as a long investor and is said to have a long position. Similarly the party that agrees to sell the asset in a future date is referred to as a short investor and is said to have a short position.
The price agreed upon is called the delivery price or the Forward Price. Settlement of forward contracts When a forward contract expires, there are two alternate arrangements possible to settle the obligation of the parties: physical settlement and cash settlement.
Both types of settlements happen on the expiry date. Default risk in forward contracts A drawback of forward contracts is that they are subject to default risk. Regardless of whether the contract is for physical or cash settlement, there exists a potential for one party to default, i. It could be either the buyer or the seller.
This results in the other party suffering a loss. This risk of making losses due to any of the two parties defaulting is known as counter party risk. The main reason behind such risk is the absence of any mediator between the parties, who could have undertaken the task of ensuring that both the parties Fulfill their obligations arising out of the contract.
Default risk is also referred to as counter party risk or credit risk. However, unlike a forward contract, a futures contract is not a private transaction but gets traded on a recognized stock exchange.
In addition, a futures contract is standardized by the exchange. All the terms, other than the price, are set by the stock exchange rather than by individual parties as in the case of a forward contract. Also, both buyer and seller of the futures contracts are protected against the counter party risk by an Entity called the Clearing Corporation. An option is a derivative contract between a buyer and a seller, where one party say First Party gives to the other say Second Party the right, but not the obligation, to buy from or sell to the First Party the underlying asset on or before a specific day at an agreed-upon price.
In return for granting the option, the party granting the option collects a payment from the other party. Unlike forwards and futures contracts, options require a cash payment called the premium upfront from the option buyer to the option seller. This payment is called option premium or option price. Options can be traded either on the stock exchange or in over the counter OTC markets. Options traded on the exchanges are backed by the Clearing Corporation thereby minimizing the risk arising due to default by the counter parties involved.
It is the seller who grants this right to the buyer of the option. The price at which the buyer has the right to buy the asset is agreed upon at the time of entering the contract. This price is known as the strike price of the contract call option strike price in this case.
The buyer of the call option does not have an obligation to buy if he does not want to. The price at which the buyer has the right to sell the asset is agreed upon at the time of entering the contract. This price is known as the strike price of the contract put option strike price in this case. The buyer and the seller are The seller is subjected to unlimited risk subject to unlimited risk of loss. The buyer and the seller have The buyer has potential to make potential to make unlimited gain or unlimited gain while the seller has a loss.
On the other hand the buyer has a limited loss potential and the seller has an unlimited loss potential. An Index future, as the name suggests, a future on the index i. There is no underlying security or a stock, which is to be delivered to fulfill the obligations as index futures are cash settled.
As other derivatives, the contract derived its value from underlying index. The underlying indices in this case will be the various eligible indices and as permitted by the Regulator from time to time. Index Options Options contract gives its holder right, but not the obligation to buy or sell something on or before a specified date at a stated price.
Generally Index options are European style. European style means those option contracts that can be exercised only on the expiration date.
The underlying indices for index options are various eligible indices and as permitted by the Regulator from time to time.
Stock Futures A stock future contract is a standardized contract to buy or sell a specific stock at a future date at an agreed price. A stock future is, as the name suggests, a future on a stock i.
The contract derives its value from the underlying stock.
Single stock futures are cash settled. Stock Options Options on individual stocks are options contracts where the underlying are individual stocks. Based on eligible criteria and subject to the approval from the regulator, stocks are selected on which options are introduced.
These contracts are cash settled and are American style. American Style options are those options contracts that can be exercised on or before the expiry date. Today Derivatives have become the part and parcel of the day-to-day life for ordinary people in major parts of the world.
The impact or magnitude of risk is normally estimated from following two factors 1. In case the event occurs the magnitude of the loss it can cause.
The probability of an adverse event happening. Risk can be classified two ways — 1 risk of small losses with frequent occurrence and 2 risk of large losses with infrequent occurrence. Insurance company does not do anything to contain the risk per se but assumes risk on your behalf.
One can manage the risk by transferring it to another party who is willing to assume risk. Management of risk through derivatives is commonly referred as hedging which enable offsetting of risk emanating from one situation. Event risk is normally managed by insurance. Derivatives are products that derive their value from some other asset called underlying asset but in other aspects they may remain distinctly different from and independent of the underlying asset.
Four broad types of instruments are: Participants in Derivative Markets 8 Hedgers: All 3 participants are essential for efficient functioning. They provide much needed liquidity to markets.
They assume riskless and profitable positions. Functions of Derivatives 9 3 major functions of derivatives are: Increased bankruptcies: Derivatives being leveraged products have caused disproportionate positions leading to several disasters and bankruptcies. Increased burden of regulations: Most derivatives hide more than they reveal.
Though used for efficient price discovery.