Unit – 1 2.

Value Depends on Underlying Assets: Financial derivatives are

the financial assets derived from underlying assets. So, value of
Introduction financial derivatives depends on the value of underlying assets.
3. Oppositely Related payoff: Financial derivatives are zero sum
game, which means, if one party make profit of certain amount,
Concept of Financial Derivatives another party of the contract make loss by same amount. Therefore,
there are oppositely related payoffs.
When an agreement or contact made between two parties to purchase or
4. Right and Obligation: Generally, there is both right and obligation
sell a specific assets at specified price within predetermined time period,
on both parties to execute contract in financial derivatives. But, in
then such type of agreement or contract is known as derivatives or
option contract, there is right but not obligation to option buyer.
financial derivatives and the assets on which contract is made is known
as underlying assets. Underlying assets may be stock, commodity and 5. Future Transaction: Financial derivative instruments are the
currency. contract for the future transaction not for spot transaction. There is
execution date in the contract at which date the contract will be
In other words, financial derivative is a security derived from the
execute.
underlying assets and the values of financial derivatives are determined
by the market price of underlying assets. Derivative is financial assets 6. Provide means of Managing Risk: Derivative instruments are used
such are options, future, and forward contract, swap convertible etc. by the business organizations, individuals and government to
manage the different types of risk exposures. Risk arises from
The parties involved in derivative transactions are known as counter
change in price of commodities, exchange rate, interest rate, and
parties. The purpose of derivative is to manage financial risk, exchange
other market variables.
rate risk, stock and commodity price changes risk. Financial derivatives
are used either minimize risk or transfer risk between two counter Types of Derivative Contract
parties. The main derivative market instruments are as follows:
Characteristics of Financial Derivatives 1) Option: Option is a contract between two parties, a buyer, and a
1. Contract: It is the contract between two parties to buy or sell of seller, that gives the right but not obligation to the buyer to sell or
underlying assets or cash flows of underlying assets in future date. purchase underlying assets at a later date at certain price at specified
on contract. An option buyer pays a certain amount of money to the
seller, which is called premium. The option seller must be ready to 2) Forward Contract: A forward contract is a contract between two
sell or buy underlying asset at predetermined price and time if the parties, a buyer and seller, to purchase or sell something at a later
buyer desires so, there are two basic types of contract they are date at a price agreed upon today. A forward contract is like an
known as call and put option. option contract to some extent, but an option contract gives the right
a) Call Option: A call option is an option contract, it gives the but not obligation to go through with the transaction. On the other
buyer the right to buy a specified number of shares of stock at a hand, parties involve in a forward contract incur the obligation to
specified price from the option writer at any time up to and ultimately buy and sell the good. Forward markets have no physical
facilities for trading, there is no building or formal corporate body
including a specified date. The contract specifies the following
organized as the market. They trade strictly in an over-the-counter
items:
market consisting of direct communications among major financial
i) The company whose share can be bought. institutions.
ii) The number of shares that can be bought. For example: A Nepalese going to visit Europe at next month he
iii) The purchase price for these shares known as exercise price. needs euro 10,000 after a month. He thinks that price of euro will be
increase in future and inter in to a contract to buy euro 10,000 after a
iv) The date after which option expires, known as expiration
month at Rs. 92/- euro. It is the case of a forward contract. At the
date.
end of one month he pay Rs. 920,000 to other party and get euro
b) Put Option: A put option is an option contract that gives its 10,000.
holder the right to sell a specified number of shares to the option
3) Future Contract: A futures contract is a legal agreement to buy
writer at a specified price at any time up to and including an
or sell a particular commodity, asset, or security at a
expiration date. The contract specifies the following items: predetermined price at a specified time in the future. The seller
of the futures contract is taking on the obligation to provide and
i) The company whose share can be sold.
deliver the underlying asset at the expiration date. In other
ii) The number of shares that can be sold. words, a futures contract is also a contract between two parties, a
buyer and a seller to buy or sell something at a future date at a
iii) The selling price for these shares known as exercise price. price agreed upon today. Futures contracts trade on organized
exchange, called futures markets and is subject to a daily
iv) The date after which option expire, known as expiration date. settlement procedure.

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 • Futures are derivative financial contracts obligating the Role/Functions of Derivative Markets
buyer to purchase an asset or the seller to sell an asset at a
predetermined future date and set price. 1) Risk Management: Derivative prices are related to the prices of the
• A futures contract allows an investor to speculate on the underlying spot market goods, they can be used to reduce or
direction of a security, commodity, or financial instrument.( increase the risk of owning the spot items. For example, buying the
to take reverse position )
spot item and selling a futures contract or call option reduces the
• Futures are used to hedge the price movement of the
underlying asset to help prevent losses from unfavorable investor’s risk.
price changes.
If the goods prices falls, the price of the futures or option contract
4) Options on Futures: Options on futures are contracts that represent
will also fall. The investor can then repurchase the contract at the
the right, not the obligation, to either buy (go long) or sell (go short)
lower price, affecting a gain that can at least partially offset the loss
a particular underlying futures contract at a specified price on or
on the spot item. This type of transaction is known as a hedge.
before a specified date, the expiration date. An option on a futures
contract give the buyer the right but not obligation to buy or sell a 2) Price Discovery: Forward and futures markets are an important
futures contract at a later date at a price agreed upon today. source of information about prices. In futures markets, prices are set
for future transaction. If assets are traded in future market at higher
5) Swaps: A swap is an agreement for a financial exchange
price than spot market then it is expected to increase in spot price. If
in which one of the two parties promises to make, with an
assets are traded at lower price then it is expected to determine
established frequency, a series of payments, in exchange for
lower price in spot market. The futures market assembles that
receiving another set of payments from the other party. These flows
information into a type of consensus, reflecting the spot price of the
normally respond to interest payments based on the nominal amount
particular asset on which the futures contract is based. The price of
of the swap. In finance, a swap is an agreement between two
the futures contract that expires the earliest is often treated as the
counterparties to exchange financial instruments or cash flows or
spot price.
payments for a certain time. The instruments can be almost anything
but most swaps involve cash based on a notional principal amount.. 3) Operational Advantage: Derivative markets offer several
A swap is a contract in which two parties agree to exchange cash operational advantages.
flows. For example, one party is currently receiving cash from one First, they entail lower transaction costs; this means that
investment but would prefer another type of investment in which the commissions and other trading costs are lower for traders in these
cash flows are different. markets.

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 Second, derivative market particularly have greater liquidity than potato. If price of potato decreases then he bear loss and such loss
the spot markets. Although, spot markets generally are quite liquid can be hedge by taking short position on potato futures.
for the securities of major companies, they always absorb some of
ii. To explore new Investment Opportunities: Primary securities like
the large levels of expected return without substantial price change. shares and bonds are not-sufficient meet the growing needs of
In some cases, one can obtained the same levels of expected return present day investors. At present there are many financial
and risk by using derivative market. derivatives markets that offer variety of derivative instrument.
Third, the smaller amount of capital required for participation in Financial derivatives are the alternative investment opportunities
derivative markets. These markets can absorb more trading because available to the investors.
less capital is required.
iii. To use as the means of increasing profit: Financial derivatives are
Fourth, Returns and risk can be adjusted at any level desired, greatly used to increase the profit. Derivative transactions require
small amount of margin and lower cost of trading so there is
4) Market Efficiency: Spot markets for securities probably would be
possibility of getting high profit. Financial derivatives provide
efficient only a few profitable arbitrage opportunities exist. The
limited loss but it provides unlimited profit with small investment.
presence of these opportunities exist means that the prices of some
asset are temporarily out of line with what they should be. Investors iv. Change the Nature of Liabilities and Assets: Derivatives assets
can earn returns that exceed what the market deems fair for the can be used to change the nature of assets or liabilities as a way to
given risk level. There are important linkages among spot and manage interest rate risk. Some loans and deposits carry fixed
derivative prices. The low cost of transaction in these markets interest rate and some carry floating interest rate and the changes in
facilitate the arbitrage trading and rapid price adjustments that market interest rate effect the banks income. Financial institutions
quickly eradicate these profit opportunities and make the market use SWAPS to hedge against the risk of change in market interest
efficient. rates.
Uses of Financial Derivatives v. Create New Instruments: Using different derivatives securities the
i. Hedge Risk: The financial derivatives can be used to hedge risk market participants can create hybrid securities and synthetic
both of financial and business risk. It is derived from an underlying securities. The process of creating new securities is called financial
assets with the purpose of to hedge or reduce the price risk. if a engineering. An investor can benefit by creating the portfolio of
trader holds potato in stock with the hope of increase in price of different derivatives.

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Participants in derivative market Misuses or Danger of Derivatives
Derivatives are those financial instruments, which derive their value Derivatives have occasionally been criticized for having been the source
from the value of other assets. In other words they have no value on of large losses by some corporations, investment funds, state and local
their own rather their value depends on the value of the underlying government, nonprofit investors, and individual. Are derivatives really
asset. For example the value of call or put option of Microsoft stock will at fault? Is electricity to be faulted when someone with little knowledge
depend on the price movement of Microsoft stock. There are 3 of it mishandles it? There is a little question that derivatives are
important participants in the derivatives market which include the powerful instruments. They typically contain a high degree of leverage,
following: meaning that small price changes can lead large gain and losses. Tough
this would appear to be an undesirable feature of derivatives; it actually
i. Hedgers: They are those who buy or sell in derivatives market in
order to reduce their risk of their portfolio. For example if the is what makes them most useful in providing the benefits. You should
portfolio of hedger is long then he will protect or hedge this position recognize that to use derivatives without having the requisite knowledge
by buying put options in derivatives market. is dangerous. Having acquired that knowledge, however, does not free
you of the responsibility to act sensibly. To use derivatives in
ii. Speculators: Speculators are those who enter into the market purely inappropriate situations is dangerous. The temptation to speculate when
for making profit by buying or selling the derivatives. They do not one should be hedging is a risk that even the knowledgeable often
have any intention of hedging their portfolio or such thing their only surrenders. Given excessive confidence in one’s ability to forecast
aim is to make profit based on their judgment about the stock or prices or interest rates and then acting on those forecasts by using
market. derivatives can be extremely risky. You should never forget that we said
iii. Arbitrageurs: Arbitrage refers to obtaining risk free profits by about efficient market.
simultaneously buying and selling similar instruments in different
markets. Arbitrageurs enter into derivative market in order to take
advantage of any such opportunity and profit from it.