Derivatives

• A derivative is a financial instrument that offers a return based on

the return of some other underlying asset.
• The price for immediate purchase of the underlying asset is called
the cash price or spot price.
• Exchange-traded contracts have standard terms and features and are
traded on an organized derivatives trading facility, usually referred to
as a futures exchange or an options exchange.
• Over-the counter contracts are any transactions created by two
parties anywhere else.
• Derivative contracts can be classified into two general categories: forward commitments
and contingent claims.
• The forward contract is an agreement between two parties in which one party, the
buyer, agrees to buy from the other party, the seller, an underlying asset at a future date
at a price established at the start.
• The contract is said to be customized. Each party is subject to the possibility that the
other party will default.
• A futures contract is a variation of a forward contract, which is public, standardized
transaction that takes place on a futures exchange, which guarantees to each party that
if the other fails to pay, the exchange will pay through clearing house.
• Daily Settlement – Marking to Market
• Margin Financing
• A swap is a variation of a forward contract that is essentially equivalent to a series of
forward contracts. Specifically, a swap is an agreement between two parties to exchange
a series of future cash flows.
• Contingent claims are derivatives in which the payoffs occur if a specific
event happens.
• An option is a financial instrument that gives one party the right, but not
the obligation, to buy or sell an underlying asset from or to another party
at a fixed price over a specific period of time.
• An option that gives the right to buy is referred to as a call.
• An option that gives the right to sell is referred to as a put.
• The fixed price at which the underlying can be bought or sold is called the
exercise price, strike price, striking price, or strike.
• Option represents the right to buy or sell. To acquire this right, the buyer of
the option must pay a price at the start to the option seller. This price is
called the option premium or sometimes just the option price.
Purpose & Criticism
Purpose
• Price discovery
• Risk Management – Hedging
• Speculation – Investment
• Low transaction cost – Investing in index
Criticism
• Complexity
• Improper utilization
• Form of legalized gambling
Pricing
• Arbitrage occurs when equivalent assets or combinations of assets
sell for two different prices.
• Law of one price
• the forward price should be the spot price increased by the interest
rate.
• Prices are set to eliminate the opportunity to profit at no risk with no
commitment of one's own funds.
Forward Contract
A forward contract is an agreement between two parties in which one
party, the buyer; agrees to buy from the other party, the seller; an
underlying asset or other derivative, at a future date at a price
established at the start of the contract.

The buyer is often called the long.

The seller is often called the short.
Nature of a forward contract hedge: It locks in a price.
Delivery and Settlement of Contract
Two possible arrangements:
• Deliverable forward contract – through delivery
• Pay the net cash value of the position – through cash settlement
• Sometimes its impractical to deliver the asset – investing in KSE – 100 index
• Also called non-deliverable forwards - NDFs
Default Risk
• Only one party-the one owing the greater amount--can default.
Termination prior to expiration
• Reverse the position
• Default risk issue
Types of Forward Contracts
• Equity Forwards – Individual stocks, stock portfolio, stock index
• Issue of dividend payment
• Bond and Interest Rate Forwards – Bonds and bond portfolio
• Contract must mature prior to bond maturity
• Bond features such like call & convertibility
• Bond default risk
• Mostly used with T-Bills
• Forward Rate Agreement (FRA)
• LIBOR
• Currency Forwards
• Stemmed from govt. relaxation of exchange rate regime after 1970’s
• Commodity Forwards – Oil, precious metal,
Default risk