Derivative Instruments- Future, Forward

Presented ByGanesha.CK

Contents Introduction

What is Derivatives

Features of Derivative Instruments

Participants in Derivative market

Reasons to use Derivatives

Concepts to understand

Future contract, Features

Forward contract, Features

Payoff, Offsetting,

Introduction

In the financial marketplace some instruments are regarded as

fundamentals, while others are regarded as derivatives.

Financial Marketplace

Derivatives Fundamentals

Financial Marketplace

Derivatives Fundamentals

•Stocks •Bonds •Etc.

•Futures•Forwards•Options•Swaps

Introduction (II)

What is a Derivative? (I)

Options

Swaps

ForwardsFuturesThe value of the

derivative instrument is DERIVED from the underlying security

Underlying instrument such as a commodity, a stock, a stock index, an

exchange rate, a bond, another derivative etc..

Options

Swaps

Forwards

Futures

The owner of an options has the OPTION to buy or sell

something at a predetermined price and is therefore

more costly than a futures contract.

The owner of a forward has the OBLIGATION to sell or

buy something in the future at a predetermined price.

The difference to a future contract is that forwards are

not standardized.

The owner of a future has the OBLIGATION to sell or

buy something in the future at a predetermined price.

What is a Derivative? (II)

A swap is an agreement between two parties to exchange

a sequence of cash flows.

Features of Derivative Instrument A Derivative instruments relates to the future contract between two parties.

Derivative instruments have the value (Derived from underlying assets )

The counter parties have specified obligation under derivative control. (all contracts are different)

The size of the derivative depends upon its notional amount.

Derivatives are also called deferred delivery or deferred payment instrument. ( short and long position)

Participants in Derivative MarketThe participants in the derivative markets an be

Banks, FIIs, Corporate, Brokers. Etc…

1.Hedgers

2.Speculators

3.Arbitrageurs

4.Spreaders

He is a person who undertakes a position in future and other markets for purpose of reducing exposure to one or more types of risk.

Speculators are operators who are willing to take a risk by taking future position with the expectation to earn profits.They are the operators who deal in different markets simultaneously for profit and eradicate the mispricing of securities across different markets.

He is a person who believes in lower expected return at the reduced risk .

Reasons to use derivatives (I)

Hedging:

Speculation:

• Interest rate volatility •Stock price volatility •Exchage rate volatility •Commodity prices volatility

VOLATILITY

•High portion of leverage •Huge returns

EXTREMELY RISKY

Derivative markets have attained an overwhelming popularity for a variety of reasons...

Reasons to use Derivatives (II)

Also derivatives create...

•a complete market, defined as a market in which all

identifiable payoffs can be obtained by trading the

securities available in the market.

•and market efficiency, characterized by low

transaction costs and greater liquidity.

Concepts to Understand

Short Selling: •Short selling is the selling of a security that the seller does not own.

•Short sellers assume the risk that they will be able to buy the stock at a more favorable price than the price at which they sold short.

Holding Long Position:

• Investors are legally owning a security.

• Investors are the legal owners of a security.

Future Contracts (I)

FuturesThe owner of a future contract has the

OBLIGATION to sell or buy something in the

future at a predetermined price.(Ex Former)

1.Commodity futures - underlying asset is a commodity 2.Financial futures - underlying is asset

Types

1. Interest rate future: Treasury bills, notes, bonds, debenture etc..

2. Foreign currency future:

3. Stock index future:

4. Bond index future:

Features of Future contract

Forward Contracts (II)

Forwards The owner of a forward has the OBLIGATION to sell or

buy something in the future at a predetermined price.

The difference to a future contract is that forwards are

not standardized.

A Forward Contract underlies the same principles as a future contract,

besides the aspect of non-standardization.

Example: x enter into contact on 1st October 2005

To buy 50 shares at Rs 1000 on 1st December 2005 from y

x has to pay 50000 on 1st December 2005

Features of Forward contracts

they are bilateral contract – counter risk

they are unique in terms of size, expiration date, asset size of both parties.

It specifies future date of delivery and payment.

It obligates the buyer and seller to delivery of assets.

It specifies the price which determined presently is to be paid in future

Payoff from forward contract

To explain profit and loss (payoff) on a forward contract

What is Offsetting the Forward contract?

In forward contract the party bears the risk until the contracts expire because profit to be incurred will depend upon the future spot price of the underlying assets

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