1. Derivative is “a substance that can be
made from another substance.”
Derivatives in Finance
work on the same principle.

2.  What Does Derivative Mean?
A security whose price is dependent upon or
derived from one or more underlying
assets. The derivative itself is merely a
contract between two or more parties.
Its value is determined by fluctuations in the
underlying asset.
The most common underlying assets
include stocks, bonds, commodities,
currencies, interest rates and market indexes.

3.  Derivative instruments are used as financial
management tools to enhance investment
returns and to manage such risks relative to
interest rates, exchange rates, and financial
instrument and commodity prices.
 Derivatives are generally used as an
instrument to hedge risk, but can also be
used for speculative purposes.

4. A Derivative is
 An agreement between two parties (i)
(between counterparties)
 To transact something (ii)
(an underlying asset)
 At a future date (iii)
 For some agreed upon price (iv)
(what is the price that we will be transacting this
asset for)
 This agreement expires (v)

5.  For example, a European investor purchasing
shares of an American company off of an
American exchange (using U.S. dollars to do
so) would be exposed to exchange-rate risk
while holding that stock.
 To hedge this risk, the investor could
purchase currency futures to lock in a
specified exchange rate for the future stock
sale and currency conversion back into Euros.

6.  Options
 Futures
 Forward Contracts
 Swaps

7.  The purchaser of an Option has rights (but not
obligations) to buy or sell the asset during a given
time for a specified price (the "Strike" price). An
Option to buy is known as a "Call," and an Option
to sell is called a "Put. "
 The seller of a Call Option is obligated to sell the
asset to the party that purchased the Option. The
seller of a Put Option is obligated to buy the asset.
 Options are traded on organized exchanges and
OTC.

8.  Although options can be written on any
underlying, let’s use options on common stock
as an example.
 A call option on a stock gives its holder the right
to buy a fixed number of shares at a given price
by some future date, while a put option gives its
holder the right to sell a fixed number of shares
on the same terms. The specified price is called
the exercise price. When the holder of an option
takes advantage of her right, she is said to
exercise the option. The purchase price of an
option – the money that changes hands on day
one – is called the option premium.

9.  Options enable their holders to lever their resources, while
at the same time limiting their risk. Suppose Smith
believes that the current price of $50 for Upside Inc. stock
is too low. Let’s assume that the premium on a call option
that confers the right to buy shares at $50 each for six
months is $10 per share. Smith can buy call options to
purchase 100 shares for $1,000. She will gain from stock
price increases as if she had invested in 100 shares, even
though she invested an amount equal to the value of 20
shares.
 With only $1,000 to invest, Smith could have borrowed
$4,000 to buy 100 shares. At maturity, she would then
have to repay the loan. The gain made upon exercising the
option is therefore similar to the gain from a levered
position in the stock – a position consisting of purchasing
shares with one’s own money plus money that’s borrowed.
However, if Smith borrowed $4,000, she could lose up to
$5,000 plus interest if the stock price fell to zero. With the
call option, the most she can lose is $1,000. But there’s no
free lunch here; she’ll lose the entire $1,000 if the stock
price does not rise above $50.

10.  A Future is a contract to buy or sell a standard
quantity and quality of an asset or security at a
specified date and price.
 Futures are similar to Forward Contracts, but
are standardized and traded on an exchange,
and are valued daily. The daily value provides
both parties with an accounting of their
financial obligations under the terms of the
Future.
 Futures often are settled in cash or cash
equivalents, rather than requiring physical
delivery of the underlying asset.

11.  In a Forward Contract, both the seller and the
purchaser are obligated to trade a security or
other asset at a specified date in the future. The
price paid for the security or asset may be
agreed upon at the time the contract is entered
into or may be determined at delivery.
 Forward Contracts generally are traded OTC.
 The price of the underlying asset for immediate
delivery is known as the spot price.

12.  A forward contract obligates one party to buy the
underlying assets at a fixed price at a certain
future date (called the maturity) from a
counterparty, who is obligated to sell the
underlying assets at that fixed price.
 Consider a U.S. exporter who expects to receive a
€100 million payment for goods in six months.
Suppose that the price of the euro is $1.20 today.
If the euro were to fall by 10 percent over the
next six months, the exporter would lose $12
million. But by selling Euros forward, the
exporter locks in the current forward exchange
rate. If the forward rate is $1.18 (less than $1.20
because the market apparently expects the euro
to depreciate a bit), the exporter is guaranteed to
receive $118 million at maturity.

13.  Hedging consists of taking a financial
position to reduce exposure to a risk. In this
example, the financial position is a forward
contract, the risk is depreciation of the euro,
and the exposure is €100 million in six
months, which is perfectly hedged with the
forward contract. Since no money changes
hands when the exporter buys euros forward,
the market value of the contract must be zero
when it is initiated, since otherwise the
exporter would get something for nothing.

14.  Interest rate swaps occur generally in three
scenarios. Exchanges of a fixed rate for a
floating rate, a floating rate for a fixed rate, or a
floating rate for a floating rate.
 The "Swaps market" has grown dramatically.
Today, Swaps involve exchanges other than
interest rates, such as mortgages, currencies,
and "cross-national" arrangements. Swaps may
involve cross-currency payments (U.S. Dollars
vs. Mexican Pesos) and cross market payments,
e.g., U.S. short-term rates vs. U.K. short-term
rates.

15.  A Swap is a simultaneous buying and selling of the
same security or obligation. Perhaps the best-known
Swap occurs when two parties exchange interest
payments based on an identical principal amount,
called the "notional principal amount."
 Think of an interest rate Swap as follows: Party A
holds a 10-year $10,000 home equity loan that has
a fixed interest rate of 7 percent, and Party B holds a
10-year $10,000 home equity loan that has an
adjustable interest rate that will change over the
"life" of the mortgage. If Party A and Party B were to
exchange interest rate payments on their otherwise
identical mortgages, they would have engaged in an
interest rate Swap.

16.  Derivatives are risk-shifting devices. Initially, they
were used to reduce exposure to changes in such
factors as weather, foreign exchange rates, interest
rates, or stock indexes.
 For example, if an American company expects
payment for a shipment of goods in British Pound
Sterling, it may enter into a derivative contract with
another party to reduce the risk that the exchange
rate with the U.S. Dollar will be more unfavorable at
the time the bill is due and paid. Under the
derivative instrument, the other party is obligated to
pay the company the amount due at the exchange
rate in effect when the derivative contract was
executed. By using a derivative product, the
company has shifted the risk of exchange rate
movement to another party.

17.  risk preference:
The attitude of an investor or decision maker to
risks.
◦ Risk-averse
◦ Risk-neutral
◦ Risk-seeker

18.  Non-financial firms
 Financial institutions
 Individuals

19.  Hedgers
◦ A trader who enters the futures market to reduce
some pre-existing risk exposure.
 Speculators
◦ A trader who enters the futures market in pursuit
of profit, accepting risk in the endeavor.
 Arbitragers
◦ A trader who enters the futures market to take
the advantage of the differences in the price of
the same assets in two different market.

20.  What Does Short Selling Mean?
The selling of a security that the seller does
not own, or any sale that is completed by the
delivery of a security borrowed by the seller.
Short sellers assume that they will be able to
buy the stock at a lower amount than the
price at which they sold short.

21.  Selling short is the opposite of going long.
That is, short sellers make money if the stock
goes down in price.
 This is an advanced trading strategy with
many unique risks and pitfalls. Novice
investors are advised to avoid short sales.

23. Risk – variability of return, and
Return – Reward for the investment (capital
gain + dividends)

26.  The derivatives market is the financial
market for derivatives, financial
instruments like futures contracts or options,
which are derived from other forms of assets.
 The market can be divided into two, that
for exchange-traded derivatives
(Organized) and that for over-the-counter
derivatives (OTC)

27.  Instruments such as options, forwards, and
futures are available for the purchase and
sale of spot market assets such as stocks and
bonds.
 The price of the derivatives are related to
those of the underlying spot market
instruments through several important
mechanisms. Like, because of its derivative
status, economic effects, etc

28.  Spot Futures
Purchase 1 Kg Gold Purchase 1 Kg of
Gold
27000 NPR/ 10 Gm 27000 NPR/ 10 Gm
1Kg=2700000 NPR 75000 (Margin)
Now, Now,
27500 NPR/10 Gm 27500 NPR/10 Gm
Profit in Kg=50000 Profit in Kg=50000
Return=1.85% Return=66.67%