Page 19 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes 1.6 Summary

Derivatives are the instruments which derive their values from the underlying assets.

The underlying assets may be financial assets like individual stock, stock indices, interest
rate, currencies, etc. or commodities like metals, cotton, coffee, etc.
Common derivatives include options, forward contracts, futures contracts, and swaps.

A forward contract is a customized contract between two entities, where settlement takes
place on a specific date in the future at today’s pre-agreed price.
A futures contract is an agreement between two parties to buy or sell an asset at a certain
time in the future at a certain price.

An option represents the right (but not the obligation) to buy or sell a security or other
asset during a given time for a specified price (the “Strike” price).

Options are of two types-calls and puts.
Swaps are private agreements between two parties to exchange cash flows in the future
according to a prearranged formula.

Derivatives that trade on an exchange are called exchange traded derivatives, whereas
privately negotiated derivative contracts are called OTC contracts.
The OTC derivatives markets have witnessed rather sharp growth over the last few years,
which have accompanied the modernization of commercial and investment banking and
globalization of financial activities.

1.7 Keywords

Basket Option: A type of option whose underlying asset is a basket of commodities, securities,
or currencies.
Currency Swaps: An arrangement in which two parties exchange specific amounts of different
currencies initially, and a series of interest payments on the initial cash flows are exchanged.
Derivative: A derivative security is a financial contract whose value is derived from the value of
something else, such as a stock price, a commodity price, an exchange rate, an interest rate, or
even an index of prices.
Exchange Traded Derivatives: Derivatives that trade on an exchange are called exchange traded
derivatives.
Forwards: A forward contract is a customized contract between two entities, where settlement
takes place on a specific date in the future at today’s pre-agreed price.
Futures: A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price.

Interest Rate Swaps: An agreement between two parties (known as counter-parties) where one
stream of future interest payments is exchanged for another based on a specified principal
amount.

Options: An option represents the right (but not the obligation) to buy or sell a security or other
asset during a given time for a specified price (the “strike “price).
OTC contracts: Privately negotiated derivative contracts are called OTC contracts.

14 LOVELY PROFESSIONAL UNIVERSITY