Page 14 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 1: Introduction to Derivatives

Notes

Task Mr. Ramesh is speculating on SBI (currently trading at `850) and is holding one
share of SBI. Three-month short futures on SBI are `840 while a put option at `842 is also
available at premium of `3. What should Ramesh do? (For simplicity, there is no margin
requirement under futures trading).

Self Assessment

State the following are true or false:
14. Privately negotiated derivative contracts are called exchange traded derivatives.

15. The OTC contracts are generally not regulated by a regulatory authority.

1.5 Summary

 In this unit, we have taken the basics of derivatives.
 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.
1.6 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.

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