Study Notes: Derivative Securities
INTRODUCTION TO DERIVATIVE MARKETS
A “derivative” is a financial instrument whose value depends upon the value of
another asset. It derives its value, thus the term DERIVATIVES. “Another asset” is
called UNDERLYING ASSET.
Where are derivatives traded?
1. Exchanged Traded Markets 2. Over-the-counter (OTC) Markets
- Organized markets; normally - Markets where transactions take
based on computer trading so place normally on telephone
parties don’t know each other trading & parties know each other
- Have standard terms and - Have non-standard terms and
conditions set by the market conditions; can be set by the
- No credit risk as the - Some credit risk as counterparties
counterparties are required to set may not be able to fulfill conditions
up margin account with the
- Example: Chicago Board Options
Exchange, Sydney Futures Market
Types of Derivatives: A derivative is broadly divided into 2 categories.
1. A forward commitment: Two parties agree to engage in a transaction at a
later date at a price agreed upon at the start of the contract. Example:
Forward contract, Futures contract, Swap.
2. A contingent claim: It is a claim made by one of the parties which depends
upon a specific event. Example: Options Study Notes: Derivative Securities
Forward contract: OTC & Forward commitment
- Contract between two parties, a buyer and a seller, to buy or sell an
underlying asset at a FUTURE DATE at a FORWARD PRICE.
“A enter into a forward contract with B on 1/1/2012 to buy 100 ounces of gold at
$5.0 per ounce on 1/7/2012. And the market price of gold on 1/1/2012 is $4.5 per
- A: buyer of underlying asset (gold) = long position/ long
- B: seller of underlying asset (gold) = short position/ short
- 1/1/2012: (today) when the contract is established between parties A and B
- 1/7/2012 (after 6 months): Future date/ contract maturity date/ delivery date/
settlement date/ expiration date
- $4.5 per ounce = Spot price: market price of the underlying asset today.
- $5.0 per ounce = Forward price/ delivery price: fixed price that is agreed by
buyer to pay to the seller on the future date for the underlying asset.
- The buyer expects the price of the underlying asset to increase; whereas the
seller expects the price to decrease.
- But, at the time that contract is entered into, the delivery price is chosen so
that the value of forward contract to both parties is zero. i.e. initial value of
forward contract is 0. This means that it costs nothing to take either a long or
short position. No initial payment to enter into a forward contract.
- Terminal value: value of the contract at maturity.
- Forward contracts can be on equities, bonds, interest rates, currencies. Study Notes: Derivative Securities
Futures contract: Market exchange & forward commitment
- Agreement between two parties; to buy or sell an underlying asset at a
FUTURE DATE at a price agreed upon at the start of the contract.
Difference between Forward contract and Futures contract:
Forward contract Futures contract
Forward commitment & OTC market Forward commitment & Exchange traded
Has non- standard terms and conditions Has standard terms and conditions made
customized to the parties’ needs by the exchange market
Subject to default risk Less/No default risk
Settlement occurs once at the end of the Daily settlement/ marking to market,
contract i.e. delivery date margin accounts of the parties are settled
daily according to market price changes
of the underlying asset
The delivery date is agreed at the start of The exact delivery date is not usually
the contract specified. The contract is referred by its
delivery month and short position has the
right to choose the time
Delivery is normally made is forward A vast number of futures contracts are
contracts not made as the holder of the contract
enters into an offsetting contract with the
same delivery month as the original
Parties don’t need to pay to initiate a Parties need to pay or maintain a margin
forward contract in the exchange to initiate the contract Study Notes: Derivative Securities
Swaps: OTC & forward commitment
- It is an agreement between two partie