Chapter 1 Inrodctio To Derivatives
Chapter 1 Inrodctio To Derivatives
Chapter 1 Inrodctio To Derivatives
Derivatives
Chapter 1
Introduction to Derivatives
Derivatives
Derivatives are the instruments for hedging risk
They are called derivative because they derive their
value from the value of other asset i.e. underlying
asset
The underlying asset may be interest rate, foreign
exchange , commodity or share or any s
Example...
Characteristics of derivatives
1. Underlying asset
2. No independent value
3. Predefined period
4. Contract fulfilment
5. Instrument or hedging risk
6. Minimal initial investment
7. Off balance sheet instrument
8. Secondary market instrument
Classification of derivatives
(Types of derivatives)
Forwards
It is the contract which buyer and seller agree to
exchange an asset on its future date at price agreed
the time of entering in to contract
It is bilateral agreement
It does not require initial payment when signing the
contract
Options
It refers to choice or freedom
It means right without obligation.
It is a contract that gives the right to holder,
without any obligation to buy or sell an asset at
an agreed price on or before a specified period of
time.
Swaps
Simply means exchange
It is an agreement between two parties to
exchange a series of cash flows over a period
in the future
It is an agreement to exchange one stream of
cash flow for another in future.
Advantages
Flexibility
Customized to requirement of parties
Underlying us it can be anything
Disadvantages
Difficult to match parties
Credit risk
Two parties are not equally strong
Transaction cost is high
Advantages
Free from counterparty risk
Transaction cost is transparent and normal
Disadvantages
They are less flexible
These are not custimized to the requirement
of the contracting parties
Liquidity function
Derivatives contract improve the liquidity of the
underlying instruments. They provide better
avenues for raising money. They contribute
sustainability to increasing the depth of the
markets. Derivative markets often have greater
liquidity than the spot markets, this higher
liquidity is at least partly due to the smaller
amount of capital required for participation in
derivative markets.
Efficiency function
Derivatives significantly increase market
liquidity, as a result, transactional costs are
lowered, the efficiency in doing business is
increased, the cost of raising capital investment is
expanded.
Criticism or Limitations of
Derivatives
1. Increased volatility
2. Increased bankruptcies
3. Increased regulatory burden
4. Enhancement of risk
5. Speculative and gambling motive
6. Instability of the financial system
7. Contact life