Tuesday, August 6, 2013

Financial Management (2066Q7): What do you mean by financial derivatives? Why are they called derivatives? Highlight the main features of derivative instruments: option, swap and futures.

Financial Derivative

A derivative is a financial contract, between two or more parties, which is derived from the future value of an underlying/existing asset. Derivatives are financial assets and can be used as an item of investment portfolio. The following figure shows the asset classification with derivatives. Generally, the transactions on derivatives are carried out through private contact and in over-the-counter market but there are also exist some organized market for some derivatives securities like option exchange, future exchange etc.

Why are they called derivatives?

Because financial derivatives derive its value from the value of underlying entities such as an asset, index or interest rate which has no intrinsic value in itself.

Main features of derivative instruments

Option:

An option is a contract between two parties wherein one party grants the right to another party to purchase or sell specified asset at specified price on or before certain exercise date. The buyer pays the seller a fee called the option premium, which is also known as initial price of option. The seller grants the right to buy or sell the asset at a fixed price. The asset on which the option contract is made is called the underlying asset. Option contract is a financial asset and can be sold in market. There are organized option exchanges to facilitate and guarantee the performance of each party's in the contract.

Types of options

1. Call options and put options:
A call option gives the holder of the option the right to buy an asset by a certain date for a certain price. A put option gives the holder of the option the right to sell an asset by a certain date for a certain price.

2. American and European options:

Features

  • The buyer has right to buy or sell the asset.
  • To acquire the right of an option, the buyer must pay a price called option price or premium.
  • The exercise price is also called fixed price or strike price or strike and is determined at the beginning of the transaction.
  • The expiration date is final date that the option holder has to exercise his right to buy or sell the underlying asset.
  • There are organized option exchanges to facilitate and guarantee the performance of each party's in the contract.

Swap

A swap is an agreement between two parties to exchange sets of cash flows over a period in the future. The payments from one party to another are based on some specific principal amount. One party pays certain percent of this amount and another party pays another percent on this amount at each payment date. This amount is called notional principal. The parties that agree to swap the cash flows are known as counter parties.

Types of Swap

1. Interest rate swap
2. Currency swap
3. Equity swap

Features

Swap contract involves the payments on different dates.
The date on which the swap contract is entered into is known as initiation date.
The date on which the swap contract terminates is called termination date.
The dates on which payments occurs are called the settlement dates.
The period between settlement dates is called the settlement period.

Futures:

Future contract or futures are exchange-traded derivatives with standardized terms. That means futures trading is organized around the concept of a futures exchange. A futures exchange is normally a corporate entity comprised of member.

Features

  • Future contracts are standardized in terms of quantity, expiration date and settlement procedures. Only price is negotiated and maturity dates are limited.
  • Future contracts are more liquid than forwarded contracts.
  • There is less default risk in the futures contract because the exchanges clearing house guarantees all payments of profits.
  • It needs security deposits initially and marking to the market regularly.
  • Futures are notional commitments to future transactions.
  • They are exchange-traded contracts.
  • Transactions on futures contracts are fully transparent.

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