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Derivatives Explained in Simplest Manner!

Derivatives derive their value from an underlying asset such as a currency, commodity, bond, or stock. The four main types of derivatives are forwards, futures, swaps, and options. Forwards and futures are agreements to buy or sell an asset at a future date for a set price. Swaps involve exchanging cash flows of one party's financial instrument for another's. Options give the buyer the right but not obligation to buy or sell the underlying asset at a strike price. While derivatives can help manage risk, their complexity and leverage also make them highly risky for some investors.

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Abhinay Singh
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15 views

Derivatives Explained in Simplest Manner!

Derivatives derive their value from an underlying asset such as a currency, commodity, bond, or stock. The four main types of derivatives are forwards, futures, swaps, and options. Forwards and futures are agreements to buy or sell an asset at a future date for a set price. Swaps involve exchanging cash flows of one party's financial instrument for another's. Options give the buyer the right but not obligation to buy or sell the underlying asset at a strike price. While derivatives can help manage risk, their complexity and leverage also make them highly risky for some investors.

Uploaded by

Abhinay Singh
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Guess what?

You can actually master


DERIVATIVES
this time!
What are Derivatives, really?

Think of an object that derives its value


from some other thing.

Here comes, derivatives.

“Derivative is simply a security that derives


its value from the value or return of
another asset or security.”
But what could be the possible
underlying asset?

CURRENCY

MARKET
INTEREST
INDEXES
RATES

Underlying assets
could be anything

BONDS
STOCKS
COMMODITIES
∴ On their own, derivatives have no value.
The price of the derivative is determined and
influenced by the price of the underlying
asset.

Financial derivatives are used for


a number of purposes -

Risk management
Hedging
Arbitrage between markets
Speculation.
etc.
Are there different types of
derivatives?

Yes, the most common derivatives are


Let's Understand these four types:

1. Forward Contract

One party agrees to buy and the


counterparty to sell a physical or
financial asset. at a specific price on
a specific date in the
future

A forward contract can be used for


hedging or speculation, although its
non-standardized nature makes it
particularly apt for hedging.

traded in because these are


Over-the-Counter non-standardized, they can
market be tailored as per speicfic
needs
Neither party to the contract makes
a payment at the initiation of a
forward contract.

If the expected future price of the asset


increases than agreed upon price, over
the life of a contract, then

Buyer of the
& Seller of the contract
contract will profit will have loss.

vice-versa, if the price falls.


2. Futures Contract

Futures are similar to Forwards

These are just-


Standardized and exchange-traded
Traded in the active secondary market
Government-regulated
Backed by clearinghouse

The number of futures contracts of


a specific kind that are outstanding
at any given time is known as the
OPEN INTEREST.
3. Swaps

These are also similar to forwards

Swaps are financial agreements


between two parties to exchange cash
flows or financial instruments over a
specific period.
( We will understand this
with help of an easy example)

These agreements can involve various


variables, such as interest rates,
currencies, or commodities.
these are also
Over-the-Counter market
traded securities
For example, imagine two friends,
Alice and Bob.

Alice has a fixed-rate loan, and Bob has


a variable-rate loan.

They decide to do a swap.

Alice agrees to pay some of Bob's


variable-rate loan, and in return, Bob
pays part of Alice's fixed-rate loan.

This way, they both get a mix of fixed


and variable rates, and they're both
happier with their loans.

Swaps work in a similar way for


businesses and investors, helping them
manage their finances.
4. Options

An option contract gives its owner the


right, but not the obligation, to either
buy or sell an underlying asset at a given
price(exercise price or strike price).

While an option buyer can choose


whether to exercise an option, the seller
is obligated to perform if the buyer
exercises the option.

I know you didn’t understand


anything 😂 , let’s make it
simple through a chart
OPTIONS

CALL OPTION PUT OPTION

Long Short Long Short


Call Call Put Put
(Now, hang on and stay with me for a
moment while I break it down)

There are 4 possible options positions.

UNDER CALL OPTION:

1. Long Call
the buyer of a call option is known as Long Call -
has the right to buy an underlying asset.

2. Short Call
the seller of a call option is known as Short Call -
has the obligation to sell the underlying asset to
Buyer of Call.
UNDER PUT OPTION:

3. Long Put
the buyer of a put option is known as Long Put -
has the right to sell the underlying asset

4. Short Put
the seller of a put option is known as short Put-
has the obligation to buy the underlying asset
from Buyer of Put.
Benefits of Derivatives

Provide price information.

Allow risk to be managed


and shifted among market
participants.

Reduce transaction costs.


Criticism of Derivatives

The criticism of Derivatives is


that they are “too risky”,
especially to investors with
limited knowledge of
sometimes complex
instruments.

Because of the high leverage


involved in derivative payoffs,
they are sometimes linked to
gambling.
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@ UJJWAL RANA

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