INTRODUCTION

Financial Asset and Its Characteristics:

Financial asset is a claim against the income or wealth of a business firm, household, or unit of
government, usually represented by a certificate, receipt, or other legal document. Familiar
examples include stocks, bonds, insurance policies, future contracts, and deposits held in a bank
or credit union. Financial assets do not provide a continuing stream of services to their owners as
a home, an automobile, or a washing machine would do. These assets promise future returns to
their owners and serve as a store of value, which is commonly known as purchasing power. The
following are some of the important characteristics of financial assets:
1. Financial asset represents a claim against the income or wealth of a business firm, household,
or unit of government.
2. Financial assets promise future returns to their owners.
3. These assets cannot be depreciated because they do not wear out like physical goods.
4. The physical condition or form of the financial asset is not relevant in determining its market
value (price).
5. Financial assets are represented by a piece of paper or by information stored in a computer and
as a result of this their cost of transportation and storage is low.
6. Financial assets can easily be changed in form and substituted for other assets.

Different Kinds of Financial Assets:

Although there are thousands of different assets, they generally fall into four categories: money,
equities, debt securities, and derivatives.
Money: Money is a financial asset that serves as a medium of exchange and standard of value for
purchases of goods and services. It is the most important and the oldest financial asset in the
economy. All financial assets are valued in terms of money, and flows of funds between lenders
and borrowers occur through the medium of money. Money performs a wide variety of important
services. The following are some of them:
1. It serves as a standard of value or unit of account for all the goods and services we might
wish to trade.
2. It serves as a medium of exchange. It is usually the only financial asset that virtually
every business, household, and unit of government will accept in payment for goods and
services.
3. It serves as a store of value-a reserve of future purchasing power. Purchasing power can
be stored in currency, in an account, or in a computer file until the time is right to buy.
4. Money functions as the only perfectly liquid asset in the financial system.
Equities: Equities, more commonly known as stock, represent ownership shares in a business
firm and, as such, are claims against the firm’s profits and against proceeds from the sale of its
assets. We usually subdivide equities into common stock and preferred stock.
Debt securities: Debt securities represent claims against the assets of a business firm, individual,
or unit of government represented by bonds and other contracts evidencing a loan of money.
Debt securities include familiar instruments as bonds, notes, accounts payable, and savings
deposits. Legally, these financial assets entitle their holders to a priority claim over the holders of
equities to the assets and income of an individual, business firm, or unit of government. Financial
analyst usually divide debt securities into two broad classes: (1) negotiable, which can easily be

Dr. S. M. Sohrab Uddin, Professor, Department of Finance, University of Chittagong. Page 1 of 9

transferred from holder to holder as a marketable security, and (2) nonnegotiable, which cannot
legally be transferred to another party.
Derivatives: Financial instruments, such as swaps, futures, options, forwards, whose value
depends upon an underlying financial instrument such as a stock (equity) or bond (debt security).
Derivatives are among the newest kinds of financial assets. These types of financial assets
usually provide hedging or risk-management services.

Properties of Financial Assets:

Financial assets have the following eleven properties:
i. Moneyness: Some financial assets are used as a medium of exchange or in settlement of
transactions. These assets are called money. Other assets, although not money, are very close to
money and they are referred to as near money.
ii. Divisibility: The property of a financial asset that allows it to be divided into small units.
iii. Reversibility: Reversibility refers to the cost of investing in a financial asset and then getting
out of it and back into cash again.
iv. Cash flow: The return that an investor will realize by holding a financial asset depends on all
the cash distributions that the financial asset will pay its owners; this includes dividends on
shares and interest payments on bonds.
v. Term to maturity: This is the length of period until the owner of a financial asset is entitled to
demand liquidation.
vi. Convertibility: Provision of a financial asset that allows the owner of that asset to convert it
into another type of financial asset.
vii. Currency: Most financial assets are denominated in one currency.
viii. Liquidity: For many financial assets liquidity is determined by contractual arrangements.
Ordinary deposits, for example, are perfectly liquid because the bank has a contractual
obligation.
ix. Return predictability: The risk that a financial asset’s value will change over the life or the
uncertainty about the return the asset will generate over that time.
x. Complexity: Some financial assets are complex in the sense that they are actually
combinations of two or more simpler assets.
xi. Tax status: Government regulations for taxing the income from the ownership or sale of a
financial asset differ from year to year, from country to country.

Financial Market and Its Classification:

Financial market is an institutional mechanism created by society to channel savings and other
financial services to those individuals and institutions willing to pay for them. The financial
markets are the heart of the global financial system, attracting and allocating savings and setting
interest rates and the prices of financial assets. It can be classified by the following ways:
A. Classification by nature of claim:
i. Debt market: Financial market for those financial assets that represent creditorship.
ii. Equity market: Financial market for those financial assets that represent ownership.
B. Classification by maturity of claim:
i. Money market: A financial market for short-term financial assets.
ii. Capital market: A financial market for longer-maturity financial assets.
C. Classification by seasoning of claim:
i. Primary market: Financial market that deals with financial claims that are newly issued.

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 ii. Secondary market: A market in which outstanding or existing securities are traded
among investors.
D. Classification by immediate delivery or future delivery:
i. Cash or spot market: The market in which a financial asset trades for immediate
delivery.
ii. Derivative market: The market in which a financial asset trades for future delivery.
E. Classification by organizational structure:
i. Organized market: Financial market that has a specified trading location.
ii. Over-the-counter market: Financial market that does not have a specified trading
location.
F. Classification by geographical location:
i. Domestic market: Financial market within the border of the issuing companies.
ii. International market: Financial market outside the border of the issuing companies.

Derivative and Financial Derivative:

In the financial marketplace, some securities are regarded as fundamental, while others are
regarded as derivative. In a corporation, for example, the stock and bonds issued by the firm are
fundamental securities. Every corporation must have stock, and stock ownership gives rights of
ownership to the firm. Owing a bond issued by a firm gives the bondholder the first claim on the
firm’s cash flows.

In contrast with fundamental securities, such as stocks and bonds, there is an entirely distinct
class of financial instrument called derivatives. In finance, a derivative is a financial instrument
or security whose payoffs depend on a more primitive or fundamental good. For example, a gold
future contract is a derivative instrument, because the value of the future contract depends upon
the value of the gold that underlies the future contract. The value of the gold is the key, since the
value of a gold future contract derives from the value of the underlying gold.
A financial derivative is a financial instrument or security whose payoffs depend on another
financial instrument or security. For example, an option on a share of stock depends on the value
of the underlying share. Because the underlying security is a financial instrument, a stock option
is a type of financial derivative. Similarly, a futures contract on Treasury bond is a financial
derivative, because the value of the T-bond futures depends on the value of the underlying
Treasury bond. Financial instruments such as swaps, futures, forward and options are the
examples of financial derivatives. The common features of all the derivatives are that the price is
negotiated today when the contract is agreed upon, while the settlement and delivery of the
contract is somewhere in the future. They are widely used to speculate on future expectations or
to reduce a security portfolio’s risk.

Forward:
A forward contract means a contract initiated at one time; performance in accordance with the
terms of the contract occurs at a subsequent time. Further, the price at which the exchange occurs
is set at the time of the initial contracting. Actual payment and delivery of the good occur later.
So defined, almost everyone has engaged in some kind of forward contract. For example, a
foreign currency forward contract calls for the exchange of some quantity of a foreign currency
at a future date in exchange for a payment at that later date. At the time of contracting, the
forward contract stipulates the price to be paid at the time of delivery of the good. From the

Dr. S. M. Sohrab Uddin, Professor, Department of Finance, University of Chittagong. Page 3 of 9

simplicity of the contract and its obvious usefulness in resolving uncertainty about the futures, it
is surprising that forward contracts have had a very long history. The origin of forward
contracting is not clear. Some authors trace the practice to Roman and even classical Greek
times.

Futures:
While the historical origins of forward contracts are obscure, organized futures markets began in
Chicago with the opening of The Chicago Board of Trade in 1848. Since then, the basic structure
of futures contracts has been adopted by a number of other exchanges.

A futures contract is a type of a forward contract with highly standardized and closely specified
contract terms. As in all forward contracts, a future contracts calls for the exchange of some good
at a future date for cash, with the payment for the good to occur at that future date. The purchase
of a futures contract undertakes to receive delivery of the good and pay for it, while the seller of
a futures contract promises to deliver the good and receive payment. The price of the good is
determined at the initial time of contracting.

How Futures Contracts Differ from Forward Contracts?

It is important how futures contracts differ from other forms of forward contracts:
• Futures contracts always trade on an organized exchange.
• Futures contracts are always highly standardized with a specified quantity of a good, and
with specified delivery date and delivery mechanism.
• Performance on futures contracts is guaranteed by a clearinghouse--a financial institution
associated with the futures exchange that guarantees the financial integrity of the market
to all traders.
• All futures contracts require that traders post margin in order to trade. Margin is a good
faith deposit made by the prospective futures trader to indicate his or her willingness and
ability to fulfill all financial obligations that may arise from trading futures.
• Futures markets are regulated by an identifiable government agency, while forward
contracts in general trade in an unorganized market.
It is important to bear in mind that forwards and futures are essentially similar contracts. In fact
they differ only in the institutional setting in which they trade; the principles for pricing and the
use of forwards and futures are almost identical.

Options:
Simply option means a choice. But option in financial market means an agreement that gives the
holder the right (but not the obligation) to buy or sell specified securities at a given price (called
an exercise price or striking price) during a specified period of time. In other words, option
represents claims on an underlying common stock, are created by investors and sold to other
investors. The corporation whose common stock underlies those claims has no direct interest in
the transaction, being in no way responsible for the creating, terminating or executing contracts.
Every option is either a call option or a put option. The owner of a call option has the right to
purchase the underlying good at a specific price, and this right lasts until a specific date. The
owner of a put option has the right to sell the underlying good at a specific price, and this right
lasts until a specific date. Options are created only by buying and selling. Therefore, for every

Dr. S. M. Sohrab Uddin, Professor, Department of Finance, University of Chittagong. Page 4 of 9

owner of an option, there is a seller. The seller of an option is also known as an option writer.
The seller receives payment for an option from the purchaser. The seller of a call option receives
payment and, in exchange, gives the owner of a call option the right to purchaser the underlying
good at a specific price, with this right lasting for a specific time. The seller of a put option
receives payment from the purchaser and promises to buy the underlying good at a specific price
for a specific time, if the owner of the put option chooses.
An Option Example:
Consider an option with a share of XYZ stock as the underlying good. Assume that today is
March 1 and that XYZ shares trade at $110. The market, we assume, trades a call option to buy a
share of XYZ at $100 with this right lasting until August 15 and the price of this option being
$15. If a trader buys the call option, he pays $15 and receives the right to purchase a share of
XYZ stock by paying an additional $100, if he so chooses, by August 15. The seller of the option
receives $15, and she promises to sell a share of XYZ for $100 if the owner of the call chooses to
buy before August 15. Note that the price of the option is paid when the option trades. The
premium the seller receives is hers to keep whether or not the owner of the call decides to
exercise the option. If the owner of the call exercises his option, he will pay $100 no matter what
the current price of XYZ stock may be.
At the same time, puts will trade on XYZ. Consider a put with a striking price of $100 trading on
March 1 that also expires on august 15. Assume the price of the put is $45. If a trader purchases a
put, he pays $45. In exchange, he receives the right to sell a share of XYZ for $100 at any time
until August 15. In both the put and call example, the payment made by the purchaser is gone
forever.
At this stage we note that there are four types of participants in options markets:
1. Buyers of calls.
2. Sellers of calls.
3. Buyers of puts
4. Sellers of puts
Buyers are referred to as having long positions; sellers are referred to as having short positions.

It should be emphasized that an option gives the holder the right to do something. The holder
does not have to exercise this right. This is what distinguishes options from forwards and futures,
where the holder is obligated to buy or sell the underlying currency. However, whereas it costs
nothing to enter into a forward or futures contract, there is a cost to acquiring an option.

An Example of Forward Contract:

On June 3, 2003, the treasurer of US corporation knows that the corporation will pay £ 1 million
in 6 months (i.e., on December 3, 2003) and wants to hedge against exchange rate moves. The
treasurer can buy £ 1 million 6 months forward at an exchange rate of £ 1.6100. The corporation
then has a long forward on British pound. It has agreed that on December 3, 2003, it will buy £ 1
million from the bank for $1.61 million. The bank has a short forward on British pound. It has
agreed that on December 3, 2003, it will sell £ 1 million for $1.61 million. Both sides have a
binding commitment. If the spot rate rose to, say, 1.7000, at the end of the 6 months, the forward
contract would be worth $90,000 ($17,00,000 - $16,10,000) to the corporation. It would enable
$1 million to be purchased at 1.6100 rather than at $1.7000. Similarly, if the spot rate fell to
1.5000 at the end of the 6 months, the forward contract would have a negative value ton the

Dr. S. M. Sohrab Uddin, Professor, Department of Finance, University of Chittagong. Page 5 of 9

corporation of $1,10,000, because it would lead to the corporation paying $1,10,000 more than
the market price for the sterling.

One of the parties to a forward contract assumes a long-position and agrees to buy the underlying
currency on a certain specified future date for a certain specified price. The other party assumes a
short position and agrees to sell the currency on the same date for the same price.

SWAP:
Swap is an agreement between two counter parties to swap or exchange future specified cash
flows at specified intervals. In other words, a swap is nothing other than a bundle of forwards
and shares all the basic features of forwards. In case of swap there is series of payments, which
make it different from forward.
Types of Swap:
The most common swaps today are interest rate swap and currency swap.
1. Interest rate swap: Interest rate swap is an arrangement in which parties “swap” interest
payments on their debt issues.
2. Currency swap: Currency swap is an agreement between two counter parties to swap or
exchange future cash flows denominated in two different currencies. In other words, a currency
swap is an agreement that allows one currency to be periodically swapped for another at
specified exchange rates. It essentially represents a series of forward contracts. Commercial
banks facilitate currency swaps by serving as the intermediary that links two parties with
opposite needs.

Can borrow from Can borrow

USA at a lower from Britain
interest rate. At a lower
. interest rate.
USA Parent British Parent

Company Company

Subsidiary Subsidiary
Company Company

When British parent company takes loan from Britain at a lower interest rate and gives to the
subsidiary company situated in USA, then it is called swap. Similarly, the USA parent company
can also do it in USA.

Dr. S. M. Sohrab Uddin, Professor, Department of Finance, University of Chittagong. Page 6 of 9

Problem 1:
An investor enters into a short forward contract to sell 1,00,000 British pounds for US dollars at
an exchange rate of 1.5000 US dollars per pound. How much does the investor gain or loss if the
exchange rate at the end of the contract is (a) 1.4900 and (b) 1.5200?
Problem 2:
A trader enters into a short forward contract to sell 100 million yen. The forward exchange rate is
$0.0080 per yen. How much does the trader gain or loss if the exchange rate at the end of the
contract is (a) $0.0074 per yen and (b) $0.0091 per yen?
Problem 3:
a. Suppose that Jim is speculator who buys a British pound call option with a strike price of
$1.40 and a December settlement date. The current spot price as of that date is about
$1.39. Jim pays a premium of $0.012 per unit for the call option. Assume there are no
brokerage fees. Just before the expiration date, the spot rate of the British reaches $1.41.
At this time, Jim exercises the call option and then immediately sells the pound at the
spot rate to a bank. What is Jim’s net profit or loss, if one option contract specifies 31,250
units?
b. Assume that Linda is the seller of the call option purchased by Jim. Also assume that
Linda would only purchase British pound if and when the option is exercises. What is
Linda’s net profit or loss?
$0.002 $62 ($0.002 × 31250)
Problem 4:
Assume the following information:
• Call option premium on Canadian dollars (C$) = $0.01 per unit.
• Strike price = $0.70
• 1 option contract represents C$50,000.
A speculator who had purchased this call option decided to exercise the option shortly before the
expiration date, when the spot rate reached $0.74. The Canadian dollars were immediately sold
in the spot market by the speculator. Given this information,
• Calculate the net profit (loss) to the speculator. [Ans. $0.3 or $1,500]

• If the seller of the call option did not obtain Canadian dollars until the option was about
to be exercised, what will be the profit or loss to the seller of the call option? [Ans. -$0.3
or -$1,500]
Problem 5:
Assume the following information:
• Put option premium on British pound = $0.04 per unit.
• Strike price = $1.40
• 1 option contract represents C$31,250.
A speculator who had purchased this put option decided to exercise the option shortly before the
expiration date, when the spot rate was $1.30. The pound were purchased in the spot market at
that time by the speculator. Given this information,
• Calculate the net profit (loss) to the speculator. [Ans. $0.06 or $1,875]

Dr. S. M. Sohrab Uddin, Professor, Department of Finance, University of Chittagong. Page 7 of 9

 • If the seller of the put sold the pounds received immediately after the option was
exercised, what will be the profit or loss to the seller of the put option? [Ans. -$0.06 or -
$1,875]

Problem 6:
XYZ Company Limited has purchased British pound call options for speculative purposes. The
option premium was $0.02 per unit and the exercise price was $1.58. Compute the net profit
(loss) to XYZ if the following spot rates exist at the time of expiration: $1.50, $1.52, $1.54,
$1.56, $1.58, $1.60, $1.62, $1.64, $1.66, $1.68. Also, draw the graph associated with XYZ. What
will be the graph relevant for the seller of call options?

Problem 7:
A company has purchased Canadian dollar put option for speculative purposes. Each option was
purchased for a premium of $0.02 per unit with an exercise price of $0.86 per unit. The company
will purchase the Canadian dollars just before it exercises the options (if it is feasible to exercise
the options). It plans to wait until the expiration date before deciding whether to exercise the
options. Find the net profit (or loss) for the company based on the following spot rates of the
Canadian dollar on the expiration date: (i) $0.75, (ii) $0.76, (iii) $0.79, (iv) $0.84, (v) $0.87, (vi)
$0.89, and (vii) $0.91.

Application of Financial Derivatives:

a. Market completeness: In the theory of finance, a complete market is a market in which any
and all identifiable payoffs can be obtained by trading the securities available in the market.
Financial derivatives play a valuable role in financial market that helps to move the market close
to completeness.
b. Speculation: Financial derivatives have a reputation for being risky. Without doubt, these
instruments can prove tremendously risky in the hands of uninformed traders. However, the risks
associated with financial derivatives are not necessarily evil, because they provide very powerful
instruments for knowledgeable traders to expose themselves to calculated and well-understood
risks in pursuit of profit. In the hands of knowledgeable trader, a position in one or more
financial derivatives can permit a careful and artful speculation on a rise or fall in interest rates,
on a change in the riskiness of the entire stock market, on changing values of one currency
versus another currency.
c. Risk management: While financial derivatives undeniably risky in some applications, they also
provide a powerful tool for limiting risks that individuals and firms face in the ordinary conduct
of their business.
d. Trading efficiency: In many instances, traders can use a position in one or more financial
derivatives as a substitute for a position in the more fundamental underlying instruments.

Types of Traders:
Derivatives markets have been outstandingly successful. The main reason is that they have
attracted many different types of traders and have a great deal or liquidity. When an investor
wants to take one side of a contract, there is usually no problem in finding some one that is
prepared to take the other side.

Dr. S. M. Sohrab Uddin, Professor, Department of Finance, University of Chittagong. Page 8 of 9

Three broad categories of traders can be identified: hedgers, speculators, and arbitrageurs.
Hedgers use derivatives to reduce the risk that they face from potential future movements in a
market variable. Speculators use them to bet on the future direction of a market variable.
Whereas, hedgers want to avoid exposure to adverse movements in the price of an asset,
speculators wish to take a position in the market. Arbitrageurs take offsetting positions in two or
more instruments to lock in a profit. They do this by simultaneously entering into transactions in
two or more markets.

An example of hedging using forward contracts:

Suppose that it is June 3, 2003, and Import Company, a company based in the United States
knows that it will have to pay ₤10 million on September 3, 2003, for goods it has purchased from
a British supplier. Import Company could hedge its foreign exchange risk by buying pounds
from the financial institution in the 3-month forward market at 1.6196. This would have the
effect of fixing the price to be paid to the British exporter at $1,61,92,000. This example
illustrates a key aspect of hedging. The cost of, or price received for, the underlying asset is
assured. However, there is no guarantee that the outcome with hedge will be better than the
outcome without hedging.

An example of hedging using futures contracts:

Consider a US speculator who in February thinks that the British pound will strengthen relative
to the US dollar over the next two months and is prepared to back that hunch to the tune of
₤2,50,000. One thing the speculator can do is purchase ₤2,50,000 in the spot market in the hope
in the hope that the sterling can be sold later at a higher price. At the same time the speculator
can enter into futures contracts for the pound.

An example of Arbitrage:
Let us consider a stock that is traded on both the New York Stock Exchange and the London
stock Exchange. Suppose the stock price is $172 in New York and ₤100 in London at a time
when the exchange rate is $1.7500 per pound. An arbitrageur could simultaneously buy 100
shares of the stock in New York and sell them in London to obtain a risk-free profit of
100 × [($1.75 × 100) − $172] or $300 in the absence of transactions costs. Transactions costs
would probably eliminate the profit for a small investor. However, a large investment bank faces
very low transactions costs in both the stock market and the foreign exchange market. It would
find the arbitrage opportunity very attractive and would try to take as much advantage of it as
possible. However, it is important to mention that arbitrage opportunities cannot last for long. As
arbitrageurs buy the stock in New York, the forces of supply and demand will cause the dollar
price to rise. Similarly, as they sell the stock in London, the sterling price will be driven down.
Very quickly the two prices will become equivalent at the current exchange rate.

Dr. S. M. Sohrab Uddin, Professor, Department of Finance, University of Chittagong. Page 9 of 9