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Financial Derivatives 3

I want a exchange and I learned

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Yaseen Arman
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28 views16 pages

Financial Derivatives 3

I want a exchange and I learned

Uploaded by

Yaseen Arman
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Financial Derivatives

Derivatives are financial contracts that are used in investment analysis to


manage risk, speculate, or increase leverage.
Type of Derivatives
Purpose of the Derivatives
Derivatives in investment analysis are used to hedge risks, speculate on price
movements, and enhance portfolio returns through leverage
Option Contract
Option is the contract that gives the buyer right to buy or sell an asset at a
predetermined price and within a specified time frame. There are two types of
options: calls and puts.
Call Option
A call option gives the buyer right to buy an asset at a specific price (the
strike price) before the option expires. Traders buy call options when they
expect the price of the asset to increase.The trader choose call option when
market is bullished.
Example of Call option
You buy a call option for this stock, which gives you the right (but not the
obligation) to buy 100 shares of XYZ stock at a strike price of $55 per share within
the next month. The price you pay for this call option (the premium) is $2 per
share, or a total of $200 (since 1 option contract represents 100 shares).
Possible Outcomes:
Stock Price Goes Up: 1.
If the stock price rises to $60 before the option expires, you can exercise your
option and buy 100 shares at the strike price of $55 (even though the current
market price is $60).
You then sell those shares at the market price of $60.
Profit: (Selling Price - Strike Price - Premium) = ($60 - $55 - $2) × 100 =
$300.
Stock Price Goes Down: 2.
If the stock price falls below $55 (e.g., to $50), your option will expire
worthless because it makes no sense to buy at $55 when the market price is lower.
Loss: You lose the premium you paid for the option, which is $200.
Put Option
A put option is a financial contract that gives you the right to sell a specific
asset (like a stock) at a certain price within a set period of time.The trader
choose put option when he predict the market does down in future . •

Example:
If you have a put option for a stock with a strike price of $50, and the stock's
price drops to $40, you can still sell it for $50, making a $10 profit per share.
2. Future Contract
A future contract is a binding agreement to buy or sell an asset at a set price
on a specific future date.
Purpose of Future contract
futures contract allows an investor to speculate on the direction of a
security, commodity, or financial instrument, either long or short, using
leverage
Example of the Future contract
An example of a futures contract is an agreement to buy 100 barrels of oil at
Rs. 5,000 per barrel, to be delivered in three months. The buyer and seller
lock in this price today, regardless of future market fluctuations.
Advantages and Disadvantages

Advantages:
Hedging, leverage, liquidity, price discovery, and reduced counterparty risk.
Disadvantages:
High risk, complexity, obligation to execute, forced liquidation, limited flexibility, and
difficulty in market timing.
3. Forward Contract
A forward contract is a customized, private agreement between two parties to buy or
sell an asset at a predetermined price at a specific time in the future. Unlike futures
contracts, which are standardized and traded on exchanges, forward contracts are
negotiated directly between the buyer and the seller and are usually traded over-the-
counter (OTC).
Example
Abbas (a farmer) and Raffy (a buyer) agree to a forward contract.

Abbas wants to sell 100 bushels of wheat.


Raffy wants to buy 100 bushels of wheat.
Terms of the Forward Contract:

Price: $5 per bushe


Delivery Date: 3 months from today
Agreement:
Abbas agrees to deliver 100 bushels of wheat to Raffy in 3 months at the price of $5
per bushel.
Raffy agrees to pay Abbas $5 per bushel for the 100 bushels at that time.
This contract allows both parties to avoid the risk of wheat prices changing in the next
three months. If the price of wheat goes up to $6 per bushel in three months, Raffy
still gets it for $5. If the price drops to $4, Abbas still has to sell it for $5.
4. Swap Contract
A swap contract is a financial agreement between two parties to exchange (or
"swap") cash flows or financial instruments over a specified period of time.
These contracts are typically used for managing financial risks, such as
interest rate risk or currency risk, or for speculation purposes.
Example
Interest Rate Swap
Company A has a loan with a floating interest rate (it changes based on market conditions, like
LIBOR). The current rate is 4%.
Company B has a loan with a fixed interest rate of 5%.
Both companies want to swap interest rates to better manage their payments:

Company A wants to switch from the floating rate to a fixed rate (to avoid uncertainty with rate
changes).
Company B wants to switch from the fixed rate to a floating rate (because they think rates might
go down).
Agreement:
Company A agrees to pay 5% fixed interest to Company B on the notional amount of the loan.
Company B agrees to pay 4% floating interest (based on LIBOR) to Company A.
Result:
Company A now has a fixed rate of 5% instead of the floating 4% rate on its loan.
Company B now has a floating rate of 4% instead of the fixed 5% rate on its loan.
This swap contract helps both companies manage their interest rate exposure according to their
preferences or market expectations.

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