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Financial Derivatives

The document outlines three types of financial derivatives: Forward Contracts, Future Contracts, and Options Contracts. It provides detailed explanations and examples for each type, illustrating how they function in terms of obligations, pricing, and potential profits or losses. Additionally, it distinguishes between call and put options, emphasizing the concept of premiums associated with these contracts.
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0% found this document useful (0 votes)
2 views5 pages

Financial Derivatives

The document outlines three types of financial derivatives: Forward Contracts, Future Contracts, and Options Contracts. It provides detailed explanations and examples for each type, illustrating how they function in terms of obligations, pricing, and potential profits or losses. Additionally, it distinguishes between call and put options, emphasizing the concept of premiums associated with these contracts.
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Financial Derivatives

There are 3 types of financial derivatives:

i. Forward Contract
ii. Future Contract
iii. Option Contract

1. Forward Contract: You have the obligation to buy or sell an instrument at a prespecified price
at a prespecified maturity date.

Example-1: A has entered into a contract with B to buy 100 shares of ABC limited from B at $10 per
share on December 31, 2025.

At December 31, 2025, the actual market (spot) price of the share is $12 per share.

Here, A can buy the shares from B at $10 per share with a total amount of $1000 (100*`10).

Or, A can take (if the contract suggests) $200 from B, which is the net amount of profit A is going to make
from this deal.

Example-2: C has entered into a contract to buy a machinery from XYZ company in USA at $1000, which
is payable at 31 December 2025. C is speculating that the USD price might increase in terms of BDT, and
considering hedging his payable position against this uncertainty. So, C enters into a contract with D to
buy $1000 at 31 December 2025, at BDT100/USD.

At 31 December 2025, the USD quote is BDT105/usd (spot price).

Either, C can buy $1000 at BDT 100/usd from D, totaling BDT 100,000.

Or, C can take a net payment of BDT5000 (1000*5) from D.

In each case, C can pay the payable to XYZ of $1000 by spending the same amount of BDT 100,000.

In an Alternate scenario:

At 31 December 2025, the USD quote is BDT95/usd (spot price).

Either, C can buy $1000 at BDT 100/usd from D, totaling BDT 100,000.

Or, C can make a net payment of BDT5000 (1000*5) to D.

In each case, C can pay the payable to XYZ of $1000 by spending the same amount of BDT 100,000.
2. Future Contract: You have the obligation to buy or sell an instrument at a prespecified price at
a prespecified maturity date.

Actual market and future market are completely different. One can enter into a transaction in the
actual market and can simultaneously enter into a transaction on the same asset on future market.

Actual Market Future Market


Example: A future instrument of USD is available at BDT
A needs $100 to pay XYZ for some inventories at 101/usd currently.
31 December 2025.
A buys a USD future now at BDT101/usd for $100
The current spot price of the USD is BDT 100/usd. USD.
Total cost of A = 100*101 = BDT 10,100
At 31 December 2025, the USD quote is BDT
104/usd. At 31 December 2025, the USD future is BDT
105/usd.
Buy USD100 to pay XYZ at 104/usd.
Profit from Future : (100*105)-10,100 = BDT 400
Total Cost = 100*104 = BDT 10,400

Net Cost = 10,400 – 400 = BDT 10,000

Example: A future instrument of USD is available at BDT


A will receive $100 XYZ for some inventories at 31 101/usd currently.
December 2025.
A sells a USD future now at BDT101/usd for $100
The current spot price of the USD is BDT 100/usd. USD.
Total receipt of A = 100*101 = BDT 10,100
At 31 December 2025, the USD quote is BDT
104/usd. At 31 December 2025, the USD future is BDT
105/usd.
Sell $100 from XYZ at 104/usd.
Loss from Future : (100*105)-10,100 = -BDT 400
Total receipt = 100*104 = BDT 10,400

Net receipt = 10,400 = BDT 10,400


You expect to pay $200 to ABC at 30 June 2025. A USD future is available at 0.0084-0.0085/BDT
The spot rate of USD is 0.0083-0.0084/BDT. (Direct quote: 117.64-119.04/USD) for 30 June
(direct quote: 119.04-120.48/USD) 2025.

At 30 June 2025, the rate falls to Now, A buys USD future at a net cost:
0.0082-0.0083/BDT (Direct quote: 120.48- $200/0.0084 = 23,800
121.95/USD).

At 30 June 2025: At 30 June 2025, the future rates are noted at


Net cost of Buying $200, = ($200/0.0082) = BDT 0.0082-0.0083/BDT (120.48-121.95/USD)
24,400-300 = BDT 24,100
You sell the future = $200/0.0083 = 24,100
BDT 300 from future earning will reduce the net
cost of USD 200 payment. Net cost of future = 24,100 – 23,800 = BDT 300

You Expect to receive 500 pounds from an UK The available future contracts for pounds are
importer at 31 July 2025. The spot rate today for trading at 0.0076-0.0077/BDT.
Pounds: 0.0075-0.0076/BDT.

At 31 July 2025, the spot rates are noted for At 31 July 2025, the spot rates for future are
pounds at: 0.0078-0.0079/BDT noted at 0.0079-0.0080

Net cost of settlement without future? Net cost of future?


Net cost of settlement with future?

3. Options Contracts: You have the obligation right to buy or sell an instrument at a prespecified
price at a prespecified maturity date.

There are two types of options contract: Call option and Put option
i. Call Option: You have the right to buy an instrument at a prespecified price at a
prespecified maturity date.

When do you enter into a call option?

Answer: When you anticipate for a price increase


Example-1: A enters into a contract with B to buy $100 at 31 December 2024 at the option of
A.

ii. Put Option: You have the right to sell an instrument at a prespecified price at a
prespecified maturity date.

When do you enter into a put option?

Answer: when you anticipate for a price decrease

Example-2: A enters into a contract with B to sell $100 at 31 December 2024 at the option of A

Please do not think that in a call option, the other party is on a put option and vice versa.

Concept of premium: The party having the right to exercise the options (call/put) needs to pay a lump
sum amount (premium) to the other party who is obligated to entertain the rights of the option-
holder.

Working Example of Call option: A enters into a contract with B to buy 100 XYZ company’s shares at the
price of $15 (strike price/exercise price) per share at 31 December 2024. A needs to pay an upfront
payment of $1 per share as premium for this option holding.

At 31 December 2024, the market price (spot price) of the share is $17 per share.

Find the profit of A from this contract?

Break Even: Strike price + Premium = $15 + $1 = $16 [ for a call option]

Profit : Spot price – Break even = $17 - $16 = $1

Total profit = 100*$1 = $100

When a call option-holder does not exercise the option, in that case, he/she only loses the premium.

Profit from call option = maximum of [{spot price – strike price}, {0}] – Premium

i. Profit = Max [{17 – 15}, {0}] – 1


= Max [{2}, {0}] – 1 = 2 – 1 = $1
ii. Profit = Max [{12-15},{0}] – 1 [assuming market price is $12]
= Max [{-3},{0}] – 1 = 0 – 1 = -$1

Working Example of Put option: A enters into a contract with B to sell 100 XYZ company’s shares at the
price of $22 (strike price/exercise price) per share at 31 December 2024. A needs to pay an upfront
payment of $2 per share as premium for this option holding.

At 31 December 2024, the market price (spot price) of the share is $17 per share.

Find the profit of A from this contract?

Break Even: Strike price - Premium = $22 - $2 = $20 [ for a put option]
Profit : Break even – Spot price = $20 - $17 = $3

Total profit = 100*$3 = $300

When a put option-holder does not exercise the option, in that case, he/she only loses the premium.

Profit from put option = maximum of [{0}, {strike price - spot price}] – Premium

i. Profit = Max [{0}, {$22 - $17] – $2


= Max [{0}, {5}] – 2 = 5 – 2 = $3
ii. Profit = Max [{0}, {$22 - $26] – $2 [ assuming the spot price is $26]
= Max [{0},{-4}] – $2 = 0 – $2 = -$2

Interest Rate Options:

Profit from put option = maximum of [{0}, {strike price - spot price}] – Premium

Profit =Max [{0}, {95 – 96}]- 0.69 = Max [0, -1] – 0.69 = 0 – 0.69 = -0.69%

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