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By: Aqib Hussain
FINANCIAL DERIVATIVES
Contents
 History
 Definition
 Traders of Derivative Market
 OTC & ETD
 Types of Derivatives Contracts (Forward, Future, Option &
Swaps)
 Derivative Markets in Pakistan
 Advantages & Disadvantages
History
 In the 17th centaury the formers of Japan used the derivatives
contract for rice.
 In 1848, a first derivatives exchange created in Chicago, US
 $1.2 quadrillion is the so-called notional value of the worldwide
derivatives market. To put that in perspective, the world's annual
gross domestic product is between $50 trillion and $60 trillion.
A quadrillion is: 1,000 times a trillion
What are Derivatives?
 A derivative is a financial instrument (Contract) whose value is derived from
the value of another asset, which is known as the underlying.
 When the price of the underlying changes, the value of the derivative also
changes.
 A Derivative is not a product. It is a contract that derives its value from
changes in the price of the underlying.
Example :
The value of a gold futures contract is derived from the
value of the underlying asset i.e. Gold.
Traders in Derivatives Market
There are 3 types of traders in the Derivatives Market :
 HEDGER
A hedger is someone who faces risk associated with price movement of an
asset and who uses derivatives as means of reducing risk.
They provide economic balance to the market.
 SPECULATOR
A trader who enters the futures market for pursuit of profits, accepting risk in
the endeavor.
They provide liquidity and depth to the market.
 ARBITRAGEUR
A person who simultaneously enters into transactions in two or more
markets to take advantage of the discrepancies between prices in these
markets.
 Arbitrage involves making profits from relative mispricing.
 Arbitrageurs also help to make markets liquid, ensure accurate and uniform
pricing, and enhance price stability
 They help in bringing about price uniformity and discovery.
 OTC and ETD.
1. Over-the-counter
Over-the-counter (OTC) or off-exchange trading is to trade financial
instruments such as stocks, bonds, commodities or derivatives directly
between two parties without going through an exchange or other
intermediary.
• The contract between the two parties are privately negotiated.
• The contract can be tailor-made to the two parties’ liking.
• Over-the-counter markets are uncontrolled, unregulated and have very
few laws. Its more like a freefall.
2. Exchange-traded Derivatives
 Exchange traded derivatives contract (ETD) are those derivatives
instruments that are traded via specialized Derivatives exchange or other
exchanges. A derivatives exchange is a market where individuals trade
standardized contracts that have been defined by the exchange.
 The world's largest derivatives exchanges (by number of transactions) are
the Korea Exchange.
 There is a very visible and transparent market price for the derivatives.
What is a Forward?
 A forward is a contract in which one party commits to buy and the
other party commits to sell a specified quantity of an agreed upon
asset for a pre-determined price at a specific date in the future.
 It is a customised contract, in the sense that the terms of the
contract are agreed upon by the individual parties.
 Hence, it is traded OTC.
Forward Contract Example
I agree to sell
500kgs wheat at
Rs.40/kg after 3
months.
Farmer Bread
Maker
3 months Later
Farmer
Bread
Maker
500kgs wheat
Rs.20,000
What are Futures?
Future contracts are also agreements between two parties in which
the buyer agrees to buy an underlying asset from the other party
(the seller). The delivery of the asset occurs at a later time, but the
price is determined at the time of purchase.
 A future is a standardized forward contract.
 It is traded on an organized exchange.
 Standardizations-
- quantity of underlying
- quality of underlying(not required in financial futures)
- delivery dates and procedure
- price quotes
Types of Futures Contracts
 Stock Futures Trading (dealing with shares)
 Commodity Futures Trading (dealing with gold futures, crude oil
futures)
What are Options?
 Contracts that give the holder the option to buy/sell specified
quantity of the underlying assets at a particular price on or
before a specified time period.
 The word “option” means that the holder has the right but not
the obligation to buy/sell underlying assets.
Types of Options
 Options are of two types – call and put.
 Call option give the buyer the right but not the obligation to
buy a given quantity of the underlying asset, at a given price
on or before a particular date by paying a premium.
 Puts give the seller the right, but not obligation to sell a
given quantity of the underlying asset at a given price on or
before a particular date by paying a premium.
Call Option Example
Right to buy 100
Nestle shares at a
price of Rs.300 per
share after 3 months.
CALL OPTION
Strike Price
Premium =
Rs.25/share
Amt to buy Call option
= Rs.2500
Current Price = Rs.250
Suppose after a month, Market
price is Rs.400, then the option is
exercised i.e. the shares are
bought.
Net gain = 40,000-30,000-
2500 = Rs.7500
Suppose after a month, market price
is Rs.200, then the option is not
exercised.
Net Loss = Premium amt
= Rs.2500
Expiry
date
Put Option Example
Right to sell 100 Nestle
shares at a price of
Rs.300 per share after
3 months.
PUT OPTION
Strike Price
Premium =
Rs.25/share
Amt to buy put option
= Rs.2500
Current Price = Rs.250
Suppose after a month, Market
price is Rs.200, then the option is
exercised i.e. the shares are sold.
Net gain = 30,000-20,000-2500 =
Rs.7500
Suppose after a month, market price
is Rs.300, then the option is not
exercised.
Net Loss = Premium amt
= Rs.2500
Expiry
date
What are SWAPS?
 Is agreement between two parties that exchange
sequence of cash flows for a set period of time.
The two commonly used Swaps are:
1. Interest Rate Swaps : A interest rate swap entails swapping only the
interest related cash flows between the parties in the same currency.
2. Currency Swaps : A currency swap is a foreign exchange
Agreement between two parties to exchange a given amount of one
currency for Another and after a specified period of time, to give back
the original Amount swapped.
Derivative Market in Pakistan
 In Pakistan, derivatives based on financial assets trade
on the Pakistan Stock Exchange (PSX), while
commodity-based derivatives trade on the Pakistan
Mercantile Exchange (PMEX).
 While the trading of cash settled and deliverable equity
futures on the PSX started in 2001, the PMEX became
operational in 2007.
 Despite the exceptional performance of the Pakistani
stock market in recent years, investors’ interest in
exchange-traded derivatives is marginal, resulting in
unimpressive turnovers. In fact, Pakistan’s derivative
markets rank the lowest in the region in terms of volumes
Advantages
 Reduces risk
 Enhance liquidity of the underlying asset
 Lower transaction costs
 Enhances liquidity of the underlying asset
 Enhances the price discovery process.
 Portfolio Management
 Provides signals of market movements
 Facilitates financial markets integration
Disadvantages
 Highly Risky
 Increasing Speculation
 Lack of Transparency
 Uncontrollable Environment
Questions
Not a trader of financial derivatives
A. Speculator
B. Financial Advisor
C. Hedger
D. Arbitrageur
When the price of the …………………. changes,
the value of the derivative also changes.
A. Stocks
B. Commodity
C. Underlying Assets
D. Rice
A person who faces risk associated with
price movement of an asset and who uses
derivatives as means of reducing risk.
A. Speculator
B. Financial Advisor
C. Hedger
D. Arbitrageur
In Pakistan, derivatives based on financial
assets trade on
A. Pakistan Stock Exchange (PSX)
B. FOREX
C. State Bank of Pakistan
D. Pakistan Mercantile Exchange (PMEX)
Agreement between two parties in which the buyer agrees to buy
an underlying asset from the other party (the seller). The delivery of
the asset occurs at a later time, but the price is determined at the
time of purchase.
A. Forward Contract
B. Swap Contract
C. Option Contract
D. Future Contract
Trading is to trade financial instruments such as
stocks, bonds, commodities or derivatives directly
between two parties without going through an
exchange or other intermediary.
A. Direct Contract
B. Over-the-Table (OTC)
C. Exchange-traded Derivatives (ETD)
D. SWAP Contract
Financial Derivatives

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Financial Derivatives

  • 2. Contents  History  Definition  Traders of Derivative Market  OTC & ETD  Types of Derivatives Contracts (Forward, Future, Option & Swaps)  Derivative Markets in Pakistan  Advantages & Disadvantages
  • 3. History  In the 17th centaury the formers of Japan used the derivatives contract for rice.  In 1848, a first derivatives exchange created in Chicago, US  $1.2 quadrillion is the so-called notional value of the worldwide derivatives market. To put that in perspective, the world's annual gross domestic product is between $50 trillion and $60 trillion. A quadrillion is: 1,000 times a trillion
  • 4. What are Derivatives?  A derivative is a financial instrument (Contract) whose value is derived from the value of another asset, which is known as the underlying.  When the price of the underlying changes, the value of the derivative also changes.  A Derivative is not a product. It is a contract that derives its value from changes in the price of the underlying. Example : The value of a gold futures contract is derived from the value of the underlying asset i.e. Gold.
  • 5. Traders in Derivatives Market There are 3 types of traders in the Derivatives Market :  HEDGER A hedger is someone who faces risk associated with price movement of an asset and who uses derivatives as means of reducing risk. They provide economic balance to the market.  SPECULATOR A trader who enters the futures market for pursuit of profits, accepting risk in the endeavor. They provide liquidity and depth to the market.
  • 6.  ARBITRAGEUR A person who simultaneously enters into transactions in two or more markets to take advantage of the discrepancies between prices in these markets.  Arbitrage involves making profits from relative mispricing.  Arbitrageurs also help to make markets liquid, ensure accurate and uniform pricing, and enhance price stability  They help in bringing about price uniformity and discovery.
  • 7.  OTC and ETD. 1. Over-the-counter Over-the-counter (OTC) or off-exchange trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties without going through an exchange or other intermediary. • The contract between the two parties are privately negotiated. • The contract can be tailor-made to the two parties’ liking. • Over-the-counter markets are uncontrolled, unregulated and have very few laws. Its more like a freefall.
  • 8. 2. Exchange-traded Derivatives  Exchange traded derivatives contract (ETD) are those derivatives instruments that are traded via specialized Derivatives exchange or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange.  The world's largest derivatives exchanges (by number of transactions) are the Korea Exchange.  There is a very visible and transparent market price for the derivatives.
  • 9. What is a Forward?  A forward is a contract in which one party commits to buy and the other party commits to sell a specified quantity of an agreed upon asset for a pre-determined price at a specific date in the future.  It is a customised contract, in the sense that the terms of the contract are agreed upon by the individual parties.  Hence, it is traded OTC.
  • 10. Forward Contract Example I agree to sell 500kgs wheat at Rs.40/kg after 3 months. Farmer Bread Maker 3 months Later Farmer Bread Maker 500kgs wheat Rs.20,000
  • 11. What are Futures? Future contracts are also agreements between two parties in which the buyer agrees to buy an underlying asset from the other party (the seller). The delivery of the asset occurs at a later time, but the price is determined at the time of purchase.  A future is a standardized forward contract.  It is traded on an organized exchange.  Standardizations- - quantity of underlying - quality of underlying(not required in financial futures) - delivery dates and procedure - price quotes
  • 12. Types of Futures Contracts  Stock Futures Trading (dealing with shares)  Commodity Futures Trading (dealing with gold futures, crude oil futures)
  • 13. What are Options?  Contracts that give the holder the option to buy/sell specified quantity of the underlying assets at a particular price on or before a specified time period.  The word “option” means that the holder has the right but not the obligation to buy/sell underlying assets.
  • 14. Types of Options  Options are of two types – call and put.  Call option give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a particular date by paying a premium.  Puts give the seller the right, but not obligation to sell a given quantity of the underlying asset at a given price on or before a particular date by paying a premium.
  • 15. Call Option Example Right to buy 100 Nestle shares at a price of Rs.300 per share after 3 months. CALL OPTION Strike Price Premium = Rs.25/share Amt to buy Call option = Rs.2500 Current Price = Rs.250 Suppose after a month, Market price is Rs.400, then the option is exercised i.e. the shares are bought. Net gain = 40,000-30,000- 2500 = Rs.7500 Suppose after a month, market price is Rs.200, then the option is not exercised. Net Loss = Premium amt = Rs.2500 Expiry date
  • 16. Put Option Example Right to sell 100 Nestle shares at a price of Rs.300 per share after 3 months. PUT OPTION Strike Price Premium = Rs.25/share Amt to buy put option = Rs.2500 Current Price = Rs.250 Suppose after a month, Market price is Rs.200, then the option is exercised i.e. the shares are sold. Net gain = 30,000-20,000-2500 = Rs.7500 Suppose after a month, market price is Rs.300, then the option is not exercised. Net Loss = Premium amt = Rs.2500 Expiry date
  • 17. What are SWAPS?  Is agreement between two parties that exchange sequence of cash flows for a set period of time. The two commonly used Swaps are: 1. Interest Rate Swaps : A interest rate swap entails swapping only the interest related cash flows between the parties in the same currency. 2. Currency Swaps : A currency swap is a foreign exchange Agreement between two parties to exchange a given amount of one currency for Another and after a specified period of time, to give back the original Amount swapped.
  • 18. Derivative Market in Pakistan  In Pakistan, derivatives based on financial assets trade on the Pakistan Stock Exchange (PSX), while commodity-based derivatives trade on the Pakistan Mercantile Exchange (PMEX).  While the trading of cash settled and deliverable equity futures on the PSX started in 2001, the PMEX became operational in 2007.  Despite the exceptional performance of the Pakistani stock market in recent years, investors’ interest in exchange-traded derivatives is marginal, resulting in unimpressive turnovers. In fact, Pakistan’s derivative markets rank the lowest in the region in terms of volumes
  • 19. Advantages  Reduces risk  Enhance liquidity of the underlying asset  Lower transaction costs  Enhances liquidity of the underlying asset  Enhances the price discovery process.  Portfolio Management  Provides signals of market movements  Facilitates financial markets integration
  • 20. Disadvantages  Highly Risky  Increasing Speculation  Lack of Transparency  Uncontrollable Environment
  • 22. Not a trader of financial derivatives A. Speculator B. Financial Advisor C. Hedger D. Arbitrageur
  • 23. When the price of the …………………. changes, the value of the derivative also changes. A. Stocks B. Commodity C. Underlying Assets D. Rice
  • 24. A person who faces risk associated with price movement of an asset and who uses derivatives as means of reducing risk. A. Speculator B. Financial Advisor C. Hedger D. Arbitrageur
  • 25. In Pakistan, derivatives based on financial assets trade on A. Pakistan Stock Exchange (PSX) B. FOREX C. State Bank of Pakistan D. Pakistan Mercantile Exchange (PMEX)
  • 26. Agreement between two parties in which the buyer agrees to buy an underlying asset from the other party (the seller). The delivery of the asset occurs at a later time, but the price is determined at the time of purchase. A. Forward Contract B. Swap Contract C. Option Contract D. Future Contract
  • 27. Trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties without going through an exchange or other intermediary. A. Direct Contract B. Over-the-Table (OTC) C. Exchange-traded Derivatives (ETD) D. SWAP Contract

Editor's Notes

  • #4: https://www.aol.com/article/2010/06/09/risk-quadrillion-derivatives-market-gdp/19509184/
  • #19: https://www.dawn.com/news/1284625