Financial Derivatives

Financial Derivatives

Financial

Futures, Options, and Swaps

Defining Derivatives

Defining

A derivative is a financial instrument whose

derivative is

value depends on – is derived from – the

value of some other financial instrument,

called the underlying asset

Common examples of underlying assets are

Common

stocks, bonds, corn, pork, wheat, rainfall,

etc.

Basic purpose of derivatives

Basic

In derivatives transactions, one party’s loss is

In

always another party’s gain

The main purpose of derivatives is to transfer risk

The

from one person or firm to another, that is, to

provide insurance

If a farmer before planting can guarantee a certain

If

price he will receive, he is more likely to plant

Derivatives improve overall performance of the

Derivatives

economy

Major categories of derivatives

Major

1.

2.

3.

Forwards and futures

Options

Swaps

Forwards and Futures

Forwards

A forward, or a forward contract, is:

forward, or

An agreement between a buyer and a seller

to exchange a commodity or a financial

instrument for a prespecified amount of cash

on a prearranged future date

Example: interest rate forwards (in text)

Example:

Forwards are highly customized, and are

Forwards

much less common than the futures

futures

Futures

Futures

A future is a forward contract that has been

future

standardized and sold through an organized

exchange

Structure of a futures contract:

Structure

– Seller (has short position) is obligated to deliver

short position)

the commodity or a financial instrument to the

buyer (has long position) on a specific date

long position)

– This date is called settlement, or delivery, date

settlement, or delivery, date

Futures (cont’d)

Futures

Part of the reason forwards are not as common is

Part

that it is hard to provide assurances that the

parties will honor the contract

In futures trading, this is done through the clearing

In

clearing

corporation

How? Through margin...