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Derivatives. Derivative: It is a financial instrument whose value is derived from the value of an underlying asset Underlying asset: It can be stocks, indices, bonds, commodities, currency, rates, etc. Main types of derivatives (explained later): Forwards and Futures Swaps Options Credit Derivatives Exotics.

Arbitrageur An arbitrageur is a type of investor who attempts to profit from market inefficiencies. These inefficiencies can relate to any aspect of the markets, whether it is price, dividends, or regulation. The most common form of arbitrage is price..

Forward commitments v/s contingent claims. Forward commitment Include forwards, futures, Legally biding to perform the action (buy / sell) in the future Payments are based on price or rate outcome whether the movement is up or down Underlying can be on equities, indexes, bonds, foreign currencies, physical assets or interest rates Contingent claim Include options and credit derivatives Claim depends on a particular event Only if a credit event happens (default / restructuring / bankruptcy) or the price is above / below threshold, transaction materializes..

Forward Markets - Definition and Characteristics.

Structure Of Derivatives Market - OTC And Exchange Traded Contracts.

A future‘s contract is an agreement between two parties in which one party, the buyer, agrees to buy from another party, the seller, an underlying asset or other derivative, at a future date at a price agreed on today. Characteristics of Futures: Standardization: Major difference between forwards & futures is that futures contracts have standardized contract terms Futures contracts specify the quality & quantity of goods that can be delivered, delivery time & the manner of delivery Uniformity promotes market liquidity Clearinghouse: Each exchange has clearinghouse It guarantees that traders will honor their obligations Act as buyer to every seller & seller to every buyer.

Distinguish Between Forward Contract & Future Contract.

Margins Interpretation. In the futures market, “margin” is the amount of money that must be put into an account by a party opening up a futures position..

Long Call Options Call Short Call The obligation to Sell the underlying Long Put Put Short Put The obligation to Buy the underlying The right but not the obligation to Buy the underlying asset at certain price The right but not the obligation to Sell the underlying asset at certain price Call Buy Put -...> Sell • Long options have rights Short options have obligations • Seller of an option is also called as option writer Option Premium: Price that the owner of an option is required to pay to acquire those rights.

There are 4 ways you can take a position Long Call Long Put Short Call Short Put Whenever you see Long means that you are paying premium. Short means you will receive premium. Call means you are betting on the upmove Put means you are betting on the down move.

European & American Options Options Type European Options Can be exercised only at the end of its life Option Premium Is Lower American Options Can be exercised at any time before or on expiration Option Premium is Higher.

Intrinsic Value of Options • Intrinsic value: is the maximum of zero and the value of the option if the option were exercised immediately • At the money: When the price of the underlying is the same as the strike price of the option, the option is termed at the money and exercising it carries a nil pay-off • In the money: o When the price of the underlying is greater than the strike price carried by a call option, the call option is termed in the money, as exercising it results in a positive pay off When the price of the underlying is less than the strike price carried by a put option, the put option is termed in the money, as exercising it results in a positive pay off • Out of the money: When the price of the underlying is less than the strike price carried by a call option, the call option is termed out of the money, as exercising it will result in a nil pay off When the price of the underlying is greater than the strike price carried by a put option, the put option is termed out of the money, as exercising it will result in a nil pay off.

Payoff for buyers and sellers. Long Call – The maximum loss is limited to premium paid. With potentially unlimited profit Long Put – The maximum loss is limited to premium paid. With potentially unlimited profit Short Call – The maximum profit is limited to premium received. With potentially unlimited loss Short Put – The maximum profit is limited to premium received. With potentially unlimited loss.

Long call payoff = Max (S Short call - X,0) Long put payoff = Max (X — ST,O) Short put.

Effect Of Greeks On Option Pricing. Value of Put(X-S) s x Value of Call(S-X) Spot Price Exercise price Vega Theta Rho.

Option Greeks. What Is Delta? Delta (Δ) is a risk metric that estimates the change in price of a derivative, such as an options contract, given a $1 change in its underlying security..

What Is Rho? Rho is the rate at which the price of a derivative changes relative to a change in the risk-free rate of interest. Rho measures the sensitivity of an option or options portfolio to a change in interest rate..

Swaps. What Is a Swap? A swap is a derivative contract through which two parties exchange the cash flows or liabilities from two different financial instruments. Most swaps involve cash flows based on a notional principal amount such as a loan or bond, although the instrument can be almost anything. Usually, the principal does not change hands. Each cash flow comprises one leg of the swap. One cash flow is generally fixed, while the other is variable and based on a benchmark interest rate, floating currency exchange rate, or index price..

Swaps are similar to forwards in several ways: Swaps typically require no payment by either party at initiation. Swaps are custom instruments. Swaps are not traded in any organized secondary market. Swaps are largely unregulated. Default risk is an important aspect of the contracts. Most participants in the swaps market are large institutions. Individuals are rarely swaps market participants..

What is “Default Risk”? Default risk, a sub-category of credit risk, is the risk that a borrower will default on or fail to repay its debts (any type of debt). For example, a company that issues a bond can default on interest payments and/or repayment of principal.

A bond is a fixed-income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental)..

STOCK represents the holder’s part-ownership in one or several companies. Meanwhile, ‘share’ refers to a single unit of ownership in a company. For example, if X has invested in stocks, it could mean that X has a portfolio of shares across different companies. But if X has invested in shares, the next questions should focus on ‘shares of which company’ or ‘how many shares’..

Equity refers to the capital contributed to a business by its owners; which may be through some sort of capital contribution such as the purchase of stock. A derivative is a financial instrument that derives its value from the movement/performance of one or many underlying assets. The main difference between derivatives and equity is that equity derives its value on market conditions such as demand and supply and company related, economic, political, or other events. Derivatives derive their value from other financial instruments such as bonds, commodities, currencies, etc. Certain derivatives also derive their value from equity such as shares and stocks. Therefore, while investing in equity may be for the purposes of making profits, investing in derivatives may be, not just for making profits (through speculation), but also for hedging against possible risks..