Financial Derivative Instrument

Derivatives

•         A derivative is a financial contract that drives it value from an underlying asset.
•         The buyer agrees to purchase the assets on a specific date at specific price.
•        The assets include commodities stock bond interest rate and currencies.
•         Derivatives can be used either for risk management or for speculation (Hedging).

Types of Derivatives

A. Futures

•    A future contract is an agreement between two parties to buy or sell on assets at a certain time in the future at certain prices.
•     Future contract to hedge against risk or peculate n the price movement of the underlying assets.
•         Future are standardized contracts traded on a centralized exchange.
•         It can be called bet between two parties.

B. Forwards

•     A forward contract is a non-standardized contract between two parties to buy or to sell an asset at a specific future time at a price agreed upon today.
•        The key difference being that unlike future, forward contract is not traded on stock exchange, rather only over the counter market.
•     Forwards are used to hedge risk in commodities, interest rate, exchange rate or equities.

C. Swap

•         A swap is most often a contract between two parties’ agreement by to trade loan terms.
•         One might use an interest rate swap to switch form a variable interest rate loan too fixed interest rate loan or vice versa.
•         If a person might seek to switch their variable interest rate loan with some else, who has a loan with a fixed interest rate that tis otherwise similar.
•       The loan will remain in the original holder’s name, the contract mandate that each party will make payment towards the others loan at a mutually agreed upon rate.
•      A swap can be risky, because if one party defaults or goes bankrupt, the others will be forced back into their original loan.
•         Swap can be made using interest rate, currencies or commodities.

D. Option

•    An option is similar to a future contract in that is an agreement between two parties garneting one the opportunity to buy or sell a security from or to the others party at a predetermined future date.
•     The key different between option and future is that option simply gives the buyer the option to their buy or sell the assets at a certain price and date.

Types of Option

1.    Call option – buyer has option for buy or not.
2.    Put option- seller has option for sell or not.

Types of option on the basis of American and European

1.    American options- it is exercise before maturity.
2.    European option- it is exercise on the date of maturity.