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Derivatives: A derivative is a security whose price ultimately depends on that of another asset.
Derivative means a contact of an agreement.
Types of Derivatives:
1. Forward Contracts
1. Forward Contracts: - It is a private contract between two parties.
An agreement between two parties to exchange an asset for a price that is specified todays. These are settled at end of contract.
2. Future contracts: - It is an Agreement to buy or sell an asset it is at a certain time in the future for a certain price. Futures will be traded in exchanges only.These is settled daily.
Futures are four types:
1. Commodity Futures: Wheat, Soyo, Tea, Corn etc..,.
2. Financial Futures: Treasury bills, Commercial Paper, Equity Shares, bonds, etc..,
3. Currency Futures: Major convertible Currencies like Dollars, Founds, Yens, and Euros.
4. Index Futures: Underline assets are famous stock market indicies. NewYork Stock Exchange.
3. Options: An option gives its Owner the right to buy or sell an Underlying asset on or before a given date at a fixed price.
There can be as may different option contracts as the number of items to buy or sell they are,
Stock options, Commodity options, Foreign exchange options and interest rate options are traded on and off organized exchanges across the globe.
Options belong to a broader class of assets called Contingent claims.
The option to buy is a call option.The option to sell is a PutOption.
The option holder is the buyer of the option and the option writer is the seller of the option.
The fixed price at which the option holder can buy or sell the underlying asset is called the exercise price or Striking price.
A European option can be excercised only on the expiration date where as an American option can be excercised on or before the expiration date.
Options traded on an exchange are called exchange traded option and options not traded on an exchange are called over-the-counter optios.
When stock price (S1) <= Exercise price (E1) the call is said to be out of money and is worthless.
When S1>E1 the call is said to be in the money and its value is S1-E1.
4. Swaps: Swaps are private agreements between two companies to exchange casflows in the future according to a prearranged formula.
So this can be regarded as portfolios of forward contracts.
Types of swaps:
1: Interest rate Swaps
2: Currency Swaps.
1. Interest rate Swaps: The most common type of interest rate swap is ‘Plain Venilla ‘.
Normal life of swap is 2 to 15 Years.
It is a transaction involving an exchange of one stream of interest obligations for another. Typically, it results in an exchange of ficed rate interest payments for floating rate interest payments.
2. Currency Swaps: - Another type of Swap is known as Currency as Currency Swap. This involves exchanging principal amount and fixed rates interest payments on a loan in one currency for principal and fixed rate interest payments on an approximately equalant loan in another currency. Like interest rate swaps currency swars can be motivated by comparative advantage.