FINANCIAL MARKET&OPERATIONS

V MODULE DERIVATIVES
SECTION A.2 MARK QUESTIONS

1. Define Derivatives
A Derivative is a contract between two parties which derives its value from an
underlying asset. The most common types of derivatives are futures,options,forwards and
swaps.
2. What do you mean by Swaps

A Swap is a derivative contract through which two parties exchange the cash flows or
liabilities from two different financial instruments.
3. Hedging
Hedging refers to an offsetting contract made in order to insulate the home currency
value of receivables or payables denominated in foreign currency. Objective of hedging is to
offset exchange risk arising from transaction exposures.
4. American option
An American option is a version of an options contract that allows holders to exercise
the option rights at any time before and including the day of expiration. American style
option allows investors to capture profit as soon as the stock price moves favourably.
5. Define option

Options are financial instruments that are derivatives based on the value of underlying
securities such as stock .An options contract offers the buy or sell depending on the type of
contract they hold the underlying asset.

6.Difference between put option and call option

A Call option gives the buyer the right,but not the obligation to buy the underlying
security at the exercise price ,at or within a specified time.A Put option gives the buyer the right ,but
not the obligation to sell the underlying security at the exercise price at or within a specified time.

7.Diffrence between American and European option

American options allow a trader to exercise their buy or sell an option at any time
before the options expirations date.European options specify that a trader can only choose to
exercise his option on the date of expiration.

8.Define futures

Futures are derivative financial contract that obligate the parties to transact an asset at a
predetermined future date and price.the buyer must purchase or the seller must sell the underlying
asset at the set price,regardless of the current market price at the expiration date.

9.initial margin in futures

It is the amount of money that you need to open a buy or sell on position on a future
contract.it is also called original margin or the same amount posted when the trade first take place.
10.currency swaps

A Currency swap is a transaction in which two parties exchange an equivlent amount of money
with each other but in different currencies.the parties are essentially loaning each other money and
will repay the amount at a specified date and exchange rate.

PART B .5 MARK QUESTIONS

1.What is options. .what are the different types of options

Option contract are agreements between two parties which give the right to buy or
sell the underlying asset for a specified price within a specified date.the parties to the option
contract are,the buyer of the options,also called the option holder.He acquires right to buy or sell.

The seller of the options is called option writer.he sells the right or obliged to exercise the contract
according to the choice of the buyer.

Types of options

a.call option-it is an option which gives the buyer the right to buy an underlying asset at a
predetermined price alled strike price on or before a specified date in future

b..put option-it gives the seller the right to sell an underlying asset at predetrermined price on or
before a specified date in future.

c.double option-it gives the option holder bot the rights either to buy or to sell an underlying asset at
a predetermined price on or before a specified date in future. s

d.American option - this option contract it can be exercised at any time between the writing of the
contract and its expiry.

e.European option-it can be exercised only at the time of maturity.

2. SWAPS .What are the different types of SWAPS

A Swap is an agreement between two counterparties to exchange two streams of

cashflow.its main purpose is to change the character of an asset or liability with another.

DIFFERENT TYPES OF SWAPS

a..Interest rate swaps- Interest swaps are basically change of interest payment between two counter
parties.no exchange of principal amount in this swap.this is also known as in the market as plain
vanilla swap.principal amount applies only for the purpose of calculating the interest to be
exchanged under interest rate swap.maturities range from a year to over 15 years

Features of interest rate swaps

A.Notional principal-interest amount whether fixed or floating is calculated on a specified

amount borrowed or lent.parties do not exchange this amount at any time.

B.Fixed rate-banks or finanancial institution who make market in interest rate swap quote the
fixed rate,they are willing to pay if they are fixed rate payers in a swap ,they are willing to receive if
they are floating rate player in a swap.
 C.-Floating rate-

b.Currency swap-in currency swap ,the two payment streams being exchanged are denominated in
two different currencies.in currency swap three basic steps are involved.

1.initial exchange of principal amount -at an agreed rate of exchange. This rate is based on
the Spot exchange rate.

2.ongoing exchange of interest-after establishing the principal amount the counter parties
exchange interest payment on an agreed date based on the outstanding principal amount at the
fixed interest rates agreed at the outset of the transaction.

3.Re exchange of principal to principal-agreement on this enables the counter parties to re

exchange the principal sums at the maturity date.

c.debt equity swap-in debt equity swap,a firm buy’s a country debt on the secondary market at a
discount and swaps it into local equity.debts are exchanged for equity by one firm with the other.it
enables the investors to purchase the external debts of such underdeveloped countries to acquire
equity or domestic currency in those same countries.

d.motivation underlying swaps-swap are important techniques or technology for transforming the
charateristics of financial claim.A Company can raise the fund in particular market at lower cost
where it receives better evaluation ,which it can swap into the desired type of instrument.

3. Diffrence between forwards and futures

basis forwards futures

Nature of contract Tailor made-privately Standardised contracts
negotiated contracts
market Customised to the individual - Organised exchanges
OTC contracts
settlement At maturity only-at the date Daily settlement.profit/loss is
specified by the parties in the calculated at the end of every
contract trading day-marked to market
Delivery of underlying asset Physical settlement is essential Not necessary
At maturity
intermediary banks Organised exchanges
payment No down payment Payment of margin money is
needed
Risk High counter party risk No counter party risks as the
trade is done through
organised exchanges
 PART C 15 MARK QUESTION

1.What is derivatives.What are the different types of derivatives in india

The past decade has witnessed the multiple growths in the volume of
international trade and business due to the wave of globalisation and liberalization all over the
world.As a result ,the demand for the international money and financial instruments increased
significantly at the global level.in this respect changes in the interest rates,exchange rates and stock
market prices at the different financial markets have increased the financial risk to the corporate
world.it is therefore to manage such risks,the new financial instruments have been developed in the
financial markets,which are also popularly known as financial derivatives

Literal meaning of derivative is that something which is derived.the term derivative

indicates that it has no independent value,its value is entirely derived from the underlying asset.the
underlying asset can be securities,commodities,bullion,currency,livestock or anything else.

Features of derivatives

1.it is a contract-derivatives is defined as the future contract between two parties.it means there
must be a contract -binding on the underlying parties and the same to be fulfilled in future.the
future period may be short or long depending upon the nature of contract.

2.derives value from an underlying asset-normally the derivative instruments have the value which is
derived from the value of other underlying asset.

3.specified obligation-in general the counter parties have specified obligation under the derivative
contract.

4direct or exchange traded-the derivatives contract undertaken directly between the two parties or
through the particular exchange like financial future contracts

5.direct or exchange traded -the derivatives contract can be undertaken directly between the two
parties or through the particular exchange

Types of derivatives

1.forwards

A Forward contract is a customised contract between two entities ,where settlement take place on
a specified date in the future at todays pre-agreed price.for example an Indian car manufacturer
buys Auto parts from a japaneese car maker with payment of one million yen due in 60 days.the
importer in india is short of yen and suppose present price of yen is rs 68.over the next 60 days yen
may rise to rs 70.the importer can hedge thre exchange risk by negotiating 60 days forward contract
with a bank at aprice of rs 70.According to forward contract ,in 60 days the bank will give the
importer one million yen and importer will give banks 70 million rupees to bank.

2.Futures

A future contract is an agreement between two parties to buy or sell an asset at a certain
time in the future at a certain price.future contract are special type of contract .a speculator expects
an increase in price of gold from current future price of rs 9000 per10 gm.The market lot is 1 kg and
he buys one lot of future gold rs 900000.assuming that there is 10% margin money requirement
and 10%increase occur in price of gold.the value of transaction will also increase ie speculator ie
9900 per 10 gm and total value will be rs 9,90,000.in other words the speculator earns rs 90000.
3.options

Options are of two types call and puts.calls 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 given future date.puts
give the buyer the right ,but not the obligation to sell a given quantity of the underlying asset at a
given price on or before a given date.

4.warrants

Options generally lives of upto one year ,the majority of options traded on options exchanges
having maximum maturity of nine months.longer dated options are called warrants and are
generally traded over the counter.

5.leaps

It means long term equity anticipation securities.these are options having a maturity period of
upto three years.

6.Baskets

Basket options are options on portfolio of underlying assets.the index options are a form of
basket options.

7.swaps

Swaps are private agreements between two parties to exchange cash flows in the future
according to a prearranged formula.they can be regarded as portfolios of forward contracts.

The two commonly used swaps are

Interest rate swaps-these entail swapping only the interest related cash flows between the
parties in the same currency

Currency swaps-these entail swapping both principal and interest on different currency than those in
theopposite direction.