Classification and comparative characteristics of derivatives.

Financial markets instruments consist of underlying stocks ( shares, bonds, commodities, foreign currencies) and their derivatives – claims that promise some payment or delivery in the future contingent on an underlying stock’s behavior.

Derivative securities are securities whose prices are determined by, or “derive from,” the prices of other securities. These assets are also called contingent claims because their payoffs are contingent on the prices of other securities.

Are used:to hedge risks, to speculate (take a view on the future direction of the market), to lock in an arbitrage profit, to change the nature of a liability, to change the nature of an investment without incurring the costs of selling one portfolio and buying another

The classification of derivatives:

1.By the relationship between the underlying asset and the derivative:

- Forward - a contract between two parties, where payment takes place at a specific time in the future at today's pre-determined price;

- Futures - are contracts to buy or sell an asset on or before a future date at a price specified today. A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold; the forward contract is a non-standardized contract written by the parties themselves.

- Options - are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. The option contract also specifies a maturity date.

- Warrants - are similar to options but apart from the commonly used short-dated options which have a maximum maturity period of 1 year, there exists certain long-dated options. These are generally traded over-the-counter.

Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies exchange rates, bonds/interest rates, commodities exchange, stocks or other assets. Swaps can basically be categorized into two types:

1.Interest Rate Swap: These basically necessitate swapping only interest associated cash flows in the same currency, between two parties.

2.Currency swap: In this kind of swapping, the cash flow between the two parties includes both principal and interest. Also, the money which is being swapped is in different currency for both parties.

2.By the type of underlying asset -equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives, or credit derivatives;

3.By the market in which they trade:

- exchange-traded -are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange(Chicago Board Options Exchange, EUREX, Korea Exchange);

-over-the-counter - are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, exotic options - and other exotic derivatives - are almost always traded in this way. The OTC derivative market is the largest market for derivatives.

104. Options. Concept, types, strategies for using.

An option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price (the strike);

The purchase price of the option is called the premium.

In the money option – the exercise produces profits

Out of the money - the exercise produces losses

At the money when the exercise price=asset price