Derivative market

Derivative market

1. DERIVATIVE MARKET

2. Contents Definition Traders of Derivative Market The Structure of Derivative Markets Instruments of Derivatives Contracts Derivative Markets in Pakistan Role of Derivative Market

3. What are Derivatives? A derivative is a financial instrument (Contract) whose value is derived from the value of another asset, which is known as the underlying . When the price of the underlying changes, the value of the derivative also changes. A Derivative is not a product. It is a contract that derives its value from changes in the price of the underlying. Example : The value of a gold futures contract is derived from the value of the underlying asset i.e. Gold.

4. Traders in Derivatives Market There are 3 types of traders in the Derivatives Market : HEDGER A hedger is someone who faces risk associated with price movement of an asset and who uses derivatives as means of reducing risk. They provide economic balance to the market. SPECULATOR A trader who enters the futures market for pursuit of profits, accepting risk in the endeavor. They provide liquidity and depth to the market.

5. ARBITRAGEUR A person who simultaneously enters into transactions in two or more markets to take advantage of the discrepancies between prices in these markets. Arbitrage involves making profits from relative mispricing. Arbitrageurs also help to make markets liquid, ensure accurate and uniform pricing, and enhance price stability They help in bringing about price uniformity and discovery.

6. Exchange-Traded Derivative Markets: Clearing and settlement process All contract terms standardized except price More liquid More transparent Credit guarantee The Structure of Derivative Markets

7. Over-the-counter Derivative Market: Informal network of market participants Dealer market Less liquid Less transparent Customized

8. Forward Commitment A forward commitment, which is an agreement to buy or sell an asset at a future date at a predetermined price. There are three main types of derivatives with forward commitments: Forward contracts, Futures contracts Swaps. Instruments of Derivative Market

9. Forward Contract A forward contract is an over-the-contract derivative contract in which one party commits to buy and the other party commits to sell a specified quantity of an agreed upon asset for a pre-determined price at a specific date in the future. It is a customized contract, in the sense that the terms of the contract are agreed upon by the individual parties. Hence, it is traded OTC.

10. Forward Contract Example I agree to sell 500kgs wheat at Rs.40/kg after 3 months. Farmer Bread Maker 3 months Later Farmer Bread Maker 500kgs wheat Rs.20,000

11. Types of Forward Contracts Equity Forwards Bond and Interest Rate Forward Contract Currency Forward Contract Other Types of Forward Contract

12. Futures Contract Future contracts are also agreements between two parties in which the buyer agrees to buy an underlying asset from the other party (the seller). The delivery of the asset occurs at a later time, but the price is determined at the time of purchase . A future is a standardized forward contract. It is traded on an organized exchange. Standardizations- - quantity of underlying - quality of underlying(not required in financial futures) - delivery dates and procedure - price quotes

13. Future Contract Example sell 500kgs wheat after 3 months. Farmer Bread Maker Farmer Bread Maker Rs.20,000 Clearing House

14. Types of Futures Contracts Stock Futures Contracts Commodity Futures Contracts Currency Futures Contracts Short-Term Interest Rate Future Contract

15. SWAPS Contract A swap is an over-the-contract derivative contract in which two parties agree to exchange a series of future cash One party makes a payment based on random outcome such as LIBOR or KIBOR Other party makes a fixed payment

16. Types of Swap Interest Rate Swaps : A interest rate swap entails swapping only the interest related cash flows between the parties in the same currency . Currency Swaps : A currency swap is a foreign exchange Agreement between two parties to exchange a given amount of one currency for Another and after a specified period of time, to give back the original Amount swapped.

17. ABC BANK XYZ Interest payment at KIBOR +25 bps Fixed payment at 6.5% Payment at KIBOR Interest Rate Swaps Example

18. Contingent Claim A contingent claim is in which the holder has the right but not the obligation to make a final payment contingent on the performance of the underlying. Types of contingent claim Option contract Credit default swap Asset-backed securities

19. Options Contract Contracts that give the holder the option to buy/sell specified quantity of the underlying assets at a particular price on or before a specified time period. The word “option” means that the holder has the right but not the obligation to buy/sell underlying assets.

20. Types of Options CALL OPTION: Call option 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 particular date by paying a premium. PUT OPTION: Puts give the seller the right, but not obligation to sell a given quantity of the underlying asset at a given price on or before a particular date by paying a premium.

21. Call Option Example Right to buy 100 Nestle shares at a price of Rs.300 per share after 3 months. CALL OPTION Strike Pric e Premium = Rs.25/share Amt to buy Call option = Rs.2500 Current Price = Rs.250 Suppose after a month, Market price is Rs.400, then the option is exercised i.e. the shares are bought. Net gain = 40,000-30,000- 2500 = Rs.7500 Suppose after a month, market price is Rs.200, then the option is not exercised. Net Loss = Premium amt = Rs.2500 Expiry date

22. Put Option Example Right to sell 100 Nestle shares at a price of Rs.300 per share after 3 months. PUT OPTION Strike Pric e Premium = Rs.25/share Amt to buy put option = Rs.2500 Current Price = Rs.250 Suppose after a month, Market price is Rs.200, then the option is exercised i.e. the shares are sold. Net gain = 30,000-20,000-2500 = Rs.7500 Suppose after a month, market price is Rs.300, then the option is not exercised. Net Loss = Premium amt = Rs.2500 Expiry date

23. Credit Derivative: A credit derivative is a class of derivative contract between two parties a credit protection buyer and a credit protection seller in which the latter provides protection to the former against a specific credit loss. Credit Default Swap: A derivative contract between two parties, a credit protection buyer and a credit protection seller, in which the buyer makes the series of cash payment to the seller and receive the promise of compensation for credit loss resulting from the default of third party

24. Asset-backed securities A asset-backed securities is a derivative contract in which a portfolio of debt instrument is assembled and claim are issued on the portfolio in the form of tranches which have different priorities of claims on the payment made by the debt securities such that prepayments or credit losses are allocated to the most-junior tranches first and most-senior tranches last.

25. Derivative Market in Pakistan In Pakistan, derivatives based on financial assets trade on the Pakistan Stock Exchange (PSX), while commodity-based derivatives trade on the Pakistan Mercantile Exchange (PMEX ). While the trading of cash settled and deliverable equity futures on the PSX started in 2001, the PMEX became operational in 2007 . Despite the exceptional performance of the Pakistani stock market in recent years, investors’ interest in exchange-traded derivatives is marginal, resulting in unimpressive turnovers. In fact, Pakistan’s derivative markets rank the lowest in the region in terms of volumes traded.

26. Economic Functions in Pakistan Reduces risk Enhance liquidity of the underlying asset Lower transaction costs Enhances the price discovery process. Portfolio Management Provides signals of market movements Facilitates financial markets integration

27. Limitations: Highly Risky Increasing Speculation Lack of Transparency Uncontrollable Environment

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