Tuesday, December 9, 2008


Derivattives / Derivative Instruments.

A derivattives is an instrument , value of which is derived from the value of another investment / asset.Called a underliying asset or security. A brief description on derivattives are given below;

(1)-Forward Contracts.

A forward contract is an agreement made between two parties to exchange an asset at a specified price at a specified date. Because it is a contract , the buyer is obliged to purchase the asset the seller is obliged to sell at the predetermined price ( the exercise price ) on the specified date ( the expiration date ).

A "future" is an agreement to buy or sell a standard quantity of a specified asset on a fixed future date at a price agreed today. There are two parties to a futures contract, a buyer & a seller whose obligations are as follows,
  • The buyer of a future enters into an obligations to buy on a specified date.
  • The seller of a future is under an onligation to sell on a future date.
These obligations relate to a standard quantity of a specified asset on a fixed future date at a price agreed today.

Types of Futures-

(1). Commodity futures,
Based on underline commodities & could be used to hedge an underline commodity position or to speculate on the commodity.

(2). Index Futures,
Based on stock indexes.

(3). Interest Rate Futures.
Based on movement in interest rates & could be used to hedge diposits or borrowings or speculate on interest rate movements .

(4). Currency Futures.
Based on foreign exchange rates between two specified currencies & could be used to hedge underlying currency positions or to speculate on currency movements.

An option is a contract that confers upon the buyer the right , but not the obligation, to buy or sell an asset at a given price on or before a given date. All the comments related to standard quantities , specified assets , fixed future dates & price agreed today that we noted for futures still apply for options as well.

In the definition above , on option was discribed as being the right , but not the obligation to buy or sell. The right to buy & the right to sell are given different names, as follows ,
  • The right to buy is known as a call option.
  • The right to sell is known as a put option.

A swap is a contractual agreement evidenced by a single document in which two parties. Called counter parties, agree to make periodic payments to each other.In other words , it is the transformation of one stream of future cash flows with another stream of future cash flows with different features.

Swaps have become one of the most important & flexible instruments available to banks & corporate treasurers for asset & liability management.Like other hedging & treasury management models, swaps themselves are not instruments for rising new funds. They are transacted to make new or existing cash flows more attractive, Swaps are often combined with bond issues to achieve particularly favorable funding costs. They also allow a borrower , unable to raise funds efficiently in the bond markets , acces to fixed rate finance. For banks, the swap market provibes a means of laying off risk when they are providing clients with medium-term fixed rate loans. Bank can also make profits from trading swaps.

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