1. Derivative market

2. Derivative market
Financial derivative is a contractual agreement, whose profits or loss depends on the price of assets underlying in a contract.
Financial derivative product:
Forward contract
Future contract
Option contract
SWAP

3. Importance of financial derivative market
Risk management:
Hedging risk
Transfer of risk
Keeping risk at an acceptable level
Price discovery:
Investors expectation of future price
Forward or future price contains valuable information
Option market provide valuable information about volatility and risk of assets
Operational advantage:
Larger transaction cost
Greater liquidity
Short selling

4. Development of forward contract
In 1840 farmers in Chicago a huge loss reasons being lowest price ,storage facilities and insufficient buyers.
In 1848 a group of businessman met together and formed Chicago board of trade, which objectives are:
Standardizing the quantities
Maintaining quality of grain
Enables farmers to sell products well around of time and thereby locking the price
In 1898, Foundation of Chicago Mercantile exchange(CME)
In 1920 established clearing house as an integer of CBOT. Clearing house facilitating the development of future market and nature of future contracts.

5. Forward Contract
Forward contract is an agreement between two parties in order to buy and sell a particular asset at a prefixed price on a certain date in the future.
Feature of FC:
Forward contract is an agreement
Forward contract is an agreement between two parties
Forward contract is an agreement to buy and sell
Trading a particular asset
Price is prefixed
Date is prefixed
FC is a product of OTC market
FC is non-standardized product
FC can be made for any amount of quantity

6. Investment asset ( stocks, bonds, gold)
Types of FC:
Foreign currency
Investment asset ( stocks, bonds, gold)
Consumption assets ( oil, jute rice)

7. Forward contract Vs Future contract
Nature
OTC
Standardized
Trading conducted
Direct conducted over phone, Fax, mail etc. in person
Automation through broker
Buy/sell
Principle and Agent
Non member deal
Participants
Mostly financial institutions and Friends and relatives
Investors, Speculators, Banks, Financial institutions
Commission No
Yes
Credit risk
Exchanged
Clearing
Margin
Not required
Required
Settlement
On maturity date
Through clearing house
Liquidity
Cash settlement
On delivery
Regulated training

8. Problem-1 (Forward contract): A one year long forward contract on a non-dividend paying stock is entered into when the stock price is Tk. 40 and the risk free interest rate is 10% p.a. with continuous compounding.
What are the forward price and the initial value of the forward contract?
Six month later, the price of the stock is Tk. 45 and the risk free interest rate is still 10%. What are the forward price and the initial value of the forward contract?

9. What is the forward price? What arbitrage opportunity is there?
Problem-2 (Forward contract): Assume that a 10-month forward contract on a stock with a price of Tk. 60. The risk free interest rate is 7% p.a. with continuous compounding. It is assumed that dividends of 0.90 per share are expected after 5 months and 8 months.
What is the forward price? What arbitrage opportunity is there?

10. Types of Future contact
Commodity future contract
Financial Future contract
- Interest rate future contract
- Currency future contract
- Stock index future contract

11. Problem-3(Future Contract): XYZ enter into future contract to buy 300 Tk. 70 each at the end of the 3 months. XYZ corporation is required to deposit 10% of contractual agreement price as margin. Maintenance margin is Tk Show margin a/c if market price is as follows:
Dec Tk. 72
Tk. 71
Tk. 69
Tk. 67
Tk. 64
Tk. 69

12. Calculate the future price of silver for delivery in nine months.
Problem-4(future contract): The current price of silver $ and the risk free rate is 7% per annum for all maturities. The storage cost are $12 per ounce per year, with the payment being made at the end of the year.
Calculate the future price of silver for delivery in nine months.
What should arbitrage do if future of goods be $1050 or $ 1080?

13. Options
Option on stock were first traded on an organized exchange in since then there has been a dramatic growth in options markets. Option are now traded on many exchanges throughout the world. Huge volumes of options are also traded OTC by banks and other financial institutions.
Characteristics of Option market:
Option market may be OTC market or organized market
Very old
Deals with the right not obligation
Option market acts as insurance

14. Products of option market: Call option Put option SWAPs option
Option on stock index
Option on currency
Option on future

15. Option is a contract that provides right to option buyer
develops obligation for option seller
facilitates for buying and selling and a particular underlying to the contract at prefixed price/strike price on the certain date in the future or during the contractual period.
Parties of the Option:
Option writer or seller
Option buyer
Option buyer paid the premium to the option seller and option seller given the right to the option buyer.

16. The underlying asserts in option market include: Stocks
Option on assets:
The underlying asserts in option market include:
Stocks
Foreign currencies
Debt securities
Commodities
Future contracts

17. Calls and puts can be one of the two types:
Types of option:
Call option: A call option grants its purchaser called the option holder, the right to purchase a specified number of units of some underlying asset from the option seller. The option seller is called the option writer or sometimes the option grantor.
Put option: A put option grants its purchaser called the option holder, the right to sell a specified number of units of some underlying asset.
Calls and puts can be one of the two types:
A European option: is an option that can only be exercised only on the expiration date itself.
A American option: in an option that can be exercised at any time from the moment it is created until the time it expires.

18. Option premium: Factors that influence for determining option premium:
Strike price: The price which is prefixed by the buyer and seller on the day of contract. Strike price depends on
Spot price
Interest rate
Inflation rate
demand and supply
Option premium: Factors that influence for determining option premium:
Total risk
risk free interest rate
Market price
profitability
Strike price
In option premium a model was develop that called Black and School model.

19. When to exercise option? Call option:
strike price(K) < market price(S)
Put option:
strike price(K) > market price(S)

20. Problem-5 (Call option): Jerry house paid a premium of $ 4 per share for one 6-month call option contract (total of $ 400 for 100 shares) of the Mahony Corporation. At the time of the purchase, Mahony stock was selling for $ 56 per share and the exercise price of the call option was $ 55.
Determine Jerry’s profit or loss if the price of Mahony’s stock is $ 54 when the option is exercised.
What is Jerry’s profit or loss if the price of mahony’s stock is $62 when the option is exercised?

21. Determine jerrey’s profit or loss if he had purchased the $2 put.
Protective put: when an investor purchase a long position in common stock, losses will incur if the price of the stock falls. One way to obtain protection from this loss is to purchase a protective put. A put where the exercise price and current price are equal.
Problem-6
Jerry is considering purchase 100 shares of Beximco’s stock at a current price of $ 50 per share. However, jerry is afraid that the price of stock could fall in two months after buys it. A current 3 month at the money put option for Beximco is selling 42 premium per share.
What profit or loss will jerry make if he purchases Beximco for $50 per share and the price of Beximco’s stock falls in one month to $40 per share without a protective put.
Determine jerrey’s profit or loss if he had purchased the $2 put.

22. Straddle:
is the combination of call and put option on the same stock for the same duration and exercise price
is simultaneously purchase of both call and put option on the same stock with the same exercise and duration.

23. Spread: is the simultaneous
purchase of call option as well as put option on the same stock
purchase of call option and sell of call option on the same stock
purchase of put option and sale of put option on the same stock
With the different exercise price same expiration date different cost of call/of put.

24. SWAP
A SWAP is an agreement between two parties in order to exchange a series of cash flow between them in future with a view to
convert floating rate obligation into fixed obligation
Convert obligation in one currency in to an another currency
convert floating price into fixed price
And finally hedge risk that arises from
volatility of interest rate
Volatility in exchange rate
Volatility in commodity price

25. Development of SWAP market
SWAP market has been experience a phenomenal growth. Reason being:
volatility of interest rate
Volatility in exchange rate
Volatility in commodity price
First, currency SWAP market was developed, engineering in London in 1973
1981, Swap market started expanding. First interest rate SWAP was done/transaction
1984, standardize document were develops for SWAP
1985, Foundation of international SWAP dealer association and published SWAP code.
1986, commodity SWAP was introduced and engineered in USA.

26. Kinds of SWAP
Interest rate SWAP: The SWAP which converted floating rate obligation into fixed obligation
Currency SWAP: The SWAP which Converted obligation in one currency in to an another currency
Commodity SWAP: The SWAP which converted floating price into fixed price

27. To reduce cost of capital To manage risk To exploit economics of scale
Why uses of SWAP?
To reduce cost of capital
To manage risk
To exploit economics of scale
To arbitrage world capital market
To enter into new financial market
Matching fixed rate asset and liabilities
Potential to benefit from anticipated fall in rate.

28. Govt. agency and Municipal Corp. a, b, d
User of SWAP
Why they use
Government
b, c
Govt. agency and Municipal Corp.
a, b, d
Expert credit agency
a, b, c
Supra Nationals
b, d, g
Financial institutions
a, b, c, d, e
Corporation
a - g