ROLE OF

FINANCIAL DERIVATIVES
By
Nishad.S
Derivatives
The term derivative indicate there is no independent
value, i.e.. The value is derived from the underlying assets

the underlying asset can be securities commodities, bullion
currency, livestock or anything else

in other words derivatives means forward, future, option or
any other hybrid contract of predetermined fixed duration ,
linked for the purpose of contract fulfillment to the value of
a specified real or financial asset or to an index of securities

derivatives are financial products

Accounting standard SFAS133 defines a derivative as, a
derivative instrument is a financial derivative or other
contract with all three of the following characteristics:

1. It has one or more underlying and one or more notional or
payment provisions or both

2. It requires no initial net investment

3. Its terms require or permits net settlement


Derivatives are something like electricity:
dangerous if mishandled, but bearing the
potential to do good

Arthur Leavitt-


Hedging
If someone bears an economic risk and
uses the futures market or other derivatives
to reduce that risk, the person is a hedger

Hedging is a prudent business practice;
today a prudent manager has an obligation
to understand and apply risk management
techniques including the use of derivatives
Speculation
A person or firm who accepts the risk the
hedger does not want to take is a
speculator
Speculators believe the potential return
outweighs the risk
The primary purpose of derivatives markets
is not speculation. Rather, they permit or
enable the transfer of risk between market
participants as they desire
Arbitrage
Arbitrage is the existence of a riskless
profit
Arbitrage opportunities are quickly
exploited and eliminated in efficient
markets
Arbitrage then contributes to the efficiency of
markets
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Arbitrage
Persons actively engaged in seeking out
minor pricing discrepancies are called
arbitrageurs
Arbitrageurs keep prices in the marketplace
efficient
An efficient market is one in which securities are
priced in accordance with their perceived level
of risk and their potential return
The pricing of options incorporates this
concept of arbitrage
Risk Management
The hedgers primary motivation is risk
management
Someone who is bullish believes prices are
going to rise
Someone who is bearish believes prices are
going to fall
We can tailor our risk exposure to any points
we wish along a bullish/bearish continuum

Income Generation
Writing a covered call is a way to generate
income
Involves giving someone the right to purchase
your stock at a set price in exchange for an up-
front fee (the option premium) that is yours to
keep no matter what happens
Writing calls is especially popular during a
flat period in the market or when prices are
trending downward

Thank you