3. Trading - Types of derivatives
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The document outlines various types of derivatives including forwards, futures, options, warrants, leaps, baskets, and swaps, providing definitions and characteristics for each. It describes contracts like forwards and futures, emphasizing their roles in trading and investment strategies, as well as the rights and obligations in options trading. Additionally, it covers specialized instruments such as warrants and swaps, highlighting their functionalities and typical uses in risk management and speculation.
3. Trading - Types of derivatives
- 2. Types of Derivatives • Forwards • Futures • Options • Warrants • LEAPS • Baskets • Swaps
- 3. Forwards • A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price.
- 4. Futures • A future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. • Futures are special types of forward contracts in the sense that futures are standardized exchange-traded contracts. • A futures contract may be offset prior to maturity by entering into an equal and opposite transaction.
- 5. Futures (Contd.) • The standardized items in a futures contract are: – Quality & Quantity of the underlying – The date and month of delivery – Location of settlement
- 6. Options • An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date. • An option is a security, just like a stock or bond, and constitutes a binding contract with strictly defined terms and properties.
- 7. Options (Contd.) • Types of options: – 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 given future date. – Put option • give the buyer the right but not the obligation to sell a given quantity of the underlying asset, at a given price on or before a given future date.
- 8. Warrants • Longer -dated options are called warrants and are generally traded over-the-counter (OTC). • A warrant gives the holder the right but not the obligation to buy an underlying security at a certain price, quantity and future time. A warrant is issued by a company. The security represented in the warrant (usually share equity) is delivered by the issuing company instead of an investor holding the shares. • Companies will often include warrants as part of a new- issue offering to entice investors into buying the new security. A warrant can also increase a shareholder's confidence in a stock, if the underlying value of the security actually does increase overtime.
- 9. Warrants (Contd.) • There are two different types of warrants: – Call warrant: • A call warrant represents a specific number of shares that can be purchased from the issuer at a specific price, on or before a certain date. – Put warrant: • A put warrant represents a certain amount of equity that can be sold back to the issuer at a specified price, on or before a stated date.
- 10. Warrants (Contd.) • Characteristics of a Warrant: – All warrants have a specified expiry date, the last day the rights of a warrant can be executed. – Warrants are classified by their exercise style: • “American warrant” can be exercised anytime before or on the stated expiry date. • “European warrant”, can be carried out only on the day of expiration. – The underlying instrument the warrant represents is also stated on warrant certificates. – A warrant typically corresponds to a specific number of shares, but it can also represent a commodity, index or a currency.
- 11. LEAPS • Long-Term Equity Anticipation Securities. These are options having a maturity of up to three years. • LEAPS are long-term option contracts that allow investors to establish positions that can be maintained for a period of up to three years. CBOE lists LEAPS on Equity and Index products.
- 12. LEAPS (Contd.) • Equity LEAPS : – Provide long-term stock market investors an opportunity to benefit from the growth of large capitalization companies without having to make outright stock purchases. – Puts can provide a hedge for stock investors against substantial declines in underlying equities. – Current equity options users may also find LEAPS appealing if they desire to take a longer term position of up to three years in some of the same options they currently trade. • Index LEAPS: – Let you trade, hedge or invest in the "entire" stock market or select industry sectors for a time that can be measured in years. – Index options let you take a bullish or bearish position on the entire market. – Index options let you hedge your investments against adverse market moves. – Let you do all this over a longer time period.
- 13. Baskets • Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options.
- 14. Swaps • Are private agreements between two parties to exchange cash flows in the future. • A swap is a derivative, where two counterparties exchange one stream of cash flows against another stream. These streams are called the legs of the swap. • Agreement on formula to be used for exchange of cash- flows is determined in advance • The cash flows are calculated over a notional principal amount. Swaps are often used to hedge certain risks, for instance interest rate risk. Another use is speculation.
- 15. Swaps (Contd.) • Swaps are over-the-counter (OTC) derivatives i.e. they are negotiated outside exchanges. As each swap is a unique contract, the only way to get out of it is by either mutually agreeing to tear it up, or by reassigning the swap to a third party. This latter option is only possible with the consent of the counterparty. • Types of Swaps: – Interest Rate Swaps: – Currency Swaps
- 16. Common Terms • Option premium: the price you pay for a Call option is called the option premium. It secures your right to buy that certain stock at a specified price, called the strike price. If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium. • Strike (or Exercise) Price: the price at which the underlying security can be bought or sold as specified in the option contract.
- 17. Common Terms (Contd.) • The Expiration Date is the day on which the option is no longer valid and ceases to exist. The expiration date for all listed stock options in India is the last Thursday of the month.
- 18. Thanks! • For more information, explore – http://www.koffeefinancial.com/Static/Learn.aspx • Or email us at learn@koffeefinancial.com