Derivative Securities:

The value of a security depends on other securities is called derivative securities.

Different forms of derivative securities are:

Common derivative contract

Some of the common variants of derivative contracts are as follows:

1. Forwards: A tailored contract between two parties, where payment takes place at
a specific time in the future at today's pre-determined price.
2. Futures: are contracts to buy or sell an asset on a future date at a price specified
today. A futures contract differs from a forward contract in that the futures
contract is a standardized contract written by a clearing house that operates an
exchange where the contract can be bought and sold; the forward contract is a
non-standardized contract written by the parties themselves.
3. Options are contracts that give the owner the right, but not the obligation, to buy
(in the case of a call option) or sell (in the case of a put option) an asset. The price
at which the sale takes place is known as the strike price, and is specified at the
time the parties enter into the option. The option contract also specifies a maturity
date. In the case of a European option, the owner has the right to require the sale
to take place on (but not before) the maturity date; in the case of an American
option, the owner can require the sale to take place at any time up to the maturity
date. If the owner of the contract exercises this right, the counter-party has the
obligation to carry out the transaction. Options are of two types: call option and
put option. The buyer of a call option has a right to buy a certain quantity of the
underlying asset, at a specified price on or before a given date in the future, but he
has no obligation to carry out this right. Similarly, the buyer of a put option has
the right to sell a certain quantity of an underlying asset, at a specified price on or
before a given date in the future, but he has no obligation to carry out this right.
4. Binary options are contracts that provide the owner with an all-or-nothing profit
profile.
5. Warrants: Apart from the commonly used short-dated options which have a
maximum maturity period of one year, there exist certain long-dated options as
well, known as warrants. These are generally traded over the counter.
6. Swaps are contracts to exchange cash (flows) on or before a specified future date
based on the underlying value of currencies exchange rates, bonds/interest rates,
commodities exchange, stocks or other assets. Another term which is commonly
associated with swap is swaption, a term for what is basically an option on the
forward swap. Similar to call and put options, swaptions are of two kinds:
receiver and payer. In the case of a receiver swaption there is an option wherein
one can receive fixed and pay floating; in the case of a payer swaption one has the
option to pay fixed and receive floating.
 Swaps can basically be categorized into two types:
 Interest rate swap: These basically necessitate swapping only interest
associated cash flows in the same currency, between two parties.
 Currency swap: In this kind of swapping, the cash flow between the two
parties includes both principal and interest. Also, the money which is
being swapped is in different currency for both parties.[33]

Forwards

Market dealing in commodities, currencies, and securities for future (forward) delivery at
prices agreed-upon today (date of making the contract). In commodity and currency
markets, forward trading is used as a means of hedging against sharp fluctuations in their
prices.
A market for exchange of currencies in the future. Participants in a forward market enter
into a contract to exchange currencies, not today, but at a specified date in the future,
typically 30, 60, or 90 days from now, and at a price (forward exchange rate) that is
agreed upon today.

In finance, a forward contract or simply a forward is a non-standardized contract

between two parties to buy or to sell an asset at a specified future time at a price agreed
upon today, making it a type of derivative instrument. This is in contrast to a spot
contract, which is an agreement to buy or sell an asset on its spot date, which may vary
depending on the instrument, for example most of the FX contracts have Spot Date two
business days from today. The party agreeing to buy the underlying asset in the future
assumes a long position, and the party agreeing to sell the asset in the future assumes a
short position. The price agreed upon is called the delivery price, which is equal to the
forward price at the time the contract is entered into. The price of the underlying
instrument, in whatever form, is paid before control of the instrument changes. This is
one of the many forms of buy/sell orders where the time and date of trade is not the same
as the value date where the securities themselves are exchanged.

The forward price of such a contract is commonly contrasted with the spot price, which is
the price at which the asset changes hands on the spot date. The difference between the
spot and the forward price is the forward premium or forward discount, generally
considered in the form of a profit, or loss, by the purchasing party. Forwards, like other
derivative securities, can be used to hedge risk (typically currency or exchange rate risk),
as a means of speculation, or to allow a party to take advantage of a quality of the
underlying instrument which is time-sensitive.
A closely related contract is a futures contract; they differ in certain respects. Forward
contracts are very similar to futures contracts, except they are not exchange-traded, or
defined on standardized assets.[54] Forwards also typically have no interim partial
settlements or "true-ups" in margin requirements like futures—such that the parties do
not exchange additional property securing the party at gain and the entire unrealized gain
or loss builds up while the contract is open. However, being traded over the counter
(OTC), forward contracts specification can be customized and may include mark-to-
market and daily margin calls. Hence, a forward contract arrangement might call for the
loss party to pledge collateral or additional collateral to better secure the party at gain.
[clarification needed]
In other words, the terms of the forward contract will determine the
collateral calls based upon certain "trigger" events relevant to a particular counterparty
such as among other things, credit ratings, value of assets under management or
redemptions over a specific time frame (e.g., quarterly, annually).

Futures

In finance, a 'futures contract' (more colloquially, futures) is a standardized contract

between two parties to buy or sell a specified asset of standardized quantity and quality
for a price agreed upon today (the futures price) with delivery and payment occurring at a
specified future date, the delivery date, making it a derivative product (i.e. a financial
product that is derived from an underlying asset). The contracts are negotiated at a futures
exchange, which acts as an intermediary between buyer and seller. The party agreeing to
buy the underlying asset in the future, the "buyer" of the contract, is said to be "long",
and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to
be "short".

While the futures contract specifies a trade taking place in the future, the purpose of the
futures exchange is to act as intermediary and mitigate the risk of default by either party
in the intervening period. For this reason, the futures exchange requires both parties to
put up an initial amount of cash (performance bond), the margin. Margins, sometimes set
as a percentage of the value of the futures contract, need to be proportionally maintained
at all times during the life of the contract to underpin this mitigation because the price of
the contract will vary in keeping with supply and demand and will change daily and thus
one party or the other will theoretically be making or losing money. To mitigate risk and
the possibility of default by either party, the product is marked to market on a daily basis
whereby the difference between the prior agreed-upon price and the actual daily futures
price is settled on a daily basis. This is sometimes known as the variation margin where
the futures exchange will draw money out of the losing party's margin account and put it
into the other party's thus ensuring that the correct daily loss or profit is reflected in the
respective account. If the margin account goes below a certain value set by the Exchange,
then a margin call is made and the account owner must replenish the margin account.
This process is known as "marking to market". Thus on the delivery date, the amount
exchanged is not the specified price on the contract but the spot value (i.e., the original
value agreed upon, since any gain or loss has already been previously settled by marking
to market). Upon marketing the strike price is often reached and creates lots of income
for the "caller".
A closely related contract is a forward contract. A forward is like a futures in that it
specifies the exchange of goods for a specified price at a specified future date. However,
a forward is not traded on an exchange and thus does not have the interim partial
payments due to marking to market. Nor is the contract standardized, as on the exchange.
Unlike an option, both parties of a futures contract must fulfill the contract on the
delivery date. The seller delivers the underlying asset to the buyer, or, if it is a cash-
settled futures contract, then cash is transferred from the futures trader who sustained a
loss to the one who made a profit. To exit the commitment prior to the settlement date,
the holder of a futures position can close out its contract obligations by taking the
opposite position on another futures contract on the same asset and settlement date. The
difference in futures prices is then a profit or loss..

Mortgage-backed securities

A mortgage-backed security (MBS) is a asset-backed security that is secured by a

mortgage, or more commonly a collection ("pool") of sometimes hundreds of mortgages.
The mortgages are sold to a group of individuals (a government agency or investment
bank) that "securitizes", or packages, the loans together into a security that can be sold to
investors. The mortgages of an MBS may be residential or commercial, depending on
whether it is an Agency MBS or a Non-Agency MBS; in the United States they may be
issued by structures set up by government-sponsored enterprises like Fannie Mae or
Freddie Mac, or they can be "private-label", issued by structures set up by investment
banks. The structure of the MBS may be known as "pass-through", where the interest and
principal payments from the borrower or homebuyer pass through it to the MBS holder,
or it may be more complex, made up of a pool of other MBSs. Other types of MBS
include collateralized mortgage obligations (CMOs, often structured as real estate
mortgage investment conduits) and collateralized debt obligations (CDOs).

The shares of subprime MBSs issued by various structures, such as CMOs, are not
identical but rather issued as tranches (French for "slices"), each with a different level of
priority in the debt repayment stream, giving them different levels of risk and reward.
Tranches—especially the lower-priority, higher-interest tranches—of an MBS are/were
often further repackaged and resold as collaterized debt obligations. These subprime
MBSs issued by investment banks were a major issue in the subprime mortgage crisis of
2006–2008 . The total face value of an MBS decreases over time, because like
mortgages, and unlike bonds, and most other fixed-income securities, the principal in an
MBS is not paid back as a single payment to the bond holder at maturity but rather is paid
along with the interest in each periodic payment (monthly, quarterly, etc.). This decrease
in face value is measured by the MBS's "factor", the percentage of the original "face" that
remains to be repaid.
Options:

An option is a contract which gives the buyer (the owner or holder of the option) the
right, but not the obligation, to buy or sell an underlying asset or instrument at a specified
strike price on a specified date, depending on the form of the option. The strike price may
be set by reference to the spot price (market price) of the underlying security or
commodity on the day an option is taken out, or it may be fixed at a discount or at a
premium. The seller has the corresponding obligation to fulfill the transaction – to sell or
buy – if the buyer (owner) "exercises" the option.

Types of Option:

According to the option rights

 Call options give the holder the right—but not the obligation—to buy something
at a specific price for a specific time period.
 Put options give the holder the right—but not the obligation—to sell something
at a specific price for a specific time period.

According to the underlying assets

 Equity option
 Bond option
 Future option
 Index option
 Commodity option
 Currency option

Other option types

Another important class of options, particularly in the U.S., are employee stock options,
which are awarded by a company to their employees as a form of incentive
compensation. Other types of options exist in many financial contracts, for example real
estate options are often used to assemble large parcels of land, and prepayment options
are usually included in mortgage loans. However, many of the valuation and risk
management principles apply across all financial options. There are two more types of
options; covered and naked.[14]

Option styles

Options are classified into a number of styles, the most common of which are:

 American option – an option that may be exercised on any trading day on or

before expiration.
 European option – an option that may only be exercised on expiry.

These are often described as vanilla options. Other styles include:

  Bermudan option – an option that may be exercised only on specified dates on or
before expiration.
 Asian option – an option whose payoff is determined by the average underlying
price over some preset time period.
 Barrier option – any option with the general characteristic that the underlying
security's price must pass a certain level or "barrier" before it can be exercised.
 Binary option – An all-or-nothing option that pays the full amount if the
underlying security meets the defined condition on expiration otherwise it expires.
 Exotic option – any of a broad category of options that may include complex
financial structures.

Contract specifications

A financial option is a contract between two counterparties with the terms of the option
specified in a term sheet. Option contracts may be quite complicated; however, at
minimum, they usually contain the following specifications:[7]

 whether the option holder has the right to buy (a call option) or the right to sell (a
put option)
 the quantity and class of the underlying asset(s) (e.g., 100 shares of XYZ Co. B
stock)
 the strike price, also known as the exercise price, which is the price at which the
underlying transaction will occur upon exercise
 the expiration date, or expiry, which is the last date the option can be exercised
 the settlement terms, for instance whether the writer must deliver the actual asset
on exercise, or may simply tender the equivalent cash amount
 the terms by which the option is quoted in the market to convert the quoted price
into the actual premium – the total amount paid by the holder to the writer

Example:

Both a call and put currently are traded on stock NSE; both have striking prices of
Tk.45.00 and matures in 06 months. What will be the profit to an Investor to buy the call
to Tk.5, if the stock price in 06 six months is Tk.50? if the price is Tk.40 ?

Swaps

A swap is a derivative in which two counterparties exchange cash flows of one party's
financial instrument for those of the other party's financial instrument. The benefits in
question depend on the type of financial instruments involved. For example, in the case
of a swap involving two bonds, the benefits in question can be the periodic interest
(coupon) payments associated with such bonds. Specifically, two counterparties agree to
the exchange one stream of cash flows against another stream. These streams are called
the swap's "legs". The swap agreement defines the dates when the cash flows are to be
paid and the way they are accrued and calculated. Usually at the time when the contract is
initiated, at least one of these series of cash flows is determined by an uncertain variable
such as a floating interest rate, foreign exchange rate, equity price, or commodity price.

The cash flows are calculated over a notional principal amount. Contrary to a future, a
forward or an option, the notional amount is usually not exchanged between
counterparties. Consequently, swaps can be in cash or collateral. Swaps can be used to
hedge certain risks such as interest rate risk, or to speculate on changes in the expected
direction of underlying prices.

Swaps were first introduced to the public in 1981 when IBM and the World Bank entered
into a swap agreement.[60] Today, swaps are among the most heavily traded financial
contracts in the world: the total amount of interest rates and currency swaps outstanding
is more than $348 trillion in 2010, according to the Bank for International Settlements
(BIS). The five generic types of swaps, in order of their quantitative importance, are:
interest rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps
(there are many other types).

Economic function of the derivative market

Some of the salient economic functions of the derivative market include:

1. Prices in a structured derivative market not only replicate the discernment of the
market participants about the future but also lead the prices of underlying to the
professed future level. On the expiration of the derivative contract, the prices of
derivatives congregate with the prices of the underlying. Therefore, derivatives
are essential tools to determine both current and future prices.
2. The derivatives market reallocates risk from the people who prefer risk aversion
to the people who have an appetite for risk.
3. The intrinsic nature of derivatives market associates them to the underlying spot
market. Due to derivatives there is a considerable increase in trade volumes of the
underlying spot market. The dominant factor behind such an escalation is
increased participation by additional players who would not have otherwise
participated due to absence of any procedure to transfer risk.
4. As supervision, reconnaissance of the activities of various participants becomes
tremendously difficult in assorted markets; the establishment of an organized
form of market becomes all the more imperative. Therefore, in the presence of an
organized derivatives market, speculation can be controlled, resulting in a more
meticulous environment.
5. Third parties can use publicly available derivative prices as educated predictions
of uncertain future outcomes, for example, the likelihood that a corporation will
default on its debts.

In a nutshell, there is a substantial increase in savings and investment in the long run due
to augmented activities by derivative market participant.