Financial derivatives are financial instruments that are linked to a specific financial instrument or indicator or commodity, and through which specific financial risks can be traded in financial markets in their own right.
5. Derivatives Markets
A derivative is a financial instrument whose price is derived from that of another
asset, and the other asset is generally referred to as the ‘underlying asset’, or
sometimes just ‘the underlying’.
Physical Markets/ Spot Market Derivatives Markets
Simply the buying, selling and
subsequent delivery of
commodities like oil, wheat,
barley and aluminium.
Exists in parallel and enables the
participants in the physical markets
to hedge the risk of adverse price
movements.
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14. Scenario 1 – The price of Wheat goes higher at 20$
Party Action Financial Impact
Farmer Obligated to sell Wheat to Cereal
Manufacture @ 12 $
Incurs a financial loss of
8 $
Cereal
Manufacture
Buys Wheat from Farmer @ 12 $ ABC saves 8 $ by virtue
of this agreement
15. Scenario 2 – The price of Wheat goes down at 8$
Party Action Financial Impact
Farmer Entitled to sell Wheat to Cereal
Manufacture @ 12 $
Enjoys a Profit of 4 $
Cereal
Manufacture
Is Obligated to buy Wheat from Farmer
@ 12 $
ABC loses 4 $ by virtue of
this agreement
If on expiry, the price is the same then neither Farmer nor the Cereal Manufacture would
benefit from the agreement.
Scenario 3 – The price of Wheat stays the same
16. feAtures of forwArD
contrAct…
It is a negotiated contract between two parties and
hence exposed to counter party risk.
Each contract is custom designed and hence unique in
terms of contract size, expiration date, asset type, asset
quality etc.
A contract has to be settled in delivery or cash on
expiration date.
In case one of the two parties wishes to reverse a
contract, he has to compulsorily go to the other party.
17. Risks Involved in the forward contract
Liquidity Risk
Default Risk/ / Counter party risk
Regulatory Risk
Rigidity
Opportunity cost
