Ace My Derivatives Assignment
Ace My Derivatives Assignment is a blog post that will have tips on how to ace your derivatives assignment. The first tip is to be prepared with the formulas you need for the derivation, which are available through your textbook or online. Second, make sure you understand what all of the symbols mean and how they are used in order to do well on this type of assignment.
Third, read over the question carefully before starting so that you can figure out what it’s asking for. Fourth, if there are multiple parts to answering the question then solve each part individually until you find one that answers all of them correctly. Finally, be careful when making any assumptions about solving math problems because sometimes these assumptions may lead you astray!
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What are derivatives contracts?
Simply put, financial derivative contracts are financial agreements in which a buyer makes a financial transaction with the seller. The deal is usually done over an asset class such as currencies, commodities, stocks and bonds because it gives them protection from adverse price movements.
Derivatives find its origin in ancient times when people used to exchange goods and services. For example, a farmer selling the produce from his harvest to a retailer would be able to protect himself from grain price fluctuations if he could agree on a financial derivative contracts with the buyer by agreeing to deliver the entire amount of product at an agreed future date.
In present context financial derivative contracts are financial instruments that derive their prices from financial assets.
Mechanics of derivative markets
The financial derivative market is an enormous market, because it includes all financial instruments that are traded in financial markets. For example, stock indexes represent financial derivative contracts between buyers and sellers of stocks. Commodities like gold or oil are financial derivatives too because they could be traded in future contracts just like shares in a company trading on stock exchanges today.
Derivative prices depend heavily on expected rate of return on investment in underlying assets, so there is always demand for financial traders who can predict price movements in financial market in order to make profit from financial derivative contracts.
Types of Derivatives Contracts
There are many financial derivative contracts, but among the most popular financial derivatives are: forward contract, financial options, futures contract and swaps. Financial derivative contracts help traders manage their financial assets to avoid risks associated with volatile financial markets and fluctuating demands from financial transactions and financial assets.
There are different types of financial derivative contracts, for example:
These are contracts in which two parties agree to exchange financial assets , financial liabilities or financial cashflows in future. The most common swap is an interest rate swap in which the principal amounts of money exchanged between parties are equal but with different interest rates like fixed-rate and floating-rate.
Forward contracts occur when parties agree on financial asset transactions at specified future date. However, both financial assets must be available when transaction is made. A good example of forward contract is foreign currency trading in which businesses that operate internationally would trade in forward contracts to protect themselves from adverse movements of currency values.
The above type of trading using derivatives as a protection against adverse risks is known as hedging.At expiration date designated by the contract parties must receive and deliver financial assets according to the prevailing market price.
is financial derivative contract where parties agree to buy or sell financial assets of a commodity at a specific date in the future. In present financial market futures contracts are used as hedging strategy against fluctuations in prices of financial assets and commodities.Future contracts resemble forward contracts apart from the minor differences between them.
Some of the differences include;
Futures contracts are traded in exchange markets while forwards are mostly sold over-the-counter and settlements done between the trading parties.
Futures contracts are marked to market daily meaning that gains and losses are calculated daily while forwards are not marked to market daily since they mostly trade over-the-counter.
Futures contracts are regulated by the exchanges and the settlements are thus publicized while forwards, which are traded over-the-counter lack heavy regulation. The trade is also a private deal between the counter-parties.
Other financial derivatives include;
Contract for differences
This is a financial derivative contract in which financial assets are exchanged when both financial instruments have the same market value. One party pays difference between contracted price and market-determined price while another one benefits from this difference.
Option contracts are financial agreements that gives the buyer certain rights to buy or sell financial assets at a specified price within a limited time span.However, the option holder is not obliged to exercise the contract. He can choose to exercise the contract if it is profitable to him.
The option’s value is derived from underlying financial asset and also can be used as hedging strategy, for example: an investor fears financial market volatility in future; he could purchase options contract on commodities like oil to protect himself against adverse changes in commodity prices.
Types of options contracts
Options are financial contracts in which parties to the agreement acquire the right but not an obligation to buy or sell financial asset at a certain pre-agreed price on or before a certain date. Financial assets can either be financial instruments of real assets like gold coins, stocks, commodities etc.
There are two types of options: a call option and a put option.
Call Option: A call option gives the holder the right to buy an underlying asset from the writer, at a certain price called exercise price or strike price. The writer has to sell their stock if he / she gets a call option.
Put Option: A put option gives the holder the right to sell an underlying asset to the writer, at a certain price called exercise price or strike price.
The two types of options have different payoff profiles based on whether buyers of these options expect that prices will go up or down respectively during specified period.
What is unique about trading in financial derivatives?
Financial derivative contracts derive their value from an underlying asset. This means that you are entering in a contract to trade the underlying asset at a certain future date at a specified price.
The main difference between trading in financial derivatives and other forms of trading is that unlike investment where you buy stocks or mutual fund; you must transact only once. Moreover, if party defaulted before expiration date ,then other party may sue to recover losses thus ,there are no such thing as credit risk since each party is obliged to honor all the trading rules in derivatives markets.
This is because financial derivatives are mostly traded on exchange markets, hence the activities of traders and intermediaries are heavily regulated.
Purpose of derivatives contracts
Financial derivative contracts have become more popular because they give financial traders protection against adverse movements of various financial assets, including stocks, bonds and commodities as well as foreign currencies. These derivatives also help businesses manage their risks associated with fluctuating demands from financial transaction as well as financial assets and commodities.
Who Uses Derivatives in Finance?
Financial derivatives are financial instruments traded in financial market that derive their value from underlying designated assets. For example, futures price of a commodity like gold depends on supply and demand for this particular commodity. Financial derivative contract is an agreement between two parties who agree on certain terms of financial instrument such as future prices of stocks or interest rates at specific dates in future.
The following are users of derivatives contracts;
These are traders who enter the derivatives market anticipating changes in market prices. Parties can be betting either for future increase or decrease price movement of underlying financial asset which will affect the price of financial derivative contract at certain date in future and thus making one party benefit while the other loses.
They enter into derivative contracts to lock in riskless profit by taking positions in the stock markets or others assets and taking a position in derivatives market. Arbitrageurs mostly perform a careful analysis of the market and identify any loopholes that would lead to arbitrage profit.
Hedging is the process of taking positions in the market to protect against adverse risks which would lead to loss of assets value. Hedgers enter the derivatives markets to protect against losses that would arise from inherent market changes.
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