Stock and derivative intruments

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Capital and Finance Markets

Stock and Derivative Instruments

Marta Cristina Amorim Miranda – Erasmus Program UWM

Stock and Derivative Instruments - Capital and Finance Market

Index
Introduction

2

1. Derivative Instruments

3

1.1. Definition

3

1.2. Pros & cons of derivative financial instruments

4

2. Futures and Forwards
2.1. Futures

4
4

2.1.1. Concept4

2.1.2. Products traded on futures market

4

2.1.3. Features

5

2.2. Forwards

5

2.2.1. Concept

5

2.2.2. Similarities and differences of forwards and futures

6

2.3. Pros and Cons of Futures and Forwards
3. Swaps

6
7

3.1. Concept

7

3.2. Types of Swaps

7

3.3. Purpose and utility of a swap operation

7

3.4. Pros and Cons of Swaps

7

4.Options

8

4.1. Concept

8

4.2. Examples

8

4.3. Pros and Cons of Options

9

Conclusion
Bibliography

10
10

1

Stock and Derivative Instruments - Capital and Finance Market

Introduction
When we mention derivatives, most people think of Nick Leeson and the
disaster of Barings Bank, and highly risky financial investments. But financial
derivatives have beendeveloped to hedge the risks associated with exchange
and interest rates and primarily, volatility. So we can say that 'Hedging' is a
good thing. It can protect companies and banks against unexpected
developments, for example sudden falls or rises in the value of currencies or
commodities.
In the 1980s, financial futures began to dominate trading. Some
investment bankers began to turn hedging intoa profitable business in its own
right, developing progressively complex ways of hedging. Swaps and options
have become the next most common form of derivative trading after the original
futures.
Options were invented because people liked the security of k nowing they
could buy or sell at a certain price, but wanted the chance to profit if the market
price suited them better at the time ofdelivery.
Swaps are, as the name suggests, an exchange of something. They are
generally done on interest rates or currencies. For example a firm may want to
swap a floating interest rate for fixed interest rate to minimize uncertainty.
There are derivatives on almost all types of asset which are traded - the
main four being bonds (which vary in price according to interest rates),
currencies,shares and what can broadly be described as goods (metals,
energy sources, agricultural produce etc.).New ones are even being developed
on catastrophes, such as earthquakes, and even on the creditworthiness of
investors.
In this paper I will discuss the main derivatives: futures, forwards, swaps and
options, as well as highlight their strengths and weaknesses.

2

Stock and DerivativeInstruments - Capital and Finance Market

1. Derivative Instruments
1.1. Definition
A derivative instrument (or simply 'derivative') is a financial instrument
which derives its value from the value of some other financial instrument or
variable. Its fair value changes with the changes of the hedged item (i.e.
changes of interest rate, security price, commodity price, currency rate, stockexchange indices value).
Derivatives have two components: the underlying variable, also called
underlying asset or 'underlying' (the payoffs depend on its price change), and
the notional component, as a certain amount of assets or liabilities whose value
derives from underlying variable.
Usually, derivatives are contracts to buy or sell the underlying asset at a
future time, with the price,quantity and other specifications defined today.
Contracts can be binding for both parties or for one party only, with the other
party reserving the option to exercise or not. If the underlying asset is not
traded, for example if the underlying is an index, some kind of cash settlement
has to take place. From the accounting point of view, a derivative is a financial
instrument which meets all...
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