Derivative part 1

Derivative contract: - A financial instrument whose value is determined by its underlying asset.

For example :- You have got a letter which can help you in getting cricket match tickets  which cost Rs.1000. But as the demand of ticket is quite high so the price shoots upto Rs.1250.  So what would be the cost of letter …. Simple Rs.250 (example from S.D.Bala Book)

The letter is itself not the asset but due to cricket ticket match its cost is Rs.250. 

Forward contract :-   it  means a contract where   there is an agreement to buy or sell an asset on a specified future date on agreed price. 

There are 2 methods for deriving the price of future :-

1. continous compounding =  It simply means like the^ compound interest formula as we used to read in our 7th class.

A = P (1+r)^n 

i.e.  A = P * e^rt     where r = rate  t= time n  e = exponential value  ( to just ease the formula) 

 As it's the interest is increasing the value. So we will take it as positive formula. But where the value depriciates it will constitute as  A = P*e^ -rt 

Equivalent rates :- I was struck upon this formula for some time, so if the same happens with you. Don't worry at all. it's ok coz I didn't  get it for first time either  . So here it goes :- 

r2 =  m*Ln (1+r1/m )

r1 =  m*(exponential of r2/m -1) 

actually if u solve those equation u will find it as prooving left side = right side . But I guess learning formula is better to avoid any big complications as its not tough either

 Here the change is  r1 = Normal interest rate  and r2 refer to continous compounding rate.  In the first formula we need to see the log table wherein next we have 2 watch exponetial table. Just place the values n boom  .... That's it !!

2.Short selling :-   As I'm going with the book's rhythm so I just understood the simple def.  You try to sell what you don't possess. And obviously for doing the same, you must borrow the funds  which is done with the help of broker. And this process is called as stock lending. why you short sale ... coz of profits. You feel that a share or security is highly appreciated now but would fall tomorrow. So you are choosing the option of selling now n buy tomorrow. It's called short selling. 

Pricing of Forwards and future contracts :- 

it was bit technical again. But with 5 minutes practice, its really smooth. Trust me ! 

Forward n future contracts are quite similar as they just  have the difference of standardized size of contract.  So here we gonna compare the actual forward rate with our calculated forward rate ( we already have read the formula ...its time 2 apply ) 

Suppose if your actual forward price is Rs.65 for a commodity. And according to you it's price should be actually Rs.67 as per your calculated price. So  what you gonna do ... obviously buy the security as its cheap then expected. Simple ... bas ye hi karna hai q me 

And after that there are simple parts of deriving the expected forward price in following situations :- 

1.  No income 

2. Known income

3. Known Yield

4. Carry type

5. Non-carry type :- except this method, all other methods work upon above formula. But in this method we gonna calculate the price of the commodity which we can't store till future like eatables which are essential to buy  no matter what the price is. On the other hand, you can't even save them for future inspite of the fact , its price gonna b really high in near future. So here comes the concept of convenience yield and which is reduced from the normal interest rate. And formula  changed as :- 

F = (Simple cost + storage cost) e^(r-c)t                                         

here c refers to convenience yield. 

6. Index futures 

Hope you've enjoyed reading n found it bit helpful ... Let me know your views 

Regards

Renu