Financial Derivative is a financial instrument whose value is based on the price of an underlying asset. It is a contract whose value is based on something else. They are those instruments whose price is derived from underlying item such as Security, commodity, bonds, interest rates ,etc.
The most common form of derivatives are:
Forwards- It is a customized contract between 2 parties to buy or sell an asset at a specified price at a specified future date.
Futures-Futures are similar to Forwards but are standardized and regulated in Stock Exchanges.
Options- Options are those financial instruments that gives the Right but not the obligation to buy (CALL) or sell (PUT) a security or other Financial asset.
Swaps- The exchange of one security for another based on different factors are termed as Swaps.
According to John C.Hull, “A Derivative can be defined as a Financial Instrument whose value depends on the value of the other, more basic underlying variable”
Black Scholes Model is used to calculate the value of Call Options and Put Option. Let's give a brief idea about Options:
Options are those Financial Instruments that gives the right to the buyer (but not the obligation) to “BUY”(CALL) or “SELL” (PUT) a security or any other financial asset on or before a certain date, at a specified price (Strike Price). The asset under consideration is termed as ‘Underlying’ which could be any security, stock indices, commodities, foreign exchange, interest rate,etc. Options are popularly classified into:
I) Call Option- A Call Option is a contract between two parties to exchange a stock at a “Strike Price” by a predetermined date. One Party, the buyer of the “Call” has the right but not the obligation, to buy the stock at the strike price by the future date, while the other party, the seller of the call has the obligation to sell the stock to the buyer at the Strike Price if the buyer exercises the Option. For example, if a stock is trading at Rs.500 and a trader feels that it might go upto Rs.600, and he buys a Rs.550 “Call Option” for a premium of Rs.5 If the stock rose to Rs.600, that would allow him to buy the stock at Rs.550, even though its valued at Rs.600, giving a profit of Rs.45 on each share. On the other hand, the person who sold him the “ Call” would be obligated to sell the stock at Rs.550. If the stock never rises above Rs.550 by expiration date, the “Call” expires worthless and the “ Call” buyer is out Rs.5 and the “Call” seller keeps Rs.5
II) Put Option- A Put Option is a contract between two parties to exchange a stock at a “Strike Price”, on or before a predetermined date (date of expiry). One party, the buyer of the “Put” has the right, but not the obligation to sell the stock from the buyer at the strike price. For example, if a stock is trading at Rs.500 and the trader thinks that it can go down to Rs.400, then he might buy a Rs.450 Put Option for Rs.5. If the stock dropped to Rs.400, then that would allow him to sell the stock at Rs.450 even though its valued at Rs.400, giving him a profit of Rs.45 on each share. On the other hand, the person who sold him the “Put” would be obligated to buy the stock from him at Rs.450 at a huge loss of Rs.45. If the stock never drops below Rs.450 by expiration date, the “Put” expires worthless and the “Put” buyer loses our Rs.5 and the “Put” seller keeps the profit Rs.5.
