PRESENTATION ON

UNDERLYING MARKET
BY:- DHAIRYA (03)
KANIKA (47)
DARSHAN (123)
 INTRODUCTION OF DERIVATES
• The term “derivatives” is used to refer to financial instruments which
derive
their value from some underlying assets.
• The underlying assets could be equities (shares), debt (bonds, T-bills, and
notes), currencies, and even indices of these various assets, such as the
Nifty 50 Index.
• Derivatives contracts are bought and sold by a large number of
individuals, institutions and other’s for a variety of purposes.
• When the price of the underlying changes, the value of the derivative
also changes.
For Example
 CHARACTERISTICS OF DERIVATES

• Written contract
• Expiration date or Maturity date
• Value
• Kind or Types
• Low transaction cost and low risk
• Relationship
• Settlement
 TYPES OF DERIVATES
FORWARD
FUTURE
OPTION
UNDERLYING ASSETS
 FORWARD CONTRACT
• A forward contract or simply a forward is a contract between two
parties to buy or sell an asset at a certain future date for a certain
price that is pre-decided on the date of the contract.
• The future date is referred to as expiry date and the pre-decided
price is referred to as Forward Price.
• It is the customized contract, in the sense that the term of the
contract are agreed upon by the individual parties.
• Hence it is traded on (OTC) Over The Counter (No need for a
licence)
TYPES OF FORWARD CONTRACT

Ready Delivery Contract

SpecificDelivery
Contract
TYPES OF DERIVATIVE MARKETS

Exchange traded derivative markets:

• Markets where standardized contracts are traded

over an exchange such as NCDEX.

• Quantities and qualities cannot be customized.

• Counter party for each transaction is the exchange.

 EXHANGE TRADED MARKETS
A derivatives exchange is a market where individuals trade
standardized contracts that have been defined by the exchange.
Derivatives exchanges have existed for a long time. The Chicago
board of trade was established in 1848 to bring farmers and
merchants together. Initially its main task was to standardized
the quantities and qualities of the grains that were traded. Within
a few years the first futures type contract was developed. It was
known as To Arrive Contract . Speculators soon became interested
in the contract and found trading the contract to be an attractive
alternative to trading the grain itself. The CBOE started trading
call option contracts on 16 stocks in 1973 and put option contacts
started trading in 1977. The CBOE now trades options on
thousands of stocks and stock indices.
OVER THE COUNTER MARKET

• Usually done between two financial institutions

or corporate bodies.

• Not listed.

• Trades are typically larger than exchange traded

derivative transactions.

• Structure can be customized as per the

requirements of the two parties.
 OVER THE COUNTER MARKETS
• Not all the derivatives trading is on exchanges. Many trades
take place in the over the counter market. Banks, other large
financial institutions, fund managers and co-operations are
the main participants in this market.
• Once an OTC trade has been agreed, the two parties can
either
present it to a central counter party or clear the trade
bilaterally.
• A CCP is like an exchange clearing house, it stands between
the two parties to the derivatives transaction so that the one
party does not have to bear the risk that the other party
will default.
• When trades are cleared bilaterally, the two parties have usually
signed an agreement covering all the transactions with each
other . Large banks are often acting as market makers for the
more commonly traded instruments this means that they are
 ELECTRONIC MARKETS

• Traditionally derivatives exchanges have used what is

known as the open outery system. This involves traders
physically meeting on the floor of exchange, shouting
and using a complicated set of hand signals to indicate
the trades they would like to carry out . Now the open
outery system is replaced by the electronic trading.
• This involves traders entering their desire trades at a
keyboard and a computer being used to match buyers
and sellers.
• Electronic trading has led to a growth in high frequency
trading, Using computer programs often without human
intervention.
 CHANGES IN OTC MARKETS

• Standardized OTC derivatives between the two financial

institutions in the united states must whenever
possible be traded on what are referred to a swap
execution facilities. These platforms are similar to
exchanges where market participants can post bid and
offer quotes and where market participants can trade
by accepting the quotes of other market participants.

• There is a requirement in most parts of world that a

CCP be used for most standardized derivatives
transactions between financial institutions.

• All trades must be reported to a central repository.

 MARKET SIZE
• Both the OTC and exchange traded markets for
derivatives are huge, but the number of
derivatives transactions per year in the OTC
markets is smaller than the exchange traded
market.
PARTICIPANTS IN THE DERIVATIVE MARKETS

HEDGERS: Use futures or option markets to reduce or

eliminate the risk associated with price of an asset.

SPECULATORS: Use futures and options contract to get

extra leverage in betting on future movements in the
price of an asset. They can increase both potential gains
and losses by usage of derivatives.

ARBITRAGURS: Are in business to take advantage of

discrepancy between prices in two different markets.
For example they see the futures price of an asset
getting out of a line with the cash price they will take
offsetting positions in the two markets to lock in a profit.
 FUTURES MARKETS

• Futures markets offer an excellent platform for the

study of several market phenomenon including
market design, contract design, market manipulation
etc.

• A future exchange performs two essential functions:

• It provides a market place where buyers and sellers
may interact and arrive at agreements.
• It provides a mechanism to protect either party
form
a possible default by the other.
 OPTIONS MARKET

An option is a financial security that gives its holder

the right to buy or sell a specified quantity of a
specified asset at a specified price on or before a
specified date.
 Underlying assets
• the underlying assets is defined as the asset on which
the financial instruments such as derivatives are based
and the value of the underlying asset is
indirectly or directly related to the contracts of the
derivatives . They are always traded on the cash
markets whereas the derivatives derived from them are
traded on the derivative segment or the future markets.
Types of underlying
assets
 1).Financial claims or stocks:-
The stock is defined as the financial claim which represents
proportionate ownership of the investor or holder towards the
earning and overall assets of issuing business. Stocks can be
bifurcated into common and preferred stocks. Stocks are primarily
issued with the intent of raising finance to fund business
operations or high-growth projects.
2).Exchange traded funds:-
Exchange traded funds are defined as the special variant of the
mutual fund whose benchmark is the underlying index. It is
basically a group of securities encompassed as one unit.
3). Debt securities or bonds:-
•Bond is defined as the financial instrument that gives fixed interest
payments to the holder. Corporations and government institutions
issue
bonds to raise finance with the intent to fund business projects
or government projects. The holder of such instruments is
termed as creditors of debt.

• 4).market index:-
• The market index is defind as the collection of securities. The
collection could be focused on one specific area of the financial
market. These are designed to assess the performance of the
financial markets. The index is
employed to develop passive investment strategies.
 5).currency:-
currency is defined as the instrument of monetary exchange replacing
traditional barter system where in such medium is broadly acceptable in
the specific country. Different country may have different curriencies. The
most common and popular acceptable currency across the globe in that
of united states dollar wherein many countries have performed
dollarization to meets its currency requirement equivalent to global
standards.
6).commodities:-
The commodity is defined as the instrument which is employed in
business and commerce related activities. These items are input for
general commerce and production of business activities. Gold and silver
are the most popular commodities that are traded over the commodities
market.
 Example of underlying asset
• Suppose an underlying asset such as stocks. A purchase at $50 displays a
down side risk. The holder hold 1 share of stock A. the holder can take up a
put option of stock A with a strike price of $50 trading at $2 in the options
markets.
• A put option is derivative contract that gives its holder the right to sell the
underlying asset at a predefined strike price before the date of expiration.
• The put option gives the right too sell but not the obligation to purchase the
selling activity.
• The underlying asset for the put option here is the stock A from which put
option is
innovative and derived.
 Underlying asset
formula:-
• They can be expressed in generalized terms of basic
mathematical expressions as displayed below:-

• Here,
• It is expressed as 𝑦 𝑛 .
• The derivative function, when applied to underlying asset, would result
in derived value.
• The derived value is expressed as 𝑛𝑦(𝑛−1).
• Different underlying assets may hold different relationship with
the derivatives and hence their formula may vary
 Advatnages :-
• Certain variants of underlyingassets such as stocks are highly
marketable in nature.
• They have an organized financial market that promotes liquidity
and exchange of securities between different parties involved.
• Many investor use the underlying assets for the purpose of
investment and hence earn high return after holding such
securities for a considerable investment horizon.
• Since these assets have an organized market, the transaction
costs
involved in trading such assets are relatively very low.
 Disadvantages :-
• Certain variants of underlying asset can be utilized for
speculative purpose. This gives rise to an equal probability of
losing money placed in such assets very quickly.
• Each type of underlying asset poses a specific risk. The stocks
and commodities bear investment risk whereas the bond bear
default risk and counterparty risk.
• The performance of the underlying asset has to be monitored
periodically to reduce and curb any potential risk associated
with these assets.
 Limitations :-
• Some of the limitations are as follows.

• The value of underlying assets is dependent on the economic conditions

of the nation .if the nation is not doing very well economically then it
can cause the value of underlying assets to be decreased.
• They are always prone to information asymmetry and adverse section.
Information asymmetry tends to happen when either party involved in
the financial transactions hides potential information among
themselves that can be influence the financial deal. The adverse
selection tends to happen when the investor chooses bad and
underperforming assets for the purpose of investment.