Derivatives

Long and Short Position

 In the trading of assets, an investor can take two types of positions: long and short.
An investor can either buy an asset (going long) or sell it (going short).
 Long and short positions are further complicated by the two types of options: the
call and put.
 An investor may enter into a long put, a long call, a short put, or a short call.
Furthermore, an investor can combine long and short positions into complex
trading and hedging strategies
 Forwards
 Forwards are contracts which give access to a commodity at a determined price and
time somewhere in the future. A forward distinguish itself from a future that it is
traded between two parties directly without using an exchange. The absence of the
exchange results in negotiable terms on delivery, size and price of the contract.
 In contrary to futures, forwards are usually executed on maturity because they are
mostly use as insurance against adverse price movement and actual delivery of the
commodity takes place. Whereas futures are widely employed by speculators who
hope to gain profit by selling the contracts at a higher price and futures are therefore
closed prior to maturity.
 Forward Example
 Let us consider the example of a farmer who harvests a certain crop and is unsure of its
price three months down the line.. In this case, the farmer can enter into a forward
contract with a certain third party by locking in the price at which he would sell his
crop in the upcoming three months. The market for such a transaction is known as the
forward market.
 Scenario 1: After 3 months the spot rate goes up to Rs.42, customer will have a gain
of Rs.10.
 Scenario 2: After 3 months if the spot rate drops to Rs.38, customer will incur a loss
of Rs.10
 Scenario 3: After 3 months if the price is stagnant at Rs.40, neither of them incurs
any profit or loss.
 Swaps
 A currency swap contract (also known as a cross-currency swap contract) is a
derivative contract between two parties that involves the exchange of interest
payments, as well as the exchange of principal amounts in certain cases, that are
denominated in different currencies. Although currency swap contracts generally
imply the exchange of principal amounts, some swaps may require only the transfer
of the interest payments.
 In order to understand the mechanism behind currency swap contracts, let’s consider the following example.
Company A is a US-based company that is planning to expand its operations in Europe. Company A requires
€850,000 to finance its European expansion. On the other hand, Company B is a German company that
operates in the United States. Company B wants to acquire a company in the United States to diversify its
business. The acquisition deal requires US$1 million in financing Neither Company A nor Company B holds
enough cash to finance their respective projects. Thus, both companies will seek to obtain the necessary funds
through debt financing. Company A and Company B will prefer to borrow in their domestic currencies (that
can be borrowed at a lower interest rate) and then enter into the currency swap agreement with each other.

 The currency swap between Company A and Company B can be designed in the following manner. Company
A obtains a credit line of $1 million from Bank A with a fixed interest rate of 3.5%. At the same time,
Company B borrows €850,000 from Bank B with the floating interest rate of 6-month LIBOR. The companies
decide to create a swap agreement with each other.According to the agreement, Company A and Company B
must exchange the principal amounts ($1 million and €850,000) at the beginning of the transaction. In
addition, the parties must exchange the interest payments semi-annually.Company A must pay Company B the
floating rate interest payments denominated in euros, while Company B will pay Company A the fixed interest
rate payments in US dollars. On the maturity date, the companies will exchange back the principal amounts at
the same rate ($1 = €0.85).