Thursday, 20 October 2011

Getting Started with Derivatives

While expressing his views in 2003, Warren Buffet had referred derivatives as weapons of mass destruction. Since it was exclaimed by Warren Buffet, his words can not be taken for granted. The complexity involved with derivatives make them bear such criticism. A brief introduction of the derivative family was there in Level I but in Level II, they are way more deeper.
Impressively while studying the pricing and valuation of forwards it was revealed that future has nothing to do with the future! Apparently it seems a vague statement but it is hard to believe that its right. As it is a convention that when forward contracts are initiated they are valued zero, the forward price is calculated by multiplying Spot price of the underlying asset with the prevailing risk free interest rates for the required time period. It implies that forward price is the function of spot price and the current, prevailing interest rates. They have nothing to do with the economic conditions or circumstances which shape up future prices. Although these events possess importance in the case of underlying assets which may produce in the coming time like wheat but for financial assets and commodities like precious metals or even currency, the forward price is a combination of spot price and prevailing risk free rates. 
There are certain forward contracts in which the forward price is either less or more than the forward price  computed through the previous discussed method, but these contracts are called off the market forward contracts. At their inception either the long pays the short or the short pays the long depending upon the side with negative value. 
Valuation in Forwards is another interesting area. Usually pricing and valuation are used interchangeably but in forwards the price refers to the future price of the underlying asset agreed today (at time= 0), valuation whereas refers to the value of the contract which is calculated by subtracting the discounted forward price of the asset for the spot price at the time of valuation, during the life of the contract or at expiration. Valuation is done for marking to the market purposes and it is business norm to value the contracts. 
Forwards are done with special conditions and involve counter-party risk. Futures whereas are standardized instruments which are marked to the market on daily basis and the gains and loss are adjusted against the initial margin. Though derivatives are complex financial instruments but the complexities seem to resolve automatically once you start understanding them.

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