---
title: C04 INTRODUCTION TO DERIVATIVES
description: "## OTC MARKET OTC Market is **customized**trading market which utilizes telephone & computers to make trade. **Advantage:-** Terms are not specified, hence participants have more flexibility to negotiate. **Disadvantage:-** The **credit risk is higher.** ## OPTION CONTRACT Option contract gives…"
url: "https://falconedufin.com/book/%25knowledge_base%25/book-3-fmp/c04-introduction-to-derivatives/"
updated: "2022-08-31"
category: Book 3 FMP
---

# C04 INTRODUCTION TO DERIVATIVES

## OTC MARKET

OTC Market is **customized**trading market which utilizes telephone & computers to make trade. **Advantage:-** Terms are not specified, hence participants have more flexibility to negotiate. **Disadvantage:-** The **credit risk is higher.**

## OPTION CONTRACT

Option contract gives the option buyer the right to buy (sell) an asset at the exercise price from (to) the option seller.

**Call option:** Gives  the option holder the **right to buy** the underlying asset at a specified price.

**Put option:** Gives the option holder the **right to sell** the underlying asset at a specified price.

**Payoff & profit of call option & put option**

Where X = Exercise price/ Strike price of option,

| ** ** | ** ****CALL** | **PUT** |
| --- | --- | --- |
| BUYER: Payoff Profit | MAX(0, S~T-X) MAX (0,S~T-X)-C | MAX(0,X-S~T) MAX(0,X-S~T)-P |
| SELLER: Payoff Profit | -MAX(0,S~T-X) C-MAX(0,S~T-X) | -MAX(0,X-S~T) P-MAX(0,X-S~T) |

S~T= Stock price at Maturity,

C= Call premium

P= Put premium

![](https://falconedufin.com/wp-content/uploads/2021/05/Picture2-1-300x150.png)![](https://falconedufin.com/wp-content/uploads/2021/05/Picture3-1-300x117.png)

## FORWARD CONTRACT

It is a contract between two parties to buy or to sell an asset at a specified future time at a **price agreed today.**

Payoff of long position = St - K

Payoff of short position = K - St

Where K = delivery price

## FUTURES CONTRACT

It is a more **formalized**, legally binding agreement to buy/sell a commodity/ financial instrument at a **price agreed today** but delivered and paid on a later date.

## HEDGING STRATEGIES

Hedgers use forward contracts & options to reduce or eliminate financial exposure by entering into an offsetting position.

## SPECULATIVE STRATEGIES

Speculators use derivatives to make **bets on the market.** Risk is higher than average, in return for a higher– than– average profit potential. Speculation requires limited amount of initial investment creating significant leverage.

## ARBITRAGE OPPORTUNITIES

Arbitrageurs earn a **risk-free profit** through the discovery and manipulation of **mis-priced securities**by entering into equivalent offsetting positions. Arbitrage opportunities does not last long as supply & demand forces eliminates the pricing differences.

## SOME OTHER IMPORTANT DERIVATIVE TERMS

**MARKET MAKER**: A dealer in securities or other assets who undertakes to buy  or sell at specified prices at all time.

**SPOT CONTRACT:**  An agreement to buy/sell an asset **today.**

**AMERICAN OPTIONS:** Contract can be exercised **any** time between issue date & expiration date.

**EUROPEAN OPTIONS:** Contract can be exercised **only**at the time of expiration.