Derivatives - Agribusiness Education and Research International

Introduction

Derivatives and Agribusiness essential to know. It is possible to describe financial engineering as the creation and innovative application of financial techniques to solve financial problems, to take advantage of investment opportunities, and to add value. Financial transactions and investment activities often entail uncertainty, especially insecurities. Financial asset fluctuations are exposed to risk. Investors, particularly dealers, are meant to hedge the risk of their financial transactions. It is also important to have a basic understanding of proper risk management tools for the investors, market makers, and financial management involved. Financial derivatives are instruments commonly used in this respect. Financial derivatives can be described as risk hedging tools involved in the purchasing, keeping, and sale of various types of financial assets, such as bonds, stocks, etc. They apply generally to financial assets/instruments for risk management resulting from the volatility existing in the financial transactions.

Therefore, financial derivatives have developed to hedge risk when dealing with financial assets in agribusiness. Since their values are derived from the underlying assets, they are generally known as derivative securities. Finally, the aim of financial derivatives is to help provide financial security for financial market participants against adverse fluctuations in the price of the underlying assets. They allow financial asset sales at or within a fixed future date at the price currently calculated. Financial derivative prices are derived from financial asset performance, interest rates, currency exchange rates, stock market indices, etc.

A financial derivative can also be characterized as a contract stating the rights and obligations on the basis of certain future events between the issuer of financial derivatives and its holder to obtain or deliver future cash flows. Some derivatives, such as options, warrants, and futures, are exchanged or transacted on organized stock markets known as exchange-traded derivatives. Some derivatives known as over-the-counter derivatives are not traded but are secretly negotiated between the parties in the organized stock exchange. Such forms of derivatives are like forwarding derivatives.

Options

An option may be defined as the right (but not the obligation) of the holder to purchase or sell, in the future, a given quantity of an asset on or before a given date at prices agreed today. The stock options that are exchanged in organized markets are similar to many corporate securities. Almost every corporate stock and bond issue has option characteristics. In addition, in terms of options, capital structure and capital budgeting decisions can be viewed. There are two types of choices: call choices and put options.

Call options

Call options to offer the holder the right, but not the duty, to purchase a certain quantity of an asset at today’s known strike price or exercise price within a sure time in the potential predicted expiration date, at prices agreed. “Investors call in” the underlying asset while exercising a call option.

Put options

Put options grant the holder the right, but not the duty, to sell, at some point in the future, at rates agreed on today, a specified amount of an asset. The investors “put” the asset to someone while exercising a put.

In an option deal, there are two parties. In the event of a call option, the investor receiving the right to purchase a certain number of shares is called the buyer. On the other hand, an investor seeking to sell a given number of shares is referred to as a seller by the buyer of the option. The option contract is initiated by the option seller and the writer of the option is called the seller. Let us take an example: Suppose a company’s current market price of a share is Tk. Huh. 200. The right to buy a share at a fixed price of Tk will be granted by a call option. 210 during the 3 months to come.

Some vocabularies

The option can only be exercised if it is profitable, otherwise, the option could be thrown away. The vocabulary linked to the choice is as follows:

Strike price:

The fixed price stated in the option contract at which the underlying asset may be purchased or sold by the option holder can be known as the strike or exercise price.

Exercising the option:

The transaction relating to the purchase or sale, under the option contract, of the underlying asset is called the exercise of the option.

Expiration date:

The day the option can be exercised on or before is called the expiry day.

American vs. European option:

An option can be known as an American option if it can be exercised on or before the date of expiration at any time. On the other hand, a European option may be identified as one which may be exercised only on the date of expiration.

Option Premium

The option premium is the amount referred to by the option as the value of the option paid by the buyer. Some variables impact the option’s premium. If the current market price is greater than the exercise price, a call option would yield a benefit for the option holder. The following outcomes may take place:

In-the-Money

The exercise price is lower than the underlying asset’s spot price, i.e. the present market price is higher than the exercise price.

At-the-Money
The exercise price shall be equal to the spot price of the underlying asset, i.e., the existing market price of the stock shall be equal to the exercise price of the attack.

Out-of-the-Money

The exercise price is higher than the underlying asset’s spot price, i.e. the stock’s current market price is lower than the exercise price.

The following words are, therefore, valid for a call option:

If S_t > E_p, the option is in the cash field,

If S_t< E_p, the alternative is to leave the cash

If S_t = E_p, the cash alternative is

Max C₀ = [S_t-E_p, 0]

For Put options:

If the option E_p > S_tis in the money,

If E_p < S_t, the option is to withdraw money

If E_p = S_t, the cash alternative is

Where to,

S_t is the value at the expiration of the stock (time t)

The exercise price is an E_P.

C₀ is the value of the option to call at expiration

If a call option is in the money, it is exercised immediately and the option holder can gain benefit. The positive cash flow or benefit incurred by the holder of the option is known as the call’s intrinsic value.

Intrinsic Value
The difference between the option’s exercise price and the underlying asset’s spot price can be defined as the intrinsic value of the call.

Speculative Value
The difference between the option premium and the intrinsic value of the option can be termed as the speculative value of the call.

Option premium = Intrinsic value + Speculative value

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