Derivatives: Forwards vs Futures

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  Before understanding what is derivative, let’s learn what is underlying asset. Underlying asset: Underlying asset can be real asset such as commodities, gold etc or financial assets such as index, interest rates etc. Derivatives: ·         These are financial instruments who value depend upon or is derived from some underlying asset. ·         A derivative does not have its own physical existence, it emerges out of contract between the buyer and seller of derivative instrument. ·         Its value depends upon the value of underlying asset. Hence returns from derivative instruments are linked to returns from underlying assets. ·         The most common underlying assets are stocks, bonds, commodities, market indices and currencies. ·         Derivatives are mainly used to control risks. They can be used to reduce risks (a process known as hedging) or to increase risks in order to enhance returns (speculation)   Classification of Derivatives: ·         Broadly we c

Can you explain Duration in layman terms?

Duration is one of the favourite question of an interviewer.

Simple answer:

Sensitivity in your portfolio value with respect to changes in your interest rate is called as Duration.

For ex: If i say that Duration of my portfolio is 5, then it means if i decrease 1% interest rate then there will be 5% increase in my portfolio value.

Now you will think how can you say whether portfolio value will increase or decrease


Ans: Simple point is that your portfolio value is the discounted value of your future cashflows.

X = y/(1+i)

so if you decrease your interest rate in this equation then the value of X will increase. Isn't it?

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Application Use: An actuary will want to know how much volatile his portfolio is due to interest rate because he has to match those assets with the liabilities. Assets and Liabilities are both present value of future cashflows in an insurance company while doing actuarial valuation. So it can be possible that decrease in your interest rate may leads to more increase in your liabilities than your assets and then it will be a problem. 

Just because of this immunisation concept into book which says that 

 

1.     Present Value of assets = Present value of Liabilities

2.     Duration of Assets = Duration of Liabilities

There is one more condition though but we will discuss that in upcoming articles.

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