Financial Derivatives

Derivative is “a substance that can be

made from another substance.” Derivatives in Finance

work on the same principle.

What Does Derivative Mean?

A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. 

The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.

Derivatives

Derivative instruments are used as financial management tools to enhance investment returns and to manage such risks relative to interest rates, exchange rates, and financial instrument and commodity prices.

Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes.

A Derivative is

An agreement between two parties (i)(between counterparties)

To transact something (ii)(an underlying asset)

At a future date (iii)

For some agreed upon price (iv)(what is the price that we will be transacting this asset for)

This agreement expires (v)

Features of derivatives

For example, a European investor purchasing shares of an American company off of an American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while holding that stock.

To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros.

Options

Futures

Forward Contracts

Swaps

Common Financial Derivatives

The purchaser of an Option has rights (but not obligations) to buy or sell the asset during a given time for a specified price (the "Strike" price). An Option to buy is known as a "Call," and an Option to sell is called a "Put. "

The seller of a Call Option is obligated to sell the asset to the party that purchased the Option. The seller of a Put Option is obligated to buy the asset.

Options are traded on organized exchanges and OTC.

Options

Although options can be written on any underlying, let’s use options on common stock as an example.

A call option on a stock gives its holder the right to buy a fixed number of shares at a given price by some future date, while a put option gives its holder the right to sell a fixed number of shares on the same terms. The specified price is called the exercise price. When the holder of an option takes advantage of her right, she is said to exercise the option. The purchase price of an option – the money that changes hands on day one – is called the option premium.

Options enable their holders to lever their resources, while at the same time limiting their risk. Suppose Smith believes that the current price of $50 for Upside Inc. stock is too low. Let’s assume that the premium on a call option that confers the right to buy shares at $50 each for six months is $10 per share. Smith can buy call options to purchase 100 shares for $1,000. She will gain from stock price increases as if she had invested in 100 shares, even though she invested an amount equal to the value of 20 shares.

With only $1,000 to invest, Smith could have borrowed $4,000 to buy 100 shares. At maturity, she would then have to repay the loan. The gain made upon exercising the option is therefore similar to the gain from a levered position in the stock – a position consisting of purchasing shares with one’s own money plus money that’s borrowed. However, if Smith borrowed $4,000, she could lose up to $5,000 plus interest if the stock price fell to zero. With the call option, the most she can lose is $1,000. But there’s no free lunch here; she’ll lose the entire $1,000 if the stock price does not rise above $50.

A Future is a contract to buy or sell a standard quantity and quality of an asset or security at a specified date and price.

Futures are similar to Forward Contracts, but are standardized and traded on an exchange, and are valued daily. The daily value provides both parties with an accounting of their financial obligations under the terms of the Future.

Futures often are settled in cash or cash equivalents, rather than requiring physical delivery of the underlying asset.

Futures

In a Forward Contract, both the seller and the purchaser are obligated to trade a security or other asset at a specified date in the future. The price paid for the security or asset may be agreed upon at the time the contract is entered into or may be determined at delivery.

Forward Contracts generally are traded OTC.

The price of the underlying asset for immediate delivery is known as the spot price.

Forward Contracts

A forward contract obligates one party to buy the underlying assets at a fixed price at a certain future date (called the maturity) from a counterparty, who is obligated to sell the underlying assets at that fixed price.

Consider a U.S. exporter who expects to receive a €100 million payment for goods in six months. Suppose that the price of the euro is $1.20 today. If the euro were to fall by 10 percent over the next six months, the exporter would lose $12 million. But by selling Euros forward, the exporter locks in the current forward exchange rate. If the forward rate is $1.18 (less than $1.20 because the market apparently expects the euro to depreciate a bit), the exporter is guaranteed to receive $118 million at maturity.

Hedging consists of taking a financial position to reduce exposure to a risk. In this example, the financial position is a forward contract, the risk is depreciation of the euro, and the exposure is €100 million in six months, which is perfectly hedged with the forward contract. Since no money changes hands when the exporter buys euros forward, the market value of the contract must be zero when it is initiated, since otherwise the exporter would get something for nothing.

Interest rate swaps occur generally in three scenarios. Exchanges of a fixed rate for a floating rate, a floating rate for a fixed rate, or a floating rate for a floating rate.

The "Swaps market" has grown dramatically. Today, Swaps involve exchanges other than interest rates, such as mortgages, currencies, and "cross-national" arrangements. Swaps may involve cross-currency payments (U.S. Dollars vs. Mexican Pesos) and cross market payments, e.g., U.S. short-term rates vs. U.K. short-term rates.

Swaps

A Swap is a simultaneous buying and selling of the same security or obligation. Perhaps the best-known Swap occurs when two parties exchange interest payments based on an identical principal amount, called the "notional principal amount."

Think of an interest rate Swap as follows: Party A holds a 10-year $10,000 home equity loan that has a fixed interest rate of 7 percent, and Party B holds a 10-year $10,000 home equity loan that has an adjustable interest rate that will change over the "life" of the mortgage. If Party A and Party B were to exchange interest rate payments on their otherwise identical mortgages, they would have engaged in an interest rate Swap.

Swaps

Derivatives are risk-shifting devices. Initially, they were used to reduce exposure to changes in such factors as weather, foreign exchange rates, interest rates, or stock indexes.

For example, if an American company expects payment for a shipment of goods in British Pound Sterling, it may enter into a derivative contract with another party to reduce the risk that the exchange rate with the U.S. Dollar will be more unfavorable at the time the bill is due and paid. Under the derivative instrument, the other party is obligated to pay the company the amount due at the exchange rate in effect when the derivative contract was executed. By using a derivative product, the company has shifted the risk of exchange rate movement to another party.

Why Have Derivatives?

risk preference: 

The attitude of an investor or decision maker to risks.

◦ Risk-averse

◦ Risk-neutral

◦ Risk-seeker

Risk Preference

Non-financial firms

Financial institutions

Individuals

Traders of Financial Derivatives

Hedgers◦ A trader who enters the futures market to

reduce some pre-existing risk exposure.

Speculators◦ A trader who enters the futures market in

pursuit of profit, accepting risk in the endeavor.

Arbitragers◦ A trader who enters the futures market to take

the advantage of the differences in the price of the same assets in two different market.

What Does Short Selling Mean?

The selling of a security that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short.

Short selling

Selling short is the opposite of going long. That is, short sellers make money if the stock goes down in price. 

This is an advanced trading strategy with many unique risks and pitfalls. Novice investors are advised to avoid short sales.

Risk and Return

Risk – variability of return, andReturn – Reward for the investment (capital gain + dividends)

The derivatives market is the financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets.

The market can be divided into two, that for exchange-traded derivatives (Organized) and that for over-the-counter derivatives (OTC)

Derivatives market

Instruments such as options, forwards, and futures are available for the purchase and sale of spot market assets such as stocks and bonds.

The price of the derivatives are related to those of the underlying spot market instruments through several important mechanisms. Like, because of its derivative status, economic effects, etc

Fundamental linkage between spot and derivative market

Spot FuturesPurchase 1 Kg Gold Purchase 1 Kg of

Gold27000 NPR/ 10 Gm 27000 NPR/ 10

Gm1Kg=2700000 NPR 75000

(Margin)Now, Now,27500 NPR/10 Gm 27500 NPR/10

GmProfit in Kg=50000 Profit in

Kg=50000Return=1.85% Return=66.67%

Spot vs Derivative Market

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