Course : MSc Financial Analysis

Module: Equity / Portfolio Management

Course Code: OUpm014125
Tutor : Ziyaad Azeer, CFA

1
INTRO

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READING 56. DERIVATIVE MARKETS AND INSTRUMENTS

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L.O.S

The candidate should be able to:

a define a derivative and distinguish between exchange-traded and over-the-counter derivatives;
b contrast forward commitments with contingent claims;
c define forward contracts, futures contracts, options (calls and puts), swaps, and credit derivatives and compare their
basic characteristics;
d describe purposes of, and controversies related to, derivative markets;
e explain arbitrage and the role it plays in determining prices and promoting market efficiency.

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First Major Bubble

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Definition

A derivative is a financial instrument that derives its value from the performance of an underlying asset.

 Derivatives are similar to insurance both transfer risk from one party to another.
• Long position: the purchaser of the derivative.
• Short position: the seller of the derivative.

 Classes of derivative:
Forward commitments these instruments force the two parties to transact in the future at a previously agreed-on
price.
Contingent claims provide the right but not obligation to buy or sell the underlying at a predetermined price.

 Derivatives serves the following purposes:

• Improve the performance of the markets of underlying
• Used to create strategies.
• Trade at lower transaction costs than spot market transaction.

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The Structure Of Derivative Markets

Exchange- Over-the-
Traded Counter

ETD are standardized contracts whose terms & OTC derivative markets an informal network of
conditions are precisely specified by the exchange. market participants that are willing to create &
trade virtually any type of legal derivative.
• Clearing: process by which the exchange verifies
the execution of a transaction & record the • OTC dealers typically hedge their risk by
participant’s identities. engaging in alternative transaction.
• Settlement: process in which exchange transfer
money from one participant to another.
• Margin bond: credit guarantee by clearing house
by requiring a cash deposit.

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Types of Derivatives – Forward Commitment

Forward • an over-the-counter contract in which two parties agree that the buyer will
Contracts purchase an underlying asset from the seller at a later date & at a fixed price they
agree on.

• a standardized derivative contract created & traded on a futures exchange.

Futures

• an over the counter derivative contract in which two parties exchange a series
Swaps of cash flows.

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Types of Derivatives – Contingent Claims

• a derivative contract in which buyer, pays a sum of money to the seller & receive
Options the right to either buy or sell an underlying asset at a fixed price.

• a class of derivative contracts between two parties, a credit protection buyer & a
Credit Derivatives credit protection seller, in which the latter provides protection to the former against a
specific credit loss.

• a derivative contract in which a portfolio of debt instruments is assembled &

Asset-Backed
claims are issued on the portfolio in the form of tranches.
Securities

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Purposes and Benefits of Derivatives

Risk allocation, • derivatives allow trading the risk without trading the instruments itself.
transfer, and
management

• price discovery as futures price is sometimes thought of as predictive.

Information
discovery

• derivatives have lower transaction costs than the underlying.

Operational
advantages

• derivative markets offer less costly ways to exploit the mispricing

Market efficiency

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Criticisms and Misuse

Speculation and • speculators are thought to engage in price manipulation & to trade at extreme
gambling prices.

• the very benefit of derivatives results in an excessive amount of speculative trading

Destabilization
that brings instability to market.
and systemic risk

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Pricing and Valuation of Options

In-the-money • if the underlying > the exercise price for a call (put) option then option is in (out) the
option money.

• when the underlying is precisely at the exercise price, the option said to be at-the-
At-the-money
money.
option

Out-of-the
money • exactly opposite from in-the-money.

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