KENYATTA UNIVERSITY

DIGITAL SCHOOL OF VIRTUAL AND OPEN LEARNING

IN COLLABORATION WITH
SCHOOL E.G. SCHOOL OF PURE & APPLIED SCIENCES
DEPARTMENT: E.G. BIOCHEMISTRY DEPARTMENT

UNIT CODE & NAME: BAC 309: FINANCIAL DERIVATIVES.

WRITTEN BY: EDITED BY:

COURSE AUTHOR’S NAME COURSE AUTHOR’S NAME
Mr.Ndede, F.W. S

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Copyright © Kenyatta University, 2014
All Rights Reserved
Published By:
KENYATTA UNIVERSITY PRESS

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INTRODUCTION

This module has been developed to provide an inroduction to the area

of financial derivatives. Finamcial derivatives is a very broad field in
the wider area of financial markets. The study of financial derivatives
include activities of forward contracts, futures, options, swaps,
interest rates derivatives and derivatives in the emrging derivatives
markets.

OBJECTIVES

At the end of this cource the learners will be expected to;

1 Explain the nature of financial derivatives;
2 Understand role played by financial derivatives in the finaclal market;
3 Discuss various types of derivatives;
4 Compute interest rates and;
5 Calculate the prices and values of derivatives.

TABLE OF CONTENTS
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1.0 Introduction...........................................................................1
Place here the module contents. These are the key learning areas or
expectationsOne............................................................................2
1.1Lecture of the student after studying this module.
1.3 ...............................................................................................3
1.4.................................................................................................4

INTRODUCTION TO FINANCIAL DERIVATIVES

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 LECTURE ONE

INTRODUCTION

In this first lesson we examine the nature, role, types, functions and application of
derivatives in the financial markets. We interogate how derivatives are used in the financial
markets.

1.2 LECTURE OBJECTIVES

Objectives:
At the end of this lesson, the leaners shoud be able to:
(1) Explain the nature of financial derivatives
(2) Understand various classes of derivatives
(3) Explain the functions of derivatives

Introduction

In this lecture we examine how financial risk arises in the financial markets. Risk is a
contingent financial loss. The loss may occur as a result of changes in commodity prices,
currency exchange rates and interest rates. A farmer for example; may be faced with the

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potential fall of the price of farm produce. Surging oil prices can wipe out airlines’ profits.
Similarly, manufacturing companies may face high rising prices of commodities.

The integration of capital markets world-wide has also given rise to increased financial risk
with the frequent changes in the interest rates, currency exchange rate and stock prices. To
overcome the risk arising out of these fluctuating variables and increased dependence of
capital markets of one set of countries to the others, risk management practices have also been
reshaped by inventing new finacial instruments to mitigate the possible financial risks.

Nature and Role of Derivatives

The best point to start exlaining the nature and role of a subject is the definition. Financial
market has witnest several changes in the recent past. The notable changes are technological
advancement in computers and telecommunication and globalization in the banking industry
and trade. These changes and others have resulted into increased competition and
deregulation. The changes also have brought abaut challenges of control as indivdual nations
are unwilling to let go the control of thei monetary policies.

Activity 1.1

So what is a financisl derivative?

The other change in the financial market is the increase in the use of financial derivatives. The
market for derivatives has grown faster than any other market in recent years, providing
corporations with new opportunities but at the same time exposing the corporations to new
risks.The term financial derivative is used to denote a special type of contract for which the

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value is derived from the performance of an underlying entity. Derivative is a product whose
value is derived from the value of one or more basic variable in a contractual manner. The
variables upon which the value is derived are called bases.The term derivative imply that the
commodity has no jndependent value but a value entirely derived from the value of another
asset. The underlying entity can be an asset, index, interest rate, security, currency, any
commodity or livestock and is often called the underlying asset. For example, the value of
Japanese yen “future”is to be based on the exchange rate between yen and another currency
like US dollar. Any financial asset whose value is derived from another asset is a financial
derivative. The price of this derivative is driven by the spot price of wheat which is the
"underlying".
The definitions acknowleges that financial derivatives exist for some purpose, and that they
help individuals and firms to benefit from their use particularly those directly engage in
derivative activities. It can be rightly assumed that derivatives exist for earning money. While
that is true, it does not represent an end to the role of financial derivatives. To understand the
role of derivatives, we examine how the use of derivatives by some firms can benefit
individuals and firms other than those who directly participate in derivative activities. Thus
the role of derivatives in the commodities markets include;
 Facilitating risk transfer
 Serving as agents for price discovery
 Promoting efficient allocation of resources
 Enhancing opportunities for investors to access alternative asset portfolios and;
 Reducing underinvestment problems by creating avenues for asset based financing.

Though there has been a long standing concern the social cost of financial derivatives, they
have remained the most prevalent financial instruments in the global financial market. The
instruments have been used successfully by many institutions among them, financial
institutions, non-financial institutions, asset managers, and government sponsored enterprises
in their commercial, finance and risk management activities. Financial derivatives can be used
for a number of purposes.The use of derivatives include among other things;

(a) Insuring against price movements (hedging). Derivatives can be used either to reduce
risk or for speculation. In international businesses, investors often experice fluctuation
in prices. This would usually affect the investors’ income. In such circumstances, the

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 ivestors would reduce their risks by hedging. Hedging operation involves purchasing
the derivatives that increase in value whenever the value of the other currency falls.
For example, a Japanese importer finds that business income tends to fall whever the
dollar value falls. The importer would reduce the risk by purchasing derivatives that
increase in value whenever the dollar value decreases.

(b) Increasing exposure to price movements for speculation.Expectation of high

future returns also expoese a business venture to new risks.

(c) Getting access to otherwise hard to trade assets or markets.

Participants in Derivatives Market

Derivatives seek to satisfy the needs of a wide range of participants.In relation to particular
commodities market there are various participants who would likely have interest in
derivative markets.

Activity 1.2

Why do each idenyified user need financial derivatives?

The way the identified user groups use derivatives include;

1. Hedgers:
They use derivatives markets to reduce or eliminate the risk associated with price
of an asset. Majority of the participants in derivatives market belongs to this category
2. Speculators:

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 3They transact futures and options contracts to get extra leverage in betting on future
movements in the price of an asset. They can increase both the potential gains and
potential losses by usage of derivatives in a speculative venture.
4 Arbitrageurs:
Their behaviour is guided by the desire to take advantage of a discrepancy between
prices of more or less the same assets or competing assets in different markets. If, for
example, they see the futures price of an asset getting out of line with the cash price,
they will take offsetting positions in the two markets to lock in a profit.

Activity 1.3

What are the common underlying assets for derivatives?

The common underlying asset can be equity, forex, commodity or any other asset. For
example, a wheat farmer may wish to sell the harvest at a future date to eliminate the risk of a
change in prices by that date. Such a transaction is an example of a derivative.
The price of this derivatives is driven by the spot price of wheat which is the "underlying".
The value of a derivative instrument depends upon the underlying asset. The underlying
assets may assume many forms. The common underlying assets for derivatives are:
i. Commodities including grain, coffee beans, Wheat;
ii. Precious metals like gold and silver;
iii. Foreign exchange rates or currencies;
iv. Bonds of different types, including medium to long term negotiable debt securities issued
by governments, companies, etc.
v. Shares and share warrants of companies traded on recognized stock exchanges and Stock
Index

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vi. Short term securities such as T-bills; and
vii. Over- the Counter (OTC) money market products such as loans or deposits.
Table 1.1 : Examples of Derivatives and the underlying assets

Example Underlying Assets

Stock option, such as option on the A stock, such as the stock of Kengen
stock of Kengen
Stock index option, such as an option A portfolio of stocks, such as the portfolio of stocks
on the NSE 20 index, S&P 100 index comprising the NSE 20 index S&P 100 index
Treasury bill futures contract A Treasury bill

Foreign currency forward contract A foreign currency

Gold futures contract Gold

Futures option on gold A gold futures contract

Weather derivative rainfall at a specified site

Classification of Financial derivatives

There are several ways of classifiying derivatives.
Derivatives are commonly classified into four groups that is.
(a) According to trading location
(b) According to underlying asset
(c) According to type of Derivative products
(d) According to the rights of parties in derivative contracts

(b) Classification According to the Underlying Asset

Commodity Derivatives
In commodity derivatives, the underlying asset is a commodity. It can be agricultural
commodity like wheat, soybeans, oil, cotton etc. or precious metals like gold, silver etc.
Financial derivatives. The term financial derivative denotes a variety of financial
instruments including stocks, bonds, treasury bills, interest rate, foreign currencies and other

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hybrid securities. Financial derivatives include futures, forwards, options, swaps, etc. Futures
contracts are the most important form of derivatives, which were in existence long before the
term ‘derivative’ was coined. Financial derivatives can also be derived from a combination of
cash market instruments or other financial derivative instruments table 1.1.
Table 1.1 Classification of derivatives based on the instrument
based on instruments
commodity financial
 Futures  forwards
 options  futures
 forwards  options
 swaps

Difference between Commodity and Financial Derivatives: The basic concept of a derivative
contract remains the same whether the underlying happens to be a commodity or a financial
asset. However there are some features, which are very peculiar to commodity derivative
markets. In the case of financial derivatives, most of these contracts are cash settled. Even in
the case of physical settlement, financial assets are not bulky and do not need special facility
for storage. Due to the bulky nature of the underlying assets, physical settlement in
commodity derivatives creates the need for warehousing. Similarly, the concept of varying
quality of asset does not really exist as far as financial underlying is concerned. However in
the case of commodities, the quality of the asset underlying a contract can vary largely. This
becomes an important issue to be managed. We have a brief look at these issues.
Physical Settlement - Physical settlement involves the physical delivery of the underlying
commodity, typically at an accredited warehouse. The seller intending to make delivery
would have to take the commodities to the designated warehouse and the buyer intending to
take delivery would have to go to the designated warehouse and pick up the commodity. This
may sound simple, but the physical settlement of commodities is a complex process. The
issues faced in physical settlement are enormous. There are limits on storage facilities in
different states. There are restrictions on interstate movement of commodities. Besides state
level octroi and duties have an impact on the cost of movement of goods across locations.

Warehousing - One of the main differences between financial and commodity derivatives is
the need for warehousing. In case of most exchange traded financial derivatives, all the
positions are cash settled. Cash settlement involves paying up the difference in prices between
the time the contract was entered into and the time the contract was closed In case of

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commodity derivatives however, there is a possibility of physical settlement. Which means
that if the seller chooses to hand over the commodity instead of the difference in cash, the
buyer must take physical delivery of the underlying asset. This requires the exchange to make
an arrangement with warehouses to handle the settlements. The efficacy of the commodities
settlements depends on the warehousing system available. Most international commodity
exchanges used certified warehouses (CWH) for the purpose of handling physical settlements.
Such CWH are required to provide storage facilities for participants in the commodities
markets and to certify the quantity and quality of the underlying commodity. The advantage
of this system is that a warehouse receipt becomes a good collateral, not just for settlement of
exchange trades but also for other purposes too.
Quality of Underlying Assets - A derivatives contract is written on a given underlying.
Variance in quality is not an issue in case of financial derivatives as the physical attribute is
missing. When the underlying asset is a commodity, the quality of the underlying asset is of
prime importance. There may be quite some variation in the quality of what is available in the
marketplace. When the asset is specified, it is therefore important that the exchange stipulate
the grade or grades of the commodity that are acceptable. Commodity derivatives demand
good standards and quality assurance/certification procedures. A good grading system allows
commodities to be traded by specification.

(a) Classification According to trading location : Exchange-Traded Vs. O.T.C

Derivatives Markets
Derivatives can also be classified according to trading location. As the word suggests,
derivatives that trade on an exchange are called exchange traded derivatives global examples
include ( Chicago Rice and Cotton Exchange, the New York Futures Exchange, the London
International Financial Futures Exchange, the Toronto Futures Exchange and the Singapore
International Monetary Exchange, Johannesburg securities exchange for futures and
options ), derivatives can be bought and sold . During 1980’s, markets developed for options
in foreign exchange, whereas privately negotiated derivative contracts are called OTC
contracts. The OTC derivatives markets have witnessed rather sharp growth over the last few
years, which has accompanied the modernization of commercial and investment banking and
globalisation of financial activities. The recent developments in information technology have
contributed to a great extent to these developments. While both exchange-traded and OTC

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derivative contracts offer many benefits, the former have rigid structures compared to the
latter.

The OTC is a telephone and computer linked network of financial institutions, fund
managers and corporate managers and corporate treasurers where two participants can
enter into any mutually acceptable contract. An exchange-traded market is a market
organised by an exchange where traders either meet physically or communicate
electronically nd the contracts that can be traded have been define on the exchange.
When a market maker quotes a bid and an offer, the bid is the price at which the
market maker is prepared to buy and the offer is the price at which the market maker
is prepared to sell

The OTC derivatives markets have the following features compared to exchange traded
derivatives:
1. The management of counter-party (credit) risk is decentralized and located within
individual institutions,
2. There are no formal centralized limits on individual positions, leverage, or margining,
3. There are no formal rules for risk and burden-sharing,
4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for
safeguarding the collective interests of market participants, and
5. The OTC contracts are generally not regulated by a regulatory authority and the exchange's
self-regulatory organization, although they are affected indirectly by national legal systems,
banking supervision and market surveillance.

Features of Exchange-traded derivatives

• They are standardized instruments with respect to certain terms and
conditions of the contract.

• They trade in accordance with rules and specifications prescribed by

the derivatives exchange and are usually subject to governmental
regulation.

• They are guaranteed by the exchange against loss resulting from the
default of one of the parties

• Over-the-counter (OTC) derivatives are contracts that are traded

directly between two parties, without going through an exchange or
other intermediary. Products such as swaps, forward rate agreements,
and exotic options are almost always traded in this way.Over-the-
counter derivatives are transactions created by any two parties off a
derivatives exchange.

• They don't have standardized

13 terms and features. The parties set all of
their own terms and conditions.
 (b) Classification According to the Underlying Asset
According to the underlying asset (instrument), derivatives are further classified into
commodity and financial derivatives.
Commodity Derivatives
In commodity derivatives, the underlying asset is a commodity. It can be agricultural
commodity like wheat, soybeans, oil, cotton etc. or precious metals like gold, silver etc.
Financial derivatives. The term financial derivative denotes a variety of financial
instruments including stocks, bonds, treasury bills, interest rate, foreign currencies and other
hybrid securities. Financial derivatives include futures, forwards, options, swaps, etc. Futures
contracts are the most important form of derivatives, which were in existence long before the
term ‘derivative’ was coined. Financial derivatives can also be derived from a combination of
cash market instruments or other financial derivative instruments table 1.1.

Table 1.1 Classification of derivatives based on the instrument

based on instruments
commodity financial
 Futures  forwards
 options  futures
 forwards  options
 swaps

Difference between Commodity and Financial Derivatives: The basic concept of a derivative
contract remains the same whether the underlying happens to be a commodity or a financial
asset. However there are some features, which are very peculiar to commodity derivative
markets. In the case of financial derivatives, most of these contracts are cash settled. Even in
the case of physical settlement, financial assets are not bulky and do not need special facility
for storage. Due to the bulky nature of the underlying assets, physical settlement in

14
commodity derivatives creates the need for warehousing. Similarly, the concept of varying
quality of asset does not really exist as far as financial underlying is concerned. However in
the case of commodities, the quality of the asset underlying a contract can vary largely. This
becomes an important issue to be managed. We have a brief look at these issues.

Physical Settlement - Physical settlement involves the physical delivery of the underlying
commodity, typically at an accredited warehouse. The seller intending to make delivery
would have to take the commodities to the designated warehouse and the buyer intending to
take delivery would have to go to the designated warehouse and pick up the commodity. This
may sound simple, but the physical settlement of commodities is a complex process. The
issues faced in physical settlement are enormous. There are limits on storage facilities in
different states. There are restrictions on interstate movement of commodities. Besides state
level octroi and duties have an impact on the cost of movement of goods across locations.

Warehousing - One of the main differences between financial and commodity derivatives is
the need for warehousing. In case of most exchange traded financial derivatives, all the
positions are cash settled. Cash settlement involves paying up the difference in prices between
the time the contract was entered into and the time the contract was closed In case of
commodity derivatives however, there is a possibility of physical settlement. Which means
that if the seller chooses to hand over the commodity instead of the difference in cash, the
buyer must take physical delivery of the underlying asset. This requires the exchange to make
an arrangement with warehouses to handle the settlements. The efficacy of the commodities
settlements depends on the warehousing system available. Most international commodity
exchanges used certified warehouses (CWH) for the purpose of handling physical settlements.
Such CWH are required to provide storage facilities for participants in the commodities
markets and to certify the quantity and quality of the underlying commodity. The advantage
of this system is that a warehouse receipt becomes a good collateral, not just for settlement of
exchange trades but also for other purposes too.
Quality of Underlying Assets - A derivatives contract is written on a given underlying.
Variance in quality is not an issue in case of financial derivatives as the physical attribute is
missing. When the underlying asset is a commodity, the quality of the underlying asset is of
prime importance. There may be quite some variation in the quality of what is available in the
marketplace. When the asset is specified, it is therefore important that the exchange stipulate
the grade or grades of the commodity that are acceptable. Commodity derivatives demand

15
good standards and quality assurance/certification procedures. A good grading system allows
commodities to be traded by specification.
(c)Classification According Derivative Products
Derivative contracts have several variants. The most common variants are forwards, futures,
options and swaps. Generally derivatives may be classified as on figure 1.1.

Figure 1.1Classification according to rights and commitments

Contingent claims are derivatives in which the payoffs occur if a specific event happens. A
contingent claim is a derivative contract with a payoff dependent on the occurrence of a future
event. It can be either exchange-traded or over-the-counter
The primary types of contingent claims are options. The payoff of an option is contingent on
the occurrence of an event.

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(d)Classification According to the rights of parties in a Derivative contract
Derivatives are classified also based on the rights and obligations of the parties that enter into
the contract. Under this category, derivatives can be classified into two groups namely:
• forward commitments
• contingent claims
Forward commitments: These are contracts in which the two parties enter into an agreement
to engage in a transaction at a later date at a price established at the start.
A forward commitment is an agreement between two parties in which one party agrees to buy
and the other agrees to sell an asset at a future date at a price agreed on today. In essence, a
forward commitment represents a commitment to buy or sell. Examples are;
• Forward contracts;
• Future contracts and;
• Swaps

Uses of Financial Derivatives

Firms are regularly affected by risks related to interest rates, stock prices and exchange rate
fluctuations in financial markets. Investors use various ways in trying to mitigate those risks.
The common way investors use is holding a broadly diversified portfolio of stocks and debt
securities of varied maturities. In addition, investors can use derivatives to reduce risks
associated with financial and commodity markets. Due to the benefits of using derivatives,
many large compaies especialy in the US use derivatives. Hedging is the most important
example of the use of derivatives. Infact, investors and analysts nowadays demand that firms
use derivatives to hedge certain risks. As a result shareholders now demand for the use of
derivatives and can sue for failure by companies to properly hedge against foreign exchange
exposure. There are several possible uses of derivatives.

1) Hedge or mitigate risk in the underlying asset, by entering into a derivative contract whose
value moves in the opposite direction to their underlying position and cancels part or all of
it out
2) Create option ability where the value of the derivative is linked to a specific condition or
event (e.g. the underlying reaching a specific price level)
3) Obtain exposure to the underlying where it is not possible to trade in the underlying (e.g.
weather derivatives)

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4) Provide leverage (or gearing), such that a small movement in the underlying value can
cause a large difference in the value of the derivative
5) Speculate and make a profit if the value of the underlying asset moves the way they
expect (e.g. moves in a given direction, stays in or out of a specified range, reaches a
certain level)
6) Switch asset allocations between different asset classes without disturbing the underlining
assets, as part of transition management
7) Avoid paying taxes. For example, an equity swap allows an investor to receive steady
payments, e.g. based on LIBOR rate, while avoiding paying capital gains tax and keeping
the stock.
8) Lock in an arbitrage profit -Taking advantage of two or more securities being mispriced
relative to each other.
9) Change the nature of a liability
10) Change the nature of an investment without incurring the costs of selling one portfolio and
buying another.

Suppose that a farmer grows wheat and a baker makes bread using wheat and other
ingredients. If the price of the wheat decreases, the farmer loses money. If the price of the
wheat increases, the baker loses money. In order to avoid possible financial losses which
may jeopardy their businesss profitability, the farmer and the baker can agree to sell/buy
wheat one year from now at a certain price.
The contract they enter is a derivative. It is a win–win contract for both of them. The two
risks are diversifiable.
Usually, the contract is not made directly between them. A market–maker or scalper
makes a contract with the farmer and another with the baker. The farmer and the baker
enter into this contract to do hedging.

(Scalpers) Market–makers buy/sell stock and derivatives making transactions possible.

Usually, scalpers are financial institutions.
In order to make a living, scalpers buy low and sell high. The price at which the scalper
buys is called the bid price. The bid price of an asset is the price at which a scalper takes
bids for an asset (a bid is an offer). The price at which the scalper sells is called the offer
price or ask price.
The bid price is lower than the offer price. The difference between the bid price and the
offer price is called the bid–ask spread.

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 When some one owns an asset, he has a long position in this asset. Later, he may sell the
asset and receive cash. Buying an asset means to make an investment. Buying an asset is
like lending money.
When some one needs to buy an asset in the future, it is said that this person has a short
position in the asset.

Summary
In this lesson, we have considered the role and nature of derivatives. We have discussed abaut
those participate in derivative activities. Also in this lesson, we have considered the
underlying assets. It is important that we note the various classes of derivatives and also the
uses of derivatives in both the commodity and financial markets.

Suggested Further Readings

For further readings, I recommend the following books:
Brigham, E.F. and Houston, F. J., Fundamentals of Financial Management 10th Ed Saurabh
Printers Pvt ltd 2004.

Review Questions--------------------------------------------------------------------------

1 What is a derivative?

1 What the underlying asset?

2 Distinquish between commodity and financial markets.

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 Place here the lecture activities, forming the body of this
module. Use the lecture guidelines given in the accompanying
template to create your lectures and paste them here to replace this
section.

LECTURE TWO: FORWARD CONTRACTS

INTRODUCTION

In this lesson two we consider the meaning, characterestics of forward markets; arbitrage,
features, hedging, speculation, swapping, forward rate aggreements and forward rate
differentials.

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LECTURE OBJECTIVES

At the end of this lesson, the leaners shoud be able to:

(1) Explain the nature of forward contracts
(2) Discuss the characterestics of forward markets
(3) Determine forward rates
(4) Find out the forward rate differentials

Some basic definations

A Commercial bank is a financial institution and a financial intermediary that accepts

deposits and channels those deposits into lending activities, either directly by loaning or
indirectly through capital markets and subject to minimum capital requirements based on an
international set of capital standards, known as the Basel Accords.

An Investment bank is a financial institution that assists individuals, corporations, and

governments in raising capital by underwriting or acting as the client's agent in the issuance of
securities (or both). An investment bank may also assist companies involved in mergers and
acquisitions and provide ancillary services such as market making, trading of derivatives and
equity securities, and FICC services (fixed income instruments, currencies, and
commodities).Unlike commercial banks and retail banks, investment banks do not take
deposits As part of the Dodd-Frank Act 2010, Volcker Rule asserts full institutional
separation of investment banking services from commercial banking.There are two main lines
of business in investment banking. Trading securities for cash or for other securities (e.g.
facilitating transactions, market-making), or the promotion of securities (e.g. underwriting,
research, etc.) An investment bank can also be split into private and public functions with an
information barrier which separates the two to prevent information from crossing. The private
areas of the bank deal with private insider information that may not be publicly disclosed,
while the public areas such as stock analysis deal with public information. These banks are
ones that are relevant and will be used in the course of studying financial derivatives. An

21
advisor who provides investment banking services in Kenya must be a licensed broker-dealer
and subject to Capital Market Authority (CMA).

A boutique investment bank is a non-full service investment bank that specializes in some
aspect of investment banking, generally corporate finance, capital raising, mergers and
acquisitions and restructuring and reorganizations as their primary activities. Due to their
smaller size, capital raising engagements are usually done on a best-efforts basis. As larger
investment banks were hit hard by the Great Recession of the 2000s, many senior bankers left
to join boutiques, some of which largely resemble the partnerships that ruled Wall Street in
the 1970s and 1980s. Boutique investment banks took a greater share of the M&A and
advising market at the same time. There are many boutique investment banks, both in the U.S.
and internationally. Large, prestigious boutique firms include The Blackstone Group, Brown
Brothers Harriman, Piper Jaffray, Mesirow Financial, Charles Schwab and William Blair &
Company.While these may be national in scale, they are not international and full-service as
are the so-called bulge bracket firms.

The Volcker Rule is a rule that to restrict U.S. banks from making certain kinds of
speculative investments that do not benefit their customers. Volcker argued that such
speculative activity played a key role in the financial crisis of 2007–2010. The rule is often
referred to as a ban on proprietary trading by commercial banks, whereby deposits are used to
trade on the bank's own accounts, although a number of exceptions to this ban were included
in the Dodd-Frank law.

Insider trading is the trading of a public company's stock or other securities (such as bonds
or stock options) by individuals with access to non-public information about the company. In
various countries insider trading based on inside information is illegal. This is because it is
seen as unfair to other investors who do not have access to the information

Fungibility is the property of a good or a commodity whose individual units are capable of
mutual substitution, such as crude oil, shares in a company, bonds, precious metals, or
currencies. It refers only to the equivalence of each unit of a commodity with other units of
the same commodity. Fungibility does not describe or relate to any exchange of one
commodity for some other, different commodity.

22
As an example: if Jennifer lends Metrine one Shs. 1000/= in a one Kshs 1000 Note
denomination, she does not care if she is repaid with the same one Shs 1000/= Note ; 2 Shs
500/=, 5 Shs 200, 10 Shs 100, 20 Shs 50 note denomination or a bunch of 50 20 shilling coins
because currency is fungible (noting that, in practice, some denominations might incur
additional operational or processing costs). However, if metrine borrows Jennifer’s car she
will most likely be upset if Metrine returns a different vehicle--even a vehicle that is the same
make and model--as automobiles are not fungible with respect to ownership. However,
gasoline is fungible and though Jennifer may have a preference for a particular brand and
grade of gasoline, her primary concern may be that the level of fuel be the same (or more) as
it was when she lent the vehicle to Metrine.

The word comes from Latin fungibilis from fungi, meaning "to perform", related to "function"
and "defunct".

Fungibility versus liquidity

Fungibility is different from liquidity. A good is liquid if it can be easily exchanged for
money or another different good. A good is fungible if one unit of the good is substantially
equivalent to another unit of the same good of the same quality at the same time and place.
Examples:
 Cash is fungible: one Kshs100, bank note is interchangeable with another. It is also
interchangeable with two Kshs 50s, ten Kshs10s, 5 Kshs 20s and other combinations.
 Different issues of a government bond (maybe issued at different times) are fungible
with one another if they carry precisely the same rights and any of them is equally
acceptable in settlement of a trade.
 Diamonds are not perfectly fungible because diamonds' varying cuts, colors, grades,
and sizes make it difficult to find many diamonds with the same cut, color, grade, and
size.
 Packaged products on a retail shelf are fungible if they are of the same type.
Customers and clerks can interchange packages freely until purchase, and sometimes
afterward. When the customer opens the package and uses the product, however, it is
usually considered unique and no longer interchangeable with unopened packages
unless there is some customer service issue, such as a return or exchange. Even then,
the customer might consider a swap with a trusted friend who also buys the same
product.

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Fungibility does not imply liquidity, and liquidity does not imply fungibility. Diamonds can
be readily bought and sold (the trade is liquid) but individual diamonds, being unique, are not
interchangeable (diamonds are not fungible).

A commodity is a marketable item produced to satisfy wants or needs. Economic

commodities comprise goods and services.

An interest rate cap is a derivative in which the buyer receives payments at the end of each
period in which the interest rate exceeds the agreed strike price. An example of a cap would
be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%.
Similarly an interest rate floor is a derivative contract in which the buyer receives payments
at the end of each period in which the interest rate is below the agreed strike price.
Caps and floors can be used to hedge against interest rate fluctuations. For example a
borrower who is paying the LIBOR rate on a loan can protect himself against a rise in rates by
buying a cap at 2.5%. If the interest rate exceeds 2.5% in a given period the payment received
from the derivative can be used to help make the interest payment for that period, thus the
interest payments are effectively "capped" at 2.5% from the borrowers point of view.

Libor-The Libor gets its name from the London Interbank Offered Rate, from the City of
London, one of the largest financial centres in the world.

The London Interbank Offered Rate is the average interest rate estimated by leading banks
in London that they would be charged if borrowing from other banks. It is usually abbreviated
to Libor/ˈlaɪbɔr/ or LIBOR, or more officially to BBA Libor (for British Bankers'
Association Libor) or the trademark bbalibor. It is the primary benchmark, along with the
Euribor, for short term interest rates around the world. Libor rates are calculated for ten
currencies and fifteen borrowing periods ranging from overnight to one year and are
published daily at 11:30 am (London time) by Thomson Reuters, or 5.30 PM Kenyan time.
Many financial institutions, mortgage lenders and credit card agencies set their own rates
relative to it. At least $350 trillion in derivatives and other financial products are tied to the
Libor.

24
A collar is an option strategy that limits the range of possible positive or negative returns on
an underlying to a specific range.
Strike price (or exercise price) of an option is the fixed price at which the owner of the
option can buy (in the case of a call), or sell (in the case of a put), the underlying security or
commodity.

The strike price is a key variable in a derivatives contract between two parties. Where the
contract requires delivery of the underlying instrument, the trade will be at the strike price,
regardless of the spot price (market price) of the underlying instrument at that time. For
example, an IBM May 50 Call has a strike price of $50 a share. When the option is exercised,
the owner of the option will buy 100 shares of IBM stock for $50 per share.

Moneyness is the value of a financial contract if the contract settlement is financial. More
specifically, it is the difference between the strike price of the option and the current trading
price of its underlying security.In options trading, terms such as in-the-money, at-the-money
and out-of-the-money describe the moneyness of options.
 A call option is in-the-money if the strike price is below the market price of the
underlying stock.
o A put option is in-the-money if the strike price is above the market price of the underlying
stock.
 A call or put option is at-the-money if the stock price and the exercise price are the same
(or close).
 A call option is out-of-the-money if the strike price is above the market price of the
underlying stock.
o A put option is out-of-the-money if the strike price is below the market price of the
underlying stock.

A hedge is an investment position intended to offset potential losses/gains that may be

incurred by a companion investment.A hedge can be constructed from many types of financial
instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps,
options, many types of over-the-counter and derivative products, and futures contracts.

A coupon payment on a bond is a periodic interest payment that the bondholder receives
during the time between when the bond is issued and when it matures.
25
The Stackelberg leadership model is a strategic game in economics in which the leader firm
moves first and then the follower firms move sequentially. In game theory terms, the players
of this game are a leader and a follower and they compete on quantity. The Stackelberg leader
is sometimes referred to as the Market Leader.

A spot contract, spot transaction, or simply spot, is a contract of buying or selling a

commodity, security or currency for settlement (payment and delivery) on the spot date,
which is normally two business days after the trade date. The settlement price (or rate) is
called spot price (or spot rate). A spot contract is in contrast with a forward contract or
futures contract where contract terms are agreed now but delivery and payment will occur at a
future date.

Normal backwardation, also sometimes called backwardation, is the market condition

wherein the price of a forward or futures contract is trading below the expected spot price at
contract maturity. The opposite market condition to normal backwardation is known as
contango. Similarly, in practice the term may be used to refer to "negative basis" where the
current spot price is below the future price.

Contango is a situation where the futures price (or forward price) of a commodity is higher
than the expected spot price. In a contango situation hedgers (commodity producers and
commodity users) or arbitrageurs/speculators (non-commercial investors), are "willing to pay
more for a commodity at some point in the future than the actual expected price of the
commodity. This may be due to people's desire to pay a premium to have the commodity in
the future rather than paying the costs of storage and carry costs of buying the commodity
today."

Interest rate parity is a no-arbitrage condition representing an equilibrium state under which
investors will be indifferent to interest rates available on bank deposits in two countries. The
fact that this condition does not always hold allows for potential opportunities to earn riskless
profits from covered interest arbitrage. Two assumptions central to interest rate parity are
capital mobility and perfect substitutability of domestic and foreign assets. Given foreign
exchange market equilibrium, the interest rate parity condition implies that the expected
return on domestic assets will equal the exchange rate-adjusted expected return on foreign
26
currency assets. Investors cannot then earn arbitrage profits by borrowing in a country with a
lower interest rate, exchanging for foreign currency, and investing in a foreign country with a
higher interest rate, due to gains or losses from exchanging back to their domestic currency at
maturity.

A clearing house is a financial institution that provides clearing and settlement services for
financial and commodities derivatives and securities transactions.

Financial market
Introduction
A financial market is a market in which people and entities can trade financial securities,
commodities, and other fungible items of value at low transaction costs and at prices that
reflect supply and demand. Securities include stocks and bonds, and commodities include
precious metals or agricultural goods.

There are both general markets (where many commodities are traded) and specialized markets
(where only one commodity is traded). Markets work by placing many interested buyers and
sellers, including households, firms, and government agencies, in one "place", thus making it
easier for them to find each other..

Financial markets facilitate:

 The raising of capital (in the capital markets)
 The transfer of risk (in the derivatives markets)
 Price discovery
 Global transactions with integration of financial markets
 The transfer of liquidity (in the money markets)
 International trade (in the currency markets)

Constituents of Financial Market.

Based on market levels

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  Primary market: Primary market is a market for new issues or new financial claims.
Hence it’s also called new issue market. The primary market deals with those
securities which are issued to the public for the first time.
 Secondary market: It’s a market for secondary sale of securities. In other words,
securities which have already passed through the new issue market are traded in this
market. Generally, such securities are quoted in the stock exchange and it provides a
continuous and regular market for buying and selling of securities.

Based on security types

 Money market: Money market is a market for dealing with financial assets and
securities which have a maturity period of up to one year. In other words, it’s a market
for purely short term funds.
 Capital market: A capital market is a market for financial assets which have a long or
indefinite maturity. Generally it deals with long term securities which have a maturity
period of above one year. Capital market may be further divided into: (a) industrial
securities market (b) Govt. securities market and (c) long term loans market.
o Equity markets: A market where ownership of securities are issued and
subscribed is known as equity market. An example of a secondary equity
market for shares is the Bombay stock exchange.
o Debt market: The market where funds are borrowed and lent is known as debt
market. Arrangements are made in such a way that the borrowers agree to pay
the lender the original amount of the loan plus some specified amount of
interest.

 Derivative markets: to be discussed in the preceeding chapters in greater detail

 Financial service market: A market that comprises participants such as commercial

banks that provide various financial services like ATM. Credit cards. Credit rating,
stock broking etc. is known as financial service market. Individuals and firms use
financial services markets, to purchase services that enhance the working of debt and
equity markets.
 Depository markets: A depository market consist of depository institutions that
accept deposit from individuals and firms and uses these funds to participate in the

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 debt market, by giving loans or purchasing other debt instruments such as treasure
bills.
 Non-Depository market: Non-depository market carry out various functions in
financial markets ranging from financial intermediary to selling, insurance etc. The
various constituency in non-depositary markets are mutual funds, insurance
companies, pension funds, brokerage firms etc.

Investment decisions

The objective of an investment decision is to get required rate of return with minimum risk.
To achieve this objective, various instruments, practices and strategies have been devised and
developed in the recent past. With the opening of boundaries for international trade and
business, the world trade gained momentum in the last decade, the world has entered into a
new phase of global integration and liberalisation. The integration of capital markets world-
wide has given rise to increased financial risk with the frequent changes in the interest rates,
currency exchange rate and stock prices. To overcome the risk arising out of these fluctuating
variables and increased dependence of capital markets of one set of countries to the others,
risk management practices have also been reshaped by inventing such instruments as can
mitigate the risk element. These new popular instruments are known as financial derivatives
which, not only reduce financial risk but also open us new opportunity for high risk takers.

A derivative is a financial contract which derives its value from the performance of another
entity such as an asset, index, or interest rate, called the "underlying". Derivatives are one of
the three main categories of financial instruments, the other two being equities (i.e. stocks)
and debt (i.e. bonds and mortgages).

Features of financial derivatives

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It is a contract: Derivative is defined as the future contract between two parties. The future
period may be short or long depending upon the nature of contract, for example, short term
interest rate futures and long term interest rate futures contract.

Derives value from underlying asset: Value of derivatives depends upon the value of
underlying instrument and which changes as per the changes in the underlying assets, and
sometimes, it may be nil or zero. Hence, they are closely related.

Specified obligation: Counter parties have specified obligation under the derivative contract
as long or short
Direct or exchange traded: Derivatives contracts can be undertaken directly between the
two parties or through the particular exchange like financial futures contracts. The exchange-
traded derivatives are quite liquid and have low transaction costs in comparison to tailor-made
contracts. Example of exchange traded derivatives such as Dow Jons, S&P 500, Nikki 225,
NIFTY option, S&P Junior that are traded on New York Stock Exchange, Tokyo Stock
Exchange, National Stock Exchange, Bombay Stock Exchange and so on.

Related to notional amount: Financial derivatives are carried off-balance sheet. The size of
the derivative contract depends upon its notional amount. The notional amount is the amount
used to calculate the payoff. For instance, in the option contract, the potential loss and
potential payoff, both may be different from the value of underlying shares, because the
payoff of derivative products differ from the payoff that their notional amount might suggest.

Delivery of underlying asset not involved: Usually, in derivatives trading, the taking or
making of delivery of underlying assets is not involved, rather underlying transactions are
mostly settled by taking offsetting positions in the derivatives themselves.
May be used as deferred delivery: Derivatives are also known as deferred delivery or
deferred payment instruments. It means that it is easier to take short or long position in
derivatives in comparison to other assets or securities.
Secondary market instruments: Derivatives are mostly secondary market instruments and
have little usefulness in mobilizing fresh capital by the corporate world, however, warrants
and convertibles are exception in this respect.

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Exposure to risk: They expose the trading parties to operational risk, counter-party risk and
legal risk. Further, there may also be uncertainty about the regulatory status of such
derivatives.

Off balance sheet item: The derivative instruments, sometimes, because of their off-balance
sheet nature, can be used to clear up the balance sheet. For example, a fund manager who is
restricted from taking particular currency can buy a structured note whose coupon is tied to
the performance of a particular currency pair.

Uses or functions of derivatives

Derivatives are used for the following:

11) Hedge or mitigate risk in the underlying, by entering into a derivative contract whose
value moves in the opposite direction to their underlying position and cancels part or all of
it out
12) Create option ability where the value of the derivative is linked to a specific condition or
event (e.g. the underlying reaching a specific price level)
13) Obtain exposure to the underlying where it is not possible to trade in the underlying (e.g.
weather derivatives)
14) Provide leverage (or gearing), such that a small movement in the underlying value can
cause a large difference in the value of the derivative
15) Speculate and make a profit if the value of the underlying asset moves the way they
expect (e.g. moves in a given direction, stays in or out of a specified range, reaches a
certain level)
16) Switch asset allocations between different asset classes without disturbing the underlining
assets, as part of transition management
17) Avoid paying taxes. For example, an equity swap allows an investor to receive steady
payments, e.g. based on LIBOR rate, while avoiding paying capital gains tax and keeping
the stock.
18) Lock in an arbitrage profit -Taking advantage of two or more securities being mispriced
relative to each other.
19) Change the nature of a liability

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20) Change the nature of an investment without incurring the costs of selling one portfolio
and buying another.

Functions of derivatives markets

a) Discovery of price: Prices in an organised derivatives market reflect the perception of
market participants about the future and lead the prices of underlying assets to the
perceived future level. The prices of derivatives converge with the prices of the
underlying at the expiration of the derivative contract. Thus derivatives help in discovery
of future as well as current prices.

b) Risk transfer: The derivatives market helps to transfer risks from those who have them
but may not like them to those who have an appetite for them.
c) Linked to cash markets: Derivatives, due to their inherent nature, are linked to the
underlying cash markets. With the introduction of derivatives, the underlying market
witnesses higher trading volumes because of participation by more players who would not
otherwise participate for lack of an arrangement to transfer risk.
d) Check on speculation: Speculation traders shift to a more controlled environment of the
derivatives market. In the absence of an organized derivatives market, speculators trade in
the underlying cash markets. Managing, monitoring and surveillance of the activities of
various participants become extremely difficult in these kind of mixed markets.
e) Encourages entrepreneurship: An important incidental benefit that flows from
derivatives trading is that it acts as a catalyst for new entrepreneurial activity. Derivatives
have a history of attracting many bright, creative, well-educated people with an
entrepreneurial attitude. They often energize others to create new businesses, new
products and new employment opportunities, the benefit of which are immense.
f) Increases savings and investments: Derivatives markets help increase savings and
investment in the long run. The transfer of risk enables market participants to expand their
volume of activity.

Evolution of derivatives

Around 8,000 B.C. writing and mathematics had developed in Sumer, located in the Tigris
and Euphrates river region, to a point they developed a unique method for accounting. Clay
tokens were used to represent the different commodities and quantities. To keep people from

32
tampering with the tokens, they baked them into a hollow vessel. Pressed into the exterior of
the vessel - prior to baking - would be markings similar to the tokens inside and a witness
mark to make it official. The beauty of this system was the way it resolves disputes. If there
were any disagreement of the values on the exterior of the vessel, they would break it open to
count the tokens inside. Eventually the tokens and vessels would become a promise to deliver
a quantity of goods by a certain date - all baked on the vessel. Now instead of wine, one
would accept a vessel and give the other party (counterparty) the product. Then based on the
quantity and time of delivery pressed into the vessel, we would receive the counterparty's
goods. These transactions were similar current forwards.

By 3,500 B.C., new forms of writing and math enabled the Sumerians to replace the vessels
with clay tablets. These trades are similar in behaviour to forward contracts.

In ancient Greece, the Athenians used shipping contracts for trading which resemble forward
contracts, with a twist. The buyer would borrow the money up front. Prior to a trading
voyage, an entrepreneur (buyer) looking to profit on a trade of commodities would make an
agreement with a merchant who would finance the voyage. They would draw up a contract.
The contract would state the amount of money loaned and required interest the entrepreneur
would pay the merchant upon return. Since these voyages were risky, the merchants
demanded a high return in the range of 30%. After all, there were many ways a ship could
disappear; pirates, unfriendly nations, and storms to name but a few. Further stipulations
would name the commodity to be purchased, state where it was to be purchased, the ships
route, and a time limit for the voyage. To make sure the entrepreneurs' would not cheat them,
the merchants had a trustworthy acquaintance or employee accompany the voyage. Upon
reaching the agreed upon port of call, our entrepreneurs' would purchase the commodity - or
sell in the case of exports. In either event, the merchant now had an effective ownership of the
commodities until they were paid back. The similarity to a forward contract can be seen since
the factors of price, commodity, and time are stipulated in the shipping contract. Profits for
the entrepreneurs' would only be realized if they could sell the commodity at a high enough
price to cover the merchant's loan and interest. If they could not cover the loan, they would
end up in court and may find much of their collateral, and perhaps their freedom, in jeopardy.
Because trade was so important, laws and regulations would develop to ensure each party
would be justly treated in disputes.

Medieval Europe
33
Around 1100 European merchants developed the "fair letter" that acted like a letter of credit
between the buyer and seller. These letters would then be settled at regional trade fairs such as
the Fairs of Champagne; an annual cycle of trading fairs held in town located in the
Champagne and Brie regions of France, which were the main markets for Northern Europe.
The seller would have the merchandise ready for pickup at a fair, and the buyer would give a
"fair letter" for payment. The Fairs of Champagne started out as mainly agricultural events,
but evolved into major trading markets for many commodities. Italian moneychangers at the
fair would settle the letters for the merchants. The Fairs of Champagne became international
clearinghouses for paper debt and credit. The seller would receive another "fair letter" or letter
of credit that could be settled in or near their hometown with a local goldsmith. Back in these
times, the local goldsmith is where merchants held their money. The goldsmiths would
eventually evolve into banks. Over time, the fairs began to lose their dominance in trade.
Many of the trade routes to the fairs were over land.

War and political issues would cause over land routes to fall from favor - traders turned to sea
routes. The fairs would move from the Champagne region to the port city of Bruges. Bruges
was interesting because of the impact natural changes in the environment had on the city and
its economy. Bruges is located near the North Sea in modern day Belgium. Prior to 1134, the
natural water channels that provided access to the sea had silted up. That year a large storm
hit the coast and reopened the natural channels near the city. Soon, because of the over land
trade issues for the Fairs of Champagne, merchants started using the port city as their main
trading location. Ships would begin to arrive from as far away as the Mediterranean. By 1309
Bruges became one of the most sophisticated money markets and trading cities in Europe.
Growth and prosperity seemed abundant until around 1500. The channels that had been the
reason for Bruges success began to silt in. Trade would move to another port city - Antwerp.
Bruges would decline.

In 1515, the city of Antwerp opens the Bourse, a dedicated building where local and
international traders could gather to conduct business. Before the Bourse, traders generally
met at a specified place and time to conduct their affairs. Now there was a dedicated
marketplace year round. Soon, the town of Antwerp grew dramatically as the Bourse became
the preferred place of trade in Northern Europe. Textiles from England, spices from the
Portuguese, and metals from Germany all were traded in Antwerp. Due to its success, by 1531
a new and larger Bourse was built outside the city in a planned development specifically with

34
trade in mind. Away from the port and warehouses, the new facility is where contracts and
other financial instruments were traded. Traders were not purchasing commodities directly;
they were buying and selling rights to commodities - intangibles. A true financial derivative
market had been established.

Antwerp was generally prosperous until 1648. Antwerp is located on the Scheldt River. The
river provided access to the ocean and allowed the city to become an international trading
post. Recall that the region was in the middle of the Eighty Years War, which ended in 1648.
Antwerp was located in the southern provinces of the Netherlands that remained under control
of Spain - the Spanish Netherlands. As part of the Treaty of Munster, the peace treaty between
Spain and the United Provinces (Dutch Republic), the Scheldt River would be closed to
navigation. Antwerp's trading activities were effectively shut down. Amsterdam would
become the new leading trading hub for Northern Europe.

For the next two hundred years the trading of commodities in the western world will utilized
agreements that are similar to forward contracts. Several civilizations would have similar type
of agreements or arrangements for trading not only for ship voyages, but for caravans as well.
However, the agreements are still generally between parties that must deal with each other
directly, sort of an ancient over-the-counter (OTC). Each party must trust the other party in
order to trade. The next revolution in trading would occur in the East.

A Major Step Forward

In Feudal Japan around 1700, many rulers in agricultural regions taxed their subjects in rice.
For currency, they would bring the rice to cities such as Osaka where it was stored and sold at
auction. Only authorized wholesalers were allowed to bid on the rice at auction. The winning
bidder would receive a rice voucher that would be settled shortly thereafter for cash. The
vouchers eventually became transferable; a new market in the buying and selling of vouchers
would develop among the merchants.

Around 1730, the Dojima Rice Exchange is established with the full support of the
government. At the exchange, there are two types of rice markets; the shomai and choaimai.
The shomai market is where actual rice trading takes place. Here traders buy and sell different
grades of rice based on the spot price. Rice vouchers are issued for each transaction and
would be settled within four days. At the choaimai the first future market was operating.

35
Choaimai roughly translates to rice trading on books. In the spring, summer, and fall different
grades of rice were contracted with standardized agreements. No cash or vouchers were
exchanged; all relevant information was recorded in a book at a clearinghouse. The contract
period was limited to four months at a time. All contracts had to be settled prior to the closing
of the contract period, and no contract was allowed to carry over to another period. Settlement
of the differences in value between the current rice spot price and the contract had to be done
with cash or an opposing contract position. With a few interruptions and updates, the rice
exchanges would operate until 1937.

To be able to participate in the exchange, traders were required to establish lines of credit with
a clearinghouse. Trades were done through the clearinghouse, and if the trader defaulted on a
trade, the clearinghouse was responsible for payment. Similar to today, the clearinghouse acts
as the intermediary and guarantees payment on trades. Hence, the Dojima Rice Exchange is
considered by many to be the first futures market. The final metamorphosis in commodities
trading and derivatives would be over a century after the establishment of the rice exchange in
the New World.

The New World

Receiving its city charter in 1837, Chicago had grown to over 4,000 inhabitants. Soon four
events would lay the groundwork for this small city to become one of the world's largest. The
year is 1848 and the Illinois and Michigan Canal has just been finished to connect the Great
Lakes to the Mississippi River and ultimately the Gulf of Mexico. That same year the
telegraph is introduced - within two years Chicago would be connected to most major East
Coast cities. Also in 1848, railroad companies install lines for commerce; the city will become
a large railroad hub. Lastly, the Chicago Board of Trade (CBOT) was founded.

Prior to the exchange, commodity trading operated similar to earlier centuries. Buyers and
sellers would need to locate each other then make an agreement - similar to a forward
contract. The problem was if the prices fluctuated too much the other party would back out of
the deal, there was significant counter-party risk. As earlier fairs and markets, the CBOT was

36
founded to make it easier to trade and bring order to the process. Initially the CBOT was a
voluntary association with little active trading activity. By 1850, the exchange had developed
rules and product standards, which allowed the grain market to operate more efficiently, but
forward contracts were still in use. Since contracts were assignable, speculators began to play
the commodities markets looking to cash in on price movements. In 1855, France moved its
grain purchasing from New York to Chicago; CBOT had become a very popular place to
trade in grains. The Illinois State Legislature incorporated the exchange in 1859. The true
revolution in commodity trading for the CBOT would not take place until 1865. That year
standardized agreements were introduced with the exchange as the counter party - futures
agreements. This is similar in nature to what the Japanese were doing 130 years earlier.

1898, The Chicago Board of Trade spun off the Chicago Butter and Egg Board, which would
evolve into the Chicago Mercantile Exchange by 1919. Over time, each exchange would
begin trading a broad range of product types from agricultural commodities to metals. Major
advances in trading derivatives would not come until 1970's. Perhaps not so coincidentally,
this period also gives birth to the microprocessor and personal computers. It is the beginning
of the Computer Age.

The Computer Age

The 1970's is when derivatives gained widespread use. Several factors were at play to propel
derivative markets. First, many governments began to deregulate pricing and controls in
markets introducing higher volatility. Tedious calculations were required utilizing probability
theories to help predict future price movements. Luckily, at this time the computer becomes
more wide spread allowing the complex models and computations to be solved quickly and
efficiently. Then in 1973, Fischer Black and Myron Scholes would publish their paper, "The
Pricing of Options and Corporate Liabilities", which established methodologies to help
determine option prices. The paper also shows using options on equities that it is possible to
create a hedged position - something fairly well known in agricultural commodities. That
same year and coincidentally, the Chicago Board of Trade opens the Chicago Board Options
Exchange. With a methodology to price options, computers to crunch the numbers, and a
market to trade- things boomed. Over the next few decades, there would be derivatives on
almost anything with a market willing to trade.

37
The next big development for derivatives would be electronic trading. Launched initially by
the Chicago Mercantile Exchange in 1992, electronic trading has gained wide acceptance.
Benefits have been greater liquidity, reduced transaction cost, and higher transparency.
Today, trading in virtually any derivative, commodity, or security can be done from one's
living room.

Property Derivatives

The price we pay may not be what the true value of the real estate is. Real estate, unlike many
other commodities, comes in many prices, sizes, and locations. Before efficient markets
develop, there would need to be a reasonable "standardization" of property values - an index.
Looking to fill the information gap, several institutions, businesses, and academia worked on
developing indices for their interests. The results of these efforts would yield indices for
commercial and residential real estate with the first indices appearing around 1980.

With the development of reliable property value indexes, the first early attempt of a property
derivative market began in London around 1994. Focusing on commercial real estate, the
market for property derivatives never really caught on with investors. In 2005, property
derivatives came back to life in the U.K. with trades on commercial property. Although many
various derivative types were available, the most common type of transaction would be in
swaps and eventually forward agreements.

The United States would not really get started in property derivatives until around 2005. Very
similar to practices in London, the market is for the most part an over the counter affair
although a market for pricing does exist. Different derivative types, but mostly forwards on
the index, are available for residential and commercial indices. A bright spot for residential
investment came in 2006 with CME/Chicago Board of Trade establishing a market for
housing futures based on the S&P/ Case-Shiller Index - although trading is light, it is really
the only market where real estate futures can be electronically traded.

Most recently, June 2009, equities (stocks) had been developed to allow traders to effortlessly
invest or hedge real estate risk - allowing even greater access to property derivatives for small
investors since equity-trading accounts have smaller deposit requirements. Known as
MacroShares, they had great potential. Unfortunately, they suspended trading in January

38
2010. Trading did not take off as expected. Perhaps they were an unfortunate victim of
timing; trying to launch a real estate investment product in the middle of a depression.

The Regulation of Derivatives Markets

Financial regulation and supervision
The term regulation refers to a set of binding rules issued by a private or public body. The
regulatory framework can be composed of primary enabling legislation, secondary legislation,
principles, rules, and codes, and guidance or policy directives.
The term supervision is often used synonymously with regulation, but is sometimes used to
refer to a less rigid and more qualitative exercise of powers of oversight and inspection. In a
global and interconnected financial world, regulations are becoming increasingly harmonised
across jurisdictions, to ensure a level playing field and resist efforts at crossborder regulatory
arbitrage. A number of international bodies have produced authoritative recommendations for
best practices in this regard, and their adoption by local regulatory authorities is generally
regarded as a key indicator of the soundness of a financial system.
1.3.6.2The history of derivatives regulation

Derivatives are often regarded as the enfants terribles of the financial world, largely due to
their association with a number of sensational losses by both professional and
nonprofessional end-users. This has periodically led to calls for these markets to be subject
to tighter controls and oversight.
While regulation of derivatives traded on exchanges was developed early on, the OTC
markets were largely excluded from this framework. During this time, derivatives traded
offexchange were of dubious legality and were considered as wagers or bets, similar to bets
on other uncertain outcomes such as horse races and sports events.
Known as difference contracts, many of these were regulated in the US and UK under the
common law rule against difference contracts. Accordingly, they could only be legally
enforced if it could be shown that at least one of the parties had a real economic interest
which was being hedged by the transaction.

The dark side of derivatives has raised some important questions concerning the regulations
of derivatives trading and financial stability. The focus appears to centre on improvements in
counterparty risk management and in favour of promoting exchange-traded derivative
markets. Very often, the lack of knowledge of counterparty’s financial health can lead to fears
about its solvency and contagion risk. Under such an environment, OTC contracts are

39
particularly exposed to risks of inadequate collateral and capitalisation. In this context,
central clearing of derivatives transactions and more robust collateralisation are important for
mitigating counterparty risk in OTC markets. In addition, financial regulators are designing
new rules to improve post-trade price transparency. There are also proposals in some
jurisdictions to encourage the migration of trading in some actively OTC traded products to
exchanges.

1.3.7. REASONs FOR GROWTH OF DERIVATIVES

A number of fundamental changes in global financial markets have contributed to the strong
growth in derivative markets since the 1970s.

First, the collapse of the Bretton Woods system of fixed exchange rates in 1971 increased the
demand for hedging against exchange rate risk. The Chicago Mercantile Exchange allowed
trading in currency futures in the following year.
Second, the changing of its monetary policy target instrument by the US Federal Reserve
(FED) and other Central Banks promoted various derivatives markets. The adoption of a
target for money growth by the FED in 1979 has led to increased interest-rate volatility of
Treasury bonds. That in turn raised the demand for derivatives to hedge against adverse
movements in interest rates. Later in 1994 when the US Federal Open Market Committee
moved to explicitly state its target level for the federal funds rate, that policy has spurred the
growth of derivatives on the federal funds rates.
Third, the many emerging market financial crises in the 1990s, which were often
accompanied by a sharp rise in corporate bankruptcy, greatly increased the demand of global
investors for hedging against credit risk.

Fourth, innovation in financial theory was another contributing factor. The advancements in
options pricing research, most notably the Nobel-prize winning Black-Scholes options pricing
model, provided a new framework for portfolio managers to manage risks. More importantly,
the rapid improvements in computer technology in the 1990s allowed these asset managers to
design and develop increasingly sophisticated derivatives as part of their risk management
tools.
1.3.8. Risks associated with derivatives
1. Leverage-Transactions in derivatives markets are rarely, if ever, fully funded, which
provides an opportunity for leverage by users.

40
 The use of leverage increases the speed and extent of potential losses, and can lead to
financial ruin far quicker than an unleveraged position. This obviously places a premium
on timely and sound risk management policies and controls, especially in respect of
participation by unsophisticated retail users in these markets.

Some derivatives instruments are explicitly designed to leverage sensitivity to one or more
risk factors, which further amplifies potential losses; examples include leveraged swaps,
and many exotic options.

2. Timing of settlement-Derivative transactions are normally contracted to settle cash

flows between the parties at a date or dates beyond the normal underlying market
settlement horizon, which is typically a few days.
The deferred settlement of derivatives has important consequences for the credit risk they
pose, which is measured by their replacement cost, should one of the parties to the contract
default. This cost becomes potentially greater, the longer the period until settlement, which
can lead to a substantial build-up of credit risk, especially in the absence of effective
collateralisation arrangements between the parties.
3. Complexity-Derivatives are generally more complex than the instruments found in the
underlying cash markets, since their value is often a complex function of the values of one
or more of those instruments.

Many of these synthetic replication models abstract from important real-world issues, such
as changes in market volatility and liquidity, which can significantly affect the cost of
hedging a derivative instrument in this way. As a result, the correct price for a derivative
instrument can only truly be determined after it has ceased to exist, by which time the real
cost of hedging it is known. This is obviously a problem for sellers of derivatives, since
prices are generally fixed in advance.

Many derivative models have turned out to be flawed in some key respects, and there have
been episodes, substantial losses from model risk. While this is normally more of a concern
for exotic or non-standard instruments, even some vanilla derivatives use models that
require careful and subjective interpretation and modification. For example, the venerable
Black-Scholes model is still widely used for option pricing, despite many of its assumptions
being recognized as incorrect.

41
 End-users of derivatives often struggle to assess fair values for these instruments, due to
the complexity of the modelling issues and/or the availability of reliable input data. These
users are often forced to rely for valuations on the vendor of the particular instrument,
which creates a potential conflict of interest. The provision of deliberately misleading
valuations for derivative instruments was a key factor in the litigation between the US
derivatives giant Bankers Trust and several of its clients in the early 1990s.
4. Accounting treatment- Derivatives are often less transparent in financial statements
than equivalent transactions in the underlying markets, largely as a result of their
traditional accounting classification as off- balance sheet. This has allowed many
transactions involving their use to escape the attention of regulators, investors, and even
auditors. Derivatives have been used extensively in creative accounting schemes, such as
those employed by Enron.

Recent changes to accounting standards have sought to ensure that derivatives are recorded
on the balance sheet at fair value, but there are exceptions to this general principle. The key
standard in this regard, IAS 39, has been the subject of much debate and disagreement, and
is not applicable in the United States, which relies on FAS 133 of US GAAP.

5. Liquidity-Some derivative instruments are extremely illiquid, which impacts their

market and credit risks, and raises issues regarding their timely and accurate valuation.

Even when the derivative market is liquid, liquidity risk can still be a problem if the
derivative market is bigger than the underlying market, especially when a derivative
contract calls for physical settlement of the underlying instrument. This problem was
particularly evident in the credit derivatives markets, but has also previously surfaced with
some equity derivatives.

6. Legal uncertainty-It is often argued that enforceability represents the greatest risk
that participants face in certain types of derivatives transactions, and there have been
instances of courts refusing to enforce derivatives contracts, for a variety of reasons.

An ongoing concern in most jurisdictions, including in South Africa, relates to the validity
of key terms in master agreements, which are used by counterparties to govern their legal
relationship in the OTC derivatives markets. In particular, provisions that permit the
setting- off of obligations, in the event of insolvency, often conflict with legal rules.

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3.9. The Dark Side of Derivatives

This represents past sensational losses by endusers due to derivatives. Eleven examples will
be used to illustrate some of the perils, especially ethical perils, in use of financial derivatives:
a) Baring Bank (1994)
b) Orange County, California (1994)
c) Long Term Capital Management (1998)
d) Enron (2001)
e) Global Crossing (2002)
Each of them represented an effort to use financial derivatives to produce inflated returns.
Two cases were proven to be frauds. Two appear to have been innocent of fraud. Two are still
to be seen.
Each was a major financial catastrophe, affecting not only those directly involved but the
world at large

The Steps on the Primrose Path for the selected six above labeled as A,B,C,D,E,F
respectively
A B C D E F
1 deregulation x
2 wis h to have s tock price go up x ? x x x
3 us e of s tock options as incentives x x x x x
4 us e of hidden borrowing x ? x x x
5 us e of financial derivatives in ris ky gambles x x x x x x
6 cons ulting by auditor on us e of derivatives x ? x x x x
7 us e of deceptive accounting to hide ris ks x x ? x x
8 acquies cence of auditor in deception x ? ? ?
9 us e of fraudulent entries to s upport deceptions x x ? ?
10 us e of hidden partners x ?
11 move from individual fraud to corporate fraud x ? ?
12 connivance of auditor in fraud x ? ?
13 us e of a Ponzi s cheme to continue fraud x ? ?
14 profiting before the collaps e x x x

summary

1) American International Group (AIG) lost more than US$18 billion through a
subsidiary over the preceding three quarters on credit default swaps (CDSs). The
United States Federal Reserve Bank announced the creation of a secured credit facility
of up to US$85 billion, to prevent the company's collapse by enabling AIG to meet its
obligations to deliver additional collateral to its credit default swap trading partners.

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 2) In the early 1990s, Procter and Gamble Corporation lost over $100 million in
transactions in equity swaps.
3) The loss of US$7.2 Billion by Société Générale in January 2008 through mis-use of
futures contracts.
4) The loss of US$6.4 billion in the failed fund Amaranth Advisors, which was long
natural gas in September 2006 when the price plummeted.
5) The loss of US$4.6 billion in the failed fund Long-Term Capital Management in 1998.

Long-Term Capital Management (LTCM) lost 4.6 billion U.S. dollars in fixed income
arbitrage in September 1998. LTCM,run by a former Vice Chairman of Federal reserve
and two Nobel Prize-winning economists-Scholes Myron, had attempted to make money
on the price difference between different bonds. For example, it would sell U.S. Treasury
securities and buy Italian bond futures. The concept was that because Italian bond futures
had a less liquid market, in the short term Italian bond futures would have a higher return
than U.S. bonds, but in the long term, the prices would converge. Because the difference
was small, a large amount of money had to be borrowed to make the buying and selling
profitable.

The downfall in this system began on August 17, 1998, when Russia defaulted on its ruble
debt and domestic dollar debt. Because the markets were already nervous due to the Asian
financial crisis, investors began selling non-U.S. treasury debt and buying U.S. treasuries,
which were considered a safe investment. As a result the price on US treasuries began to
increase and the return began decreasing because there were many buyers, and the return
(yield) on other bonds began to increase because there were many sellers (i.e. the price of
those bonds fell). This caused the difference between the prices of U.S. treasuries and
other bonds to increase, rather than to decrease as LTCM was expecting. Eventually this
caused LTCM to fold, and their creditors had to arrange a bail-out. More controversially,
officials of the Federal Reserve assisted in the negotiations that led to this bail-out, on the
grounds that so many companies and deals were intertwined with LTCM that if LTCM
actually failed, they would as well, causing a collapse in confidence in the economic
system. Thus LTCM failed as a fixed income arbitrage fund, although it is unclear what
sort of profit was realized by the banks that bailed LTCM out

6) The loss of US$1.3 billion equivalent in oil derivatives in 1993 and 1994 by
Metallgesellschaft AG.

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7) The loss of US$1.2 billion equivalent in equity derivatives in 1995 by Barings Bank.
8) UBS AG, Switzerland's biggest bank, suffered a $2 billion loss through unauthorized
trading discovered in September 2011.
9) Orange County Bankruptcy-On December 6, 1994, Orange County in California
became the largest municipality in U.S. history to declare bankruptcy. The county treasurer
had lost $1.7 billion of taxpayers' money through investments in derivatives. The
bankruptcy resulted from unsupervised investment activity of Bob Citron, the County
Treasurer, who was entrusted with a $7.5 billion portfolio belonging to county schools,
cities, special districts and the county itself.
Thus, Citron invested in financial derivatives and leveraged the portfolio to the hilt, with
expectations of decreasing interest rates (wrong-way bet on interest rates -the so-called
“inverse floaters”). As a result, he was able to increase returns on the county pool far above
those for the State pool. Citron was viewed as a wizard who could painlessly deliver greater
returns to investors. The pool was in such demand due to its track record that Citron had to
turn down investments by agencies outside Orange County.
Some local school districts and cities even issued short-term taxable notes to reinvest in the
pool (thereby increasing their leverage even further).
The investment strategy worked excellently until 1994, when the Fed started a series of
interest rate hikes that caused severe losses to the pool. Initially, this was announced as a
“paper” loss. Citron kept buying in the hope interest rates would decline.
Almost no one was paying attention to what the treasurer was doing and even fewer
understood it—until the auditors informed the Board of Supervisors, in November 1994,
that he had lost nearly $1.7 billion.
Shortly thereafter, the county declared bankruptcy and decided to liquidate the portfolio,
thereby realizing the paper loss.
10) Enron Bankruptcy-In 1985, Kenneth Lay, using proceeds from junk bonds,
combined his company, Houston Natural Gas, with another natural-gas pipeline to form
Enron. From that start, the company then moved beyond selling and transporting gas to
become a big player in the newly deregulated energy markets by trading in futures
contracts. In the same way that traders buy and sell soyabean and orange juice futures,
Enron began to buy and sell electricity and gas futures.
In the mid-1980s, oil prices fell precipitously. Buyers of natural gas switched to newly cheap
alternatives such as fuel oil. Gas producers, led by Enron, lobbied vigorously for deregulation.
Once-stable gas prices began to fluctuate. Then Enron began marketing futures contracts

45
which guaranteed a price for delivery of gas sometime in the future. The US government,
again lobbied by Enron and others, deregulated electricity markets over the next several years,
creating a similar opportunity for Enron to trade futures in electric power.
In 1990, Lay hired Jeffrey Skilling, a consultant with McKinsey & Co., to lead a new division
—Enron Finance Corp. Skilling was made president and chief operating officer of Enron in
1997. Even as Enron was gaining a reputation as a "new-economy" trailblazer, it continued—
to some degree apparently against Skilling's wishes—to pursue such stick-in-the-mud "old-
economy" goals as building power plants around the world.
Enron’s energy projects sprouted in places no other firm would go but appear not to have
earned it a dime. With operations in 20 countries, Enron launched bold projects in poverty-
ravaged countries such as Nigeria and Nicaragua. It set up huge barges—with names like
Esperanza, Margarita and El Enron—in ports around the world to generate power for energy-
starved cities. Enron's international investment totaled more than $7 billion, including over $3
billion in Latin America, $1 billion in India and $2.9 billion to develop a British water-supply
and waste-treatment company.
The U.S. government had been a major backer of Enron's overseas expansion. Since 1992,
Overseas Private Investment Corp provided about $1.7billion for Enron's foreign deals and
promised $500million more for projects that didn't go forward. The Export-Import Bank
put about $700 million into Enron's foreign ventures. Both agencies provide financing and
political-risk insurance for foreign projects undertaken by U.S. companies. Enron enlisted
U.S. ambassadors and secretaries of State, Commerce and Energy to buttonhole foreign
officials on Enron’s behalf. It cultivated international political connections, recruiting
former government officials and relatives of heads of state as investors and lobbyists.
Like other parts of Enron's vast operation, its international division was fueled by intense
internal competition and huge financial incentives. Executives pocketed multimillion-
dollar bonuses for signing international deals under a structure that based their rewards on
the long-term estimated value of projects rather than their actual returns. The system
encouraged executives to gamble without regard to risk.
In reports to investors, the company played down or obscured what analysts and others saw as
inevitable losses. But in an interview with academic researchers in 2001, Jeffrey K.
Skilling, who then was chief operating officer, conceded that Enron "had not earned
compensatory rates of return" on investments in overseas power plants, waterworks and
pipelines. Skilling said the projects had fueled an "acrimonious debate" among executives
about the wisdom of its heavy foreign investments.

46
An internal investigation released that month showed that two foreign projects, in Brazil and
Poland, were entangled in Enron's off-the-books partnerships, accounting devices
controlled by then-Chief Financial Officer Andrew S. Fastow that shielded huge debts
from investors. Those arrangements allowed Enron to present a more optimistic report to
investors.Other partnerships also were involved: “Whitewing”, with interests in Turkey,
Brazil, Colombia, and Italy; Ponderosa, with interests in Brazil, Colombia, and Argentina.

The problem with this arrangement was:

1. Acting as Principal in transactions!
2. Failing really to make money,
3. Creating trading shell companies,
4. Acting as partner in transactions!
5. Playing games with financial reporting and Being Greedy.
Later there was a sudden announcement of losses in Oct 2001, then File for bankruptcy in Dec
2001, Bankruptcy, Congressional Investigations began in Dec 2001 and attempted
destruction of documents
In mid-February 2002, Overseas Private Investment Corp., which backed many of Enron’s
overseas energy projects, moved to stem its $1-billion Enron exposure by canceling $590
million in loans to the company, once one of its largest clients. Enron had missed deadlines
for OPIC requirements in financing projects in Brazil, an OPIC spokesman said. OPIC's
decision shifted more of the burden for the troubled projects from the U.S. government to
Enron's creditors, lenders and partners
11) Global Crossing Bankruptcy- January 29, 2002: “Global Crossing Ltd, which spent
five years and $15 billion to build a worldwide network of high-speed Internet and
telephone lines, files for bankruptcy after failing to find enough customers to make
network profitable; had attracted many notable business and political figures, including US
Democratic National Committee chairman Terry McAuliffe, former US Pres George Bush,
Tisch family and former ARCO chairman and big Republican fund-raiser Lodwrick Cook.”
This is the largest bankruptcy of a telecommunications company.Global Crossing was formed
in 1999 from a merger of a Bermuda-based fiber-optic cable company with a local U.S.
telecom company. In the ensuing years, it developed a 100,000-mile global network of
fiber-optic cables—including links that traverse the Atlantic Ocean—linking more than
200 cities in 27 countries in the Americas, Asia and Europe. It was regarded as one of the
most promising of the new generation of telecom companies that sprang up in the late

47
 1990s, and had secured a stock market value of $75bn. While it incurred more than $12bn
debts, its assets are believed to be worth nearly $24bn, almost twice as much as its debts.
About mid-2000, things began to turn sour for the telecom industry. Optimistic network
operators had completed huge infrastructures just as a nationwide economic slowdown
curtailed corporate spending for such services. That left not only Global Crossing but other
network companies with insufficient revenue to pay the massive debt they had accumulated
to build their costly networks. In fact, Global Crossing had never reported annual profit
since its creation, and by the first quarter of 2001, cash was running short. Global Crossing
then entered into swaps with other networks, using indefeasible rights of use, or IRUs.
Global Crossing would buy an IRU and book the price as a capital expense, which could be
spread over a number of years. But the income from IRUs was booked as current
revenue.Technically, the practice is within the arcane rules that govern financial derivative
accounting methods, but only if the swap transactions are real and entered into for a
genuine business purpose. But there was the possibility that these transactions were not for
legitimate business purposes and indeed were potentially fraudulent.
Such concerns are a direct result of the revelations about misleading accounting methods used
by the failed energy trader Enron. Global Crossing had said it will launch an independent
probe of its accounts (by a company other than Anderson). "Recent happenings in the
industry have brought a lot of attention to accounting," a spokesman said (but without
mentioning Enron). Global Crossing had said it will also look into allegations of
impropriety by a former employee.  
At the center of the controversy is Joseph Perrone, the company's former executive vice
president of finance and former outside auditor. For 31 years he had been an auditor and
partner with the Big Five accounting firm Arthur Andersen & Co.  By the time he joined
Global Crossing in May 2000, Perrone was intimately familiar its operations, having
directed Andersen's work in connection with Global's 1998 initial public offering, which
raised about $400 million. Though it is common for outside auditors to jump ship and go
in-house at the companies they audit, Perrone's move was unusual because he was so
highly placed at Andersen.
To lure Perrone from Andersen, Global Crossing offered him a $2.5-million signing bonus on
top of a base salary of $400,000 and a target annual bonus of $400,000, according to SEC
filings. Perrone also received 500,000 Global Crossing stock options, along with shares in
its sister company, Asia Global Crossing Ltd., which were to vest over a three-year period.
Perrone also is chief accounting officer at Asia Global Crossing. This all piqued the

48
 interest of SEC officials, who questioned whether Perrone's hiring "impaired" Andersen's
independence. Ultimately, the SEC was satisfied that Andersen "met the requirements for
independence."“Chairman Gary Winnick could lose control if bankruptcy plan is accepted,
but the blow would be softened by stock deals that reaped him more than $730 million.
Company shares traded for more than $60 as recently as March 2000. They had now fallen
more than 99 percent, to 13.5 cents, in over-the-counter trading after being de-listed by the
New York Stock Exchange.

Pricing and Valuation of Derivatives.

Each derivative type pricing and valuation will be dicussed under its relevant
heading in the next chapters.

3.11. Participants in derivative markets

Each market is unique as to the interest of the parties concerned. So market
participants will be discussed per derivative type. But the most commmon
participants are, hedgers,dealers, speculators and arbitrageurs. The important
players in a derivative market as per their specific needs would be:

a) Hedgers
b) Speculators
c) Arbitrageurs
a) Hedgers:

Hedgers are investors, their objective is to use different markets to minimize or eliminate a
particular risk that they face from the potential future movements in the market variables. For
example, an airline company will enter into a long position to reduce the risk, related to
fluctuation in the price of jet fuel, in contrast a farmer who knows that he/she can harvest in
the future enters into a short potion in order to reduce the commodity price falls. Hedgers
stand not to make a huge gain but moderately to protect their existing position against the
price fluctuations. A perfect hedge is rare but investor can reduce their risk which goes
against them.
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 b) Speculators

Speculators are investors who bet on the future direction of a market variable; either they bet
that the price of an asset will go up or down. They take a view on the market and play
accordingly, provide liquidity and strength to the market. For example, if a speculator thinks
that the British pounds will strengthen relative to U.S.doller over the next two months, a
speculator can purchase British pounds in the sport price and sold it later or can enter into a
long position.

Speculation is the practice of engaging in risky financial transactions in an attempt to profit

from short or medium term fluctuations in the market value of a tradable good such as a
financial instrument, rather than attempting to profit from the underlying financial attributes
embodied in the instrument such as capital gains, interest, or dividends. Many speculators pay
little attention to the fundamental value of a security and instead focus purely on price
movements. Speculation can in principle involve any tradable good or financial instrument.
Speculators are particularly common in the markets for stocks, bonds, commodity futures,
currencies, fine art, collectibles, real estate, and derivatives.

Derivatives can be used to acquire risk, rather than to hedge against risk. Thus, some
individuals and institutions will enter into a derivative contract to speculate on the value of the
underlying asset, betting that the party seeking insurance will be wrong about the future value
of the underlying asset. Speculators look to buy an asset in the future at a low price according
to a derivative contract when the future market price is high, or to sell an asset in the future at
a high price according to a derivative contract when the future market price is less.
Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson,
a trader at Barings Bank, made poor and unauthorized investments in futures contracts.
Through a combination of poor judgment, lack of oversight by the bank's management and
regulators, and unfortunate events like the Kobe earthquake, Leeson incurred a US$1.2 billion
loss that bankrupted the centuries-old institution.

c) Arbitrageurs: Arbitrageurs are investors who trade in two different markets or exchanges;
their aim is locking in a riskless profit by simultaneously entering into transaction in two or
more markets. For example, shares of IBM trade on both the New York Stock Exchange and
the Boston Stock Exchange; suppose that shares of IBM trade for $110 on the New York

50
market and for $ 105 on the Boston Exchange, a trader could make the following two
transactions simultaneously:

Arbitrage is the practice of taking advantage of a price difference between two or more
markets: striking a combination of matching deals that capitalize upon the imbalance, the
profit being the difference between the market prices. When used by academics, an arbitrage
is a transaction that involves no negative cash flow at any probabilistic or temporal state and a
positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit
after transaction costs. For instance, an arbitrage is present when there is the opportunity to
instantaneously buy low and sell high.

Arbitrage is a process through which an investor can buy an asset or combination of assets at
one price and concurrently sell at a higher price, thereby earning a profit without investing
any money or being exposed to any risk. The combined actions of many investors engaging in
arbitrage results in rapid price adjustments that eliminate these opportunities, thereby bringing
prices back in line and making markets more efficient.

People who engage in arbitrage are called arbitrageurs such as a bank or brokerage firm. The
term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives,
commodities and currencies.

Arbitrage-free-If the market prices do not allow for profitable arbitrage, the prices are said to
constitute an arbitrage equilibrium or arbitrage-free market. An arbitrage equilibrium is a
precondition for a general economic equilibrium. The assumption that there is no arbitrage is
used in quantitative finance to calculate a unique risk neutral price for derivatives.

Conditions for arbitrage

Arbitrage is possible when one of three conditions is met:
1) The same asset does not trade at the same price on all markets ("the law of one price").
2) Two assets with identical cash flows do not trade at the same price.
3) An asset with a known price in the future does not today trade at its future price
discounted at the risk-free interest rate (or, the asset has significant costs of storage; as
such, for example, this condition holds for grain but not for securities).
Arbitrage is not simply the act of buying a product in one market and selling it in another for a
higher price at some later time. The transactions must occur simultaneously to avoid exposure

51
to market risk, or the risk that prices may change on one market before both transactions are
complete. In practical terms, this is generally possible only with securities and financial
products that can be traded electronically, and even then, when each leg of the trade is
executed the prices in the market may have moved. Missing one of the legs of the trade (and
subsequently having to trade it soon after at a worse price) is called 'execution risk' or more
specifically 'leg risk'.
"True" arbitrage requires that there be no market risk involved. Where securities are traded on
more than one exchange, arbitrage occurs by simultaneously buying in one and selling on the
other.

Uses of arbitrage
i) Arbitrage has the effect of causing prices in different markets to converge. As a result of
arbitrage, the currency exchange rates, the price of commodities, and the price of securities in
different markets tend to converge. The speed at which they do so is a measure of market
efficiency. Arbitrage tends to reduce price discrimination by encouraging people to buy an
item where the price is low and resell it where the price is high (as long as the buyers are not
prohibited from reselling and the transaction costs of buying, holding and reselling are small
relative to the difference in prices in the different markets).

ii) Arbitrage moves different currencies toward purchasing power parity. As an example,
assume that a car purchased in the United States is cheaper than the same car in Canada.
Canadians would buy their cars across the border to exploit the arbitrage condition. At the
same time, Americans would buy US cars, transport them across the border, then sell them in
Canada. Canadians would have to buy American dollars to buy the cars and Americans would
have to sell the Canadian dollars they received in exchange. Both actions would increase
demand for US dollars and supply of Canadian dollars. As a result, there would be an
appreciation of the US currency. This would make US cars more expensive and Canadian cars
less so until their prices were similar. On a larger scale, international arbitrage opportunities
in commodities, goods, securities and currencies tend to change exchange rates until the
purchasing power is equal.

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iii) Similarly, arbitrage affects the difference in interest rates paid on government bonds
issued by the various countries, given the expected depreciations in the currencies relative to
each other (see interest rate parity).

Risks- Arbitrage transactions in modern securities markets involve fairly low day-to-day
risks, but can face extremely high risk in rare situations, particularly financial crises, and can
lead to bankruptcy. Formally, arbitrage transactions have negative skew – prices can get a
small amount closer (but often no closer than 0), while they can get very far apart. The day-to-
day risks are generally small because the transactions involve small differences in price, so an
execution failure will generally cause a small loss (unless the trade is very big or the price
moves rapidly). The rare case risks are extremely high because these small price differences
are converted to large profits via leverage (borrowed money), and in the rare event of a large
price move, this may yield a large loss.

The idea that seemingly very low risk arbitrage trades might not be fully exploited because of
these risk factors and other considerations is often referred to as limits to arbitrage. The risks
include:

i ) Execution risk -Generally it is impossible to close two or three transactions at the same
instant; therefore, there is the possibility that when one part of the deal is closed, a quick shift
in prices makes it impossible to close the other at a profitable price. However, this is not
necessarily the case. Many exchanges and inter-dealer brokers allow multi legged trades (e.g.
basis block trades on LIFFE).

Competition in the marketplace can also create risks during arbitrage transactions. As an
example, if one was trying to profit from a price discrepancy between IBM on the NYSE and
IBM on the London Stock Exchange, they may purchase a large number of shares on the
NYSE and find that they cannot simultaneously sell on the LSE. This leaves the arbitrageur in
an unhedged risk position.

In the 1980s, risk arbitrage was common. In this form of speculation, one trades a security
that is clearly undervalued or overvalued, when it is seen that the wrong valuation is about to
be corrected by events. The standard example is the stock of a company, undervalued in the
stock market, which is about to be the object of a takeover bid; the price of the takeover will
more truly reflect the value of the company, giving a large profit to those who bought at the

53
current price—if the merger goes through as predicted. Traditionally, arbitrage transactions in
the securities markets involve high speed, high volume and low risk. At some moment a price
difference exists, and the problem is to execute two or three balancing transactions while the
difference persists (that is, before the other arbitrageurs act). When the transaction involves a
delay of weeks or months, as above, it may entail considerable risk if borrowed money is used
to magnify the reward through leverage. One way of reducing the risk is through the illegal
use of inside information, and in fact risk arbitrage with regard to leveraged buyouts was
associated with some of the famous financial scandals of the 1980s such as those involving
Michael Milken and Ivan Boesky.

ii) Mismatch Another risk occurs if the items being bought and sold are not identical and
the arbitrage is conducted under the assumption that the prices of the items are correlated or
predictable; this is more narrowly referred to as a convergence trade. In the extreme case this
is merger arbitrage, described below. In comparison to the classical quick arbitrage
transaction, such an operation can produce disastrous losses.

iii) Counterparty risk As arbitrages generally involve future movements of cash, they are
subject to counterparty risk: if a counterparty fails to fulfill their side of a transaction. This is
a serious problem if one has either a single trade or many related trades with a single
counterparty, whose failure thus poses a threat, or in the event of a financial crisis when many
counterparties fail. This hazard is serious because of the large quantities one must trade in
order to make a profit on small price differences.

For example, if one purchases many risky bonds, then hedges them with CDSes, profiting
from the difference between the bond spread and the CDS premium, in a financial crisis the
bonds may default and the CDS writer/seller may itself fail, due to the stress of the crisis,
causing the arbitrageur to face steep losses.

iv) Liquidity risk Arbitrage trades are necessarily synthetic, leveraged trades, as they
involve a short position. If the assets used are not identical (so a price divergence makes the
trade temporarily lose money), or the margin treatment is not identical, and the trader is
accordingly required to post margin (faces a margin call), the trader may run out of capital (if
they run out of cash and cannot borrow more) and be forced to sell these assets at a loss even
though the trades may be expected to ultimately make money. In effect, arbitrage traders
synthesize a put option on their ability to finance themselves.

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Prices may diverge during a financial crisis, often termed a "flight to quality"; these are
precisely the times when it is hardest for leveraged investors to raise capital (due to overall
capital constraints), and thus they will lack capital precisely when they need it most.

Types of arbitrage

a) Spatial arbitrage Also known as Geographical arbitrage is the simplest form of

arbitrage. In case of spatial arbitrage arbitrageurs look for pricing discrepancies across
geographically separate markets.
b) Merger arbitrage;
c) Municipal bond arbitrage;
d) Convertible bond arbitrage -Given the complexity of the calculations involved and the
convoluted structure that a convertible bond can have- based on interest rate. stock
price. Credit spread; an arbitrageur often relies on sophisticated quantitative models in
order to identify bonds that are trading cheap versus their theoretical value.
e) Depository receipts arbitrage;
f) Dual-listed companies arbitrage -a case of Royal Dutch Shell—which had a DLC
structure until 2005—by the hedge fund Long-Term Capital Management (LTCM, see
also the discussion below). Lowenstein (2000)[7]describes that LTCM established an
arbitrage position in Royal Dutch Shell in the summer of 1997, when Royal Dutch traded
at an 8 to 10 percent premium. In total $2.3 billion was invested, half of which long in
Shell and the other half short in Royal Dutch (Lowenstein, p. 99). In the autumn of 1998
large defaults on Russian debt created significant losses for the hedge fund and LTCM
had to unwind several positions. Lowenstein reports that the premium of Royal Dutch had
increased to about 22 percent and LTCM had to close the position and incur a loss.
According to Lowenstein (p. 234), LTCM lost $286 million in equity pairs trading and
more than half of this loss is accounted for by the Royal Dutch Shell trade.) :
g) Private to public equities: (The market prices for privately held companies are
typically viewed from a return on investment perspective (such as 25%), whilst publicly
held and or exchange listed companies trade on a Price to earnings ratio (P/E) (such as a
P/E of 10, which equates to a 10% ROI). Thus, if a publicly traded company specialises in
the acquisition of privately held companies, from a per-share perspective there is a gain
with every acquisition that falls within these guidelines. Exempli gratia, Berkshire

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 Hathaway. A hedge fund that is an example of this type of arbitrage is Greenridge Capital,
which acts as an angel investor retaining equity in private companies which are in the
process of becoming publicly traded, buying in the private market and later selling in the
public market. Private to public equities arbitrage is a term which can arguably be applied
to investment banking in general. Private markets to public markets differences may also
help explain the overnight windfall gains enjoyed by principals of companies that just did
an initial public offering (IPO).
h) Regulatory arbitrage Regulatory arbitrage is where a regulated institution takes
advantage of the difference between its real (or economic) risk and the regulatory
position. For example, if a bank, operating under the Basel I accord, has to hold 8%
capital against default risk, but the real risk of default is lower, it is profitable to securitise
the loan, removing the low risk loan from its portfolio. On the other hand, if the real risk is
higher than the regulatory risk then it is profitable to make that loan and hold on to it,
provided it is priced appropriately. This process can increase the overall riskiness of
institutions under a risk insensitive regulatory regime,
i) Telecom arbitrage-Telecom arbitrage companies allow phone users to make
international calls for free through certain access numbers.
j) Statistical arbitrage- Statistical arbitrage is an imbalance in expected nominal values.
A casino has a statistical arbitrage in every game of chance that it offers—referred to as
the house advantage, house edge, vigorish or house vigorish.
k) Types of financial arbitrage include; Arbitrage betting, Covered interest arbitrage,
Fixed income arbitrage, Political arbitrage, Risk arbitrage, Statistical arbitrage, Triangular
arbitrage, Uncovered interest arbitrage and Volatility arbitrage

Agood example under this category (arbitrage) is the debacle of Long-Term Capital
Management discussed earlier on.

OTHER PLAYERS ARE: A dealer is a financial institution that makes a market in forward
contracts and other derivatives. A dealer stands ready to take either side of a transaction. An
end user is a party that comes to a dealer needing a transaction, usually for the purpose of
managing a particular risk.

Derivatives Classification

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Derivatives can be classified by different criteria: according to their market as OTC or
as exchange traded, according to their underlying assets, or according to the derivative
product type.

 Types based on market

OTC and exchange-traded
In broad terms, there are two groups of derivative contracts, which are distinguished by the
way they are traded in the market:
 Over-the-counter (OTC) derivatives are contracts that are traded (and privately
negotiated) directly between two parties, without going through an exchange or other
intermediary. Products such as swaps, forward rate agreements, exotic options – and other
exotic derivatives – are almost always traded in this way. The OTC derivative market is the
largest market for derivatives, and is largely unregulated with respect to disclosure of
information between the parties, since the OTC market is made up of banks and other highly
sophisticated parties, such as hedge funds. Reporting of OTC amounts is difficult because
trades can occur in private, without activity being visible on any exchange.

Because OTC derivatives are not traded on an exchange, there is no central counter-party.
Therefore, they are subject to counterparty risk, like an ordinary contract, since each counter-
party relies on the other to perform.

 Exchange-traded derivatives (ETD) are those derivatives instruments that are traded via
specialized derivatives exchanges or other exchanges.
o A derivatives exchange is a market where individuals trade standardized contracts that
have been defined by the exchange.
o A derivatives exchange acts as an intermediary to all related transactions, and takes
initial margin from both sides of the trade to act as a guarantee.
o The world's largest derivatives exchanges (by number of transactions) are the Korea
Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide
range of European products such as interest rate & index products), and CME Group
(made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago
Board of Trade and the 2008 acquisition of the New York Mercantile Exchange).

Exchange traded Over the Counter

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Terms of a contract have to be those specified by anTerms of a contract do not have
exchange (the price that is quoted for a particularto be those specified by an
instrument is always the same regardless of the size orexchange
sophistication of the person or entity making the trade.

Removes counterparty risk, or the chance that the personCredit Risk ( risk that the contract
who you are trading with will default on their obligations may not be honored)
relating to the trade

All firms that offer exchange traded products must beThe low barriers to entry and lack
members and register with the exchange, there is greater of heavy oversight also make it
regulatory oversight which can make exchange tradedeasier for firms offering trading to
markets a much safer place for individuals to trade operate in a dishonest or
fraudulent way

Stock and futures market trade on centralized exchanges Spot forex and many debt markets
trade in OTC

Higher transaction costs Lower transaction costs

b) Types based by the nature of engagement/contract

Derivative contracts can be further classified into two general categories: forward
commitments or as "lock products" and contingent claims or "option" products. In the
following section, we examine forward commitments, which are contracts in which the two
parties enter into an agreement to engage in a transaction at a later date at a price established
at the start.

Lock products (such as swaps, futures, or forwards) obligate the contractual parties to the
terms over the life of the contract. Option products (such as interest rate caps) provide the
buyer the right, but not the obligation to enter the contract under the terms specified.

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The forward commitments are agreements between two parties in which one party, the
buyer, agrees to buy from the other party, the seller, an underlying asset at a future date at a
price established at the start. The parties to the transaction specify the forward contract's terms
and conditions, such as when and where delivery will take place and the precise identity of the
underlying. In this sense, the contract is said to be customized. Each party is subject to the
possibility that the other party will default.

Contingent claims are derivatives in which the payoffs occur if a specific event happens. We
generally refer to these types of derivatives as options. Specifically, an option is a financial
instrument that gives one party the right, but not the obligation, to buy or sell an underlying
asset from or to another party at a fixed price over a specific period of time. The holder of the
option has the right to exercise it and will do so if conditions are advantageous; otherwise, the
option will expire unexercised. Thus, the payoff of the option is contingent on an event taking
place, so options are sometimes referred to as contingent claims.

c) Types of derivatives based on product type

Derivatives are of two types: financial and commodities.

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Common derivative contract types

Some of the common variants of derivative contracts are as follows:

1. Forwards: A tailored contract between two parties, where payment takes place at a specific
time in the future at today's pre-determined price.
2. Futures: are contracts to buy or sell an asset on or before a future date at a price specified
today. A futures contract differs from a forward contract in that the futures contract is a
standardized contract written by a clearing house that operates an exchange where the
contract can be bought and sold; the forward contract is a non-standardized contract written
by the parties themselves.
3. Options are contracts that give the owner the right, but not the obligation, to buy (in the
case of a call option) or sell (in the case of a put option) an asset. The price at which the
sale takes place is known as the strike price, and is specified at the time the parties enter
into the option. The option contract also specifies a maturity date. In the case of a European
option, the owner has the right to require the sale to take place on (but not before) the
maturity date; in the case of an American option, the owner can require the sale to take
place at any time up to the maturity date. If the owner of the contract exercises this right,
the counter-party has the obligation to carry out the transaction. Options are of two types:
call option and put option. The buyer of a Call option has a right to buy a certain quantity
of the underlying asset, at a specified price on or before a given date in the future, he
however has no obligation whatsoever to carry out this right. Similarly, the buyer of a Put
option has the right to sell a certain quantity of an underlying asset, at a specified price on

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 or before a given date in the future, he however has no obligation whatsoever to carry out
this right.
4. Binary options are contracts that provide the owner with an all-or-nothing profit profile.
5. Warrants: Apart from the commonly used short-dated options which have a maximum
maturity period of 1 year, there exists certain long-dated options as well, known as Warrant
(finance). These are generally traded over-the-counter.
6. Swaps are contracts to exchange cash (flows) on or before a specified future date based on
the underlying value of currencies exchange rates, bonds/interest rates, commodities
exchange, stocks or other assets. Another term which is commonly associated to Swap is
Swaption which is basically an option on the forward Swap. Similar to a Call and Put
option, a Swaption is of two kinds: a receiver Swaption and a payer Swaption. While on
one hand, in case of a receiver Swaption there is an option wherein you can receive fixed
and pay floating, a payer swaption on the other hand is an option to pay fixed and receive
floating.

Swaps can basically be categorized into two types:

 Interest rate swap: These basically necessitate swapping only interest associated cash flows
in the same currency, between two parties.
 Currency swap: In this kind of swapping, the cash flow between the two parties includes
both principal and interest. Also, the money which is being swapped is in different currency
for both parties.

PROBLEMS
1. For all parties involved, which of the following financial instruments is NOT an example of a forward
commitment?
A. Swap B. Call option C. Futures contract D. Forward contract
2. The main risk faced by an individual who enters into a forward contract to buy the S&P 500 Index is that
A. the market may rise. B. the market may fall.
C. market volatility may rise. D. market volatility may fall.
3. Which of the following statements is most accurate?
A. Futures contracts are private transactions.
B. Forward contracts are marked to market daily.
C. Futures contracts have more default risk than forward contracts.
D. Forward contracts require that both parties to the transaction have a high degree of
creditworthiness.

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4. Which of the following statements is least accurate?
A. Futures contracts are easier to offset than forward contracts.
B. Forward contracts are generally more liquid than futures contracts.
C. Forward contracts are easier to tailor to specific needs than futures contracts.
D. Futures contracts are characterized by having a clearinghouse as an intermediary.
5. A swap is best characterized as a
A. series of forward contracts.
B. derivative contract that has not gained widespread popularity.
C. single fixed payment in exchange for a single floating payment.
D. contract that is binding on only one of the parties to the transaction.
6. Which of the following is most representative of forward contracts and contingent claims?

7. For the long position, the most likely advantage of contingent claims over forward commitments is that
contingent claims
A. are easier to offset than forward commitments.
B. have lower default risk than forward commitments.
C. permit gains while protecting against losses.
D. are typically cheaper to initiate than forward commitments.
8. For derivative contracts, the notional principal is best described as
A. the amount of the underlying asset covered by the contract.
B. a measure of the actual payments made and received in the contract.
C. tending to underestimate the actual payments made and received in the contract.
D. being, conceptually and in aggregate, the best available measure of the size of the market.

9. By volume, the most widely used group of derivatives is the one with contracts written on which of the
following types of underlying assets?
A. Financial B. Commodities C. Energy-related D. Precious metals
10. Which of the following is least likely to be a purpose served by derivative markets?
A. Arbitrage B. Price discovery C. Risk management D. Hedging and speculation
11. The most likely reason derivative markets have flourished is that
A. derivatives are easy to understand and use.
B. derivatives have relatively low transaction costs.

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 C. the pricing of derivatives is relatively straightforward.
D. strong regulation ensures that transacting parties are protected from fraud.
12. If the risk-free rate of interest is 5 percent and an investor enters into a transaction that has no risk, the rate of
return the investor should earn in the absence of arbitrage opportunities is
A. 0%. B. between 0% and 5%. C. 5%. D. more than 5%.
13. If the spot price of gold is $250 per ounce and the risk-free rate of interest is 10 percent per annum, the six-
month forward price per ounce of gold, in equilibrium, should be closest to
A. $250.00. B. $256.25. C. $262.50. D. $275.00.
14. Concerning efficient financial (including derivative) markets, the most appropriate description is that
A. it is often possible to earn abnormal returns.
B. the law of one price holds only in the academic literature.
C. arbitrage opportunities rarely exist and are quickly eliminated.
D. arbitrage opportunities often exist and can be exploited for profit.
15. Stock A costs $10.00 today and its price will be either $7.50 or $12.50 next period. Stock B's price will be
either $18.00 or $30.00 next period. If risk-free borrowing and lending are possible at 8 percent per period,
neither stock pays dividends, and it is possible to buy and sell fractional shares, Stock B's equilibrium price
today should be closest to
A. $19.00. B. $21.00. C. $24.00. D. $26.00.

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