DERIVATIVES REPORTING OUTLINE

I. INTRODUCTION

Investors use derivatives to hedge speculate or increase their leverage and there
is a growing vast array of instruments to choose from but it's crucial that an
investor should know the risks derivatives can pose to their portfolio.

A derivative investment is one in which the investor is not only the underlying
asset but instead bets on the asset price movement with another party. It derives
its value from the performance of the underlying assets, and the riskier that asset
is the riskier the derivative.

Investors typically use derivatives to hedge their position for leverage or to

speculate. Hedging protects investors against asset Risk.
For example an investor may buy a put option on a stock she owns to protect
against the chance the stocks value will fall in volatile markets an option can
provide leverage especially when the price of the underlying asset moves in a
favorable direction and speculating let's investors

WHAT IS DERIVATIVES

KEY TAKEAWAYS
● Derivatives are financial contracts, set between two or more parties, that derive
their value from an underlying asset, group of assets, or benchmark.
● A derivative can trade on an exchange or over-the-counter.
● Prices for derivatives derive from fluctuations in the underlying asset.
● Derivatives are usually leveraged instruments, which increases their potential
risks and rewards.
● Common derivatives include futures contracts, forwards, options, and swaps.

The term derivative refers to a type of financial contract whose value is

dependent on an underlying asset, group of assets, or benchmark. A derivative is
set between two or more parties that can trade on an exchange or over-the-
counter (OTC).

These contracts can be used to trade any number of assets and carry their own
risks. Prices for derivatives derive from fluctuations in the underlying asset.
These financial securities are commonly used to access certain markets and may
 be traded to hedge against risk. Derivatives can be used to either mitigate risk
(hedging) or assume risk with the expectation of commensurate reward
(speculation). Derivatives can move risk (and the accompanying rewards) from
the risk-averse to the risk seekers.

Underlying asset - An underlying asset can be used to identify the item

within the agreement that provides value to the contract. The underlying asset
supports the security involved in the agreement, which the parties involved agree
to exchange as part of the derivative contract.
Knowing the value of an underlying asset helps traders determine the
appropriate action (buy, sell, or hold) with their derivative.

Example of an Underlying Asset

In cases involving stock options, the underlying asset is the stock itself.
For example, with a stock option to purchase 100 shares of Company X at a
price of $100, the underlying asset is the stock of Company X. The underlying
asset is used to determine the value of the option up till expiration. The value of
the underlying asset may change before the expiration of the contract, affecting
the value of the option. The value of the underlying asset at any given time lets
traders know whether the option is worth exercising or not.

Uses of Derivatives
–Risk management
● Hedging (e.g. farmer with corn forward)
> Derivatives are most frequently traded in order to hedge (reduce risk) or
speculate (increase risk with the aim of making a financial gain), and their
value is set according to the supply and demand for the underlying asset.
> Using Derivatives to Manage Risk: A Jargon Free Guide
Ref: https://www.czarnikow.com/blog/price-risk-management-how-we-use-derivatives-
czarnikow#:~:text=Derivatives%20and%20risk%20management,demand%20for%20the
%20underlying%20asset.

–Speculation
● Essentially making bets on the price of something
–Reduced transaction costs
● Sometimes cheaper than manipulating cash portfolios
–Regulatory arbitrage
 ● Tax loopholes, etc
● Regulatory arbitrage is a corporate practice of utilizing more
favorable laws in one jurisdiction to circumvent less favorable
regulation elsewhere.
● This practice is often legal as it takes advantage of existing
loopholes; however, it is often considered unethical.
● Closing loopholes and enforcing regulatory regimes across national
borders can help reduce the prevalence of regulatory arbitrage.

Perspectives on Derivatives
–The end-user
oUse for one or more of the reasons above
KEY TAKEAWAYS
● An end user is a person or other entity that consumes or makes use of the goods
or services produced by businesses.
● In this way, an end user may differ from a customer—since the entity or person
that buys a product or service may not be the one who actually uses it.
● Delivery to the end user is often the final step in manufacturing and selling
products.
● End user experience and support are crucial for the success of user-oriented
products and services.
● References to "end users" as customers are most common in the technology
industry.
–The market-maker
oBuy or sell derivatives as dictated by end users
oHedge residual positions
oMake money through bid/offer spread

The market-maker spread is the difference between the price at which a market-maker
(MM) is willing to buy a security and the price at which it is willing to sell the security.
The market-maker spread is effectively the bid-ask spread that market makers are
willing to commit to. It is the difference between the bid and the ask price posted by the
market maker for security.

This spread represents the potential profit that the market maker can make from this
activity, and it's meant to compensate it for the risk of market-making. The risk inherent
in a given market can affect the width of the market-maker spread: High volatility or a
lack of liquidity in a security will tend to increase the size of the market-maker spread.
 ● The market-maker spread is the difference in bid and ask price set by the market
makers in a particular security.
● Market makers earn a living by having investors or traders buy securities where
MMs offer them for sale and having them sell securities where MMs are willing to
buy.
● The wider the spread, the more potential earnings an MM can make, but
competition among MMs and other market actors can keep spreads tight.
● High volatility or increased risk can lead to MMs widening their spreads to
compensate.
Video What Is the Market-Maker Spread?

–The economic observer

oRegulators, and other high-level participants

The Economic Observer: Finally, we can look at the use of derivatives, the activities of
the marketmakers, the organization of the markets, and the logic of the pricing models
and try to make sense of everything. This is the activity of the economic observer.
Regulators must often don their economic observer hats when deciding whether and
how to regulate a certain activity or market participant.
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Regulators: How best it should be managed, not mass bankruptcies
Financial Engineering and Security Design
–Financial engineering
•The construction of a given financial product from other products
oMarket-making relies upon manufacturing payoffs to hedge risk
oCreates more customization opportunities
oImproves intuition about certain derivative products because they are similar or
equivalent to something we already understand
–Enables regulatory arbitrage

What Is Financial Engineering?

Financial engineering is the use of mathematical techniques to solve financial problems.
Financial engineering uses tools and knowledge from the fields of computer science,
statistics, economics, and applied mathematics to address current financial issues as
well as to devise new and innovative financial products.
Financial engineering is sometimes referred to as quantitative analysis and is used by
regular commercial banks, investment banks, insurance agencies, and hedge funds.

● Financial engineering is the use of mathematical techniques to solve financial

problems.
● Financial engineers test and issue new investment tools and methods of
analysis.
● They work with insurance companies, asset management firms, hedge funds,
and banks.
● Financial engineering led to an explosion in derivatives trading and speculation in
the financial markets.
● It has revolutionized financial markets, but it also played a role in the 2008
financial crisis.
•The Role of the Financial Markets
–Financial markets impact the lives of average people all the time, whether they realize
it or not
oEmployer’s prosperity may be dependent upon financing rates
oEmployer can manage risk in the markets
oIndividuals can invest and save
oProvide diversification
oProvide opportunities for risk-sharing/insurance
oBank sells off mortgage risk which enables people to get mortgages

Financial markets exist for several reasons, but the most fundamental function
is to allow for the efficient allocation of capital and assets in a financial
economy. By allowing a free market for the flow of capital, financial
obligations, and money the financial markets make the global economy run
more smoothly while also allowing investors to participate in capital gains over
time.

Rather than trading stocks directly, a derivatives market trades in futures and
options contracts, and other advanced financial products, that derive their
value from underlying instruments like bonds, commodities, currencies,
interest rates, market indexes, and stocks.
Ref: https://www.investopedia.com/terms/e/end-user.asp

II. UNDERSTANDING DERIVATIVES

a. Why do investors enter derivative contracts
> Arbitrage Advantage
> Protection against market volatility
> Park surplus funds
b. Participants in derivatives Market
> Hedgers
> Speculators
> Margin traders
> Arbitrageurs

IV. TYPES OF DERIVATIVES

Four Major Types of Derivatives

1. Options
a. Trading (buying and selling ) Call Options
b. Trading (buying and selling ) Put Options

Other Options Terminology

In addition to these four basic options positions, traders can also

use options to build spreads or combinations. A spread involves buying
and selling options together on the same underlying, while a combination
is buying (selling) two or more options. Here are a few basics:
● Vertical call/put spread: Buy (sell) one call (put) and sell (buy) and more
out-of-the-money call (put). Vertical spreads that profit in up markets are
bull spreads; in down markets bear spreads.
● Calendar Spread: Buy (sell) an option with one maturity to sell (buy) an
option with a different maturity.
● Straddle: buying both a call and a put of the same strike and expiration
● Strangle: buying both a call and a put at the same expiration but different
(out-of-the-money) strikes.
● Butterfly: a market-neutral strategy involving buying (selling) a straddle
and selling (buying) a strangle
● Covered Call: sell shares against an existing stock position.
● Protective Put: buy shares against an existing stock position.

2. Futures
> Futures Contracts
> Hedge
> Stock Market Index Future
> Over-the-counter
> Types of OTC Securities
- Stocks
- Bonds
- Derivatives
- ADRs
- Foreign Currency
- Cryptocurrency
> OTCQX
> OTCQB
> Pink Sheets

3. Forwards
> Hedging
> Derivative Date
> Spot Price
> Interest Rate Risk
> Settlement Date
> Forward rate
> Spot rate
> Event of default
> Expiration Dates

4. Swaps
> Interest rate swap
> Commodity swaps
> Currency Swaps
> Debt Equity Swaps
> Total Return Swaps
> Credit Default Swaps
OTHER TYPES OF DERIVATIVES

1. INTEREST RATE DERIVATIVE

2. ARBITRAGE
3. COLLATERALIZED DEBT OBLIGATION
4. EQUITY DERIVATIVE
5. LEVERAGE
6. CREDIT DERIVATIVE
7. CONTRACT FOR DIFFERENCE
8. INTEREST
9. WARRANT

V. ADVANTAGE AND DISADVANTAGES OF DERIVATIVES

References:

https://www.investopedia.com/terms/d/derivative.asp
https://www.investopedia.com/terms/u/underlying-asset.asp
https://www.czarnikow.com/blog/price-risk-management-how-we-use-derivatives-
czarnikow#:~:text=Derivatives%20and%20risk%20management,demand%20for%20the
%20underlying%20asset.