Altamayyuz academy

IE Business School

Student: Ali Alnajrani

Capstone project: Financial Derivatives
 Executive summary
Financial derivatives are financial instruments that derive their value from underlying assets or
financial indices. Derivatives are used in finance for hedging and speculation purposes, enabling
investors to protect themselves from losses or profit from price movements in underlying
assets. Over the past few decades, the usage of financial derivatives has increased dramatically
due to advancements in technology, which have allowed for trading to be done more efficiently
and with higher liquidity. This essay will provide an overview of financial derivatives, including a
definition of what they are and how they are used in finance, the different types available
today, an examination of both the advantages and disadvantages associated with using
derivatives.

Table of contents:
1. What are financial derivatives?
2. Advantages and disadvantages
3. Type of financial der
 Options
 Swabs
 Futures and forwards
4. Conclusion
5. Reference
 financial derivatives

Financial derivatives are a financial instrument that derives its value from an underlying asset,
index, or benchmark. They provide investors with a way to hedge against risk or speculate on
price movements in financial markets. Derivatives can be complex and vary in type, with
different types of contracts serving different purposes. Investors should understand the risks
involved with each type of derivative before investing. futures contracts are one of the most
common types of derivatives. They allow investors to buy or sell an underlying asset at a future
date at a predetermined price. Futures are commonly used to hedge against price fluctuations
in commodities such as oil or agricultural products, but they can also be used for financial
products like stocks and bonds. Futures contracts are standardized, which means that they are
traded on exchanges and have set expiration dates and delivery terms. Second derivatives are
options which give the holder the right but not the obligation to buy or sell an underlying asset
at a predetermined price before a specific expiration date. Third is Swaps, which involve
exchanging cash flows over a specified period. It is typically used to manage risk associated with
interest rates, currencies, or commodities. Interest rate swaps involve exchanging fixed-rate
interest payments for floating-rate interest payments or vice versa.

Also, there are more complex types of derivatives such as Exotic options. Exotic options may
have unique features such as knock-in or knock-out levels, barriers, or other complex payout
structures. Equity-linked notes and credit-linked notes are types of exotic options that grant
holders rights based on specific equities or debt instruments, respectively. Forward rate
agreements (FRAs) are another type of derivative that involve interest rate swaps. FRAs are
contracts between two parties to exchange a fixed interest rate for a floating interest rate at a
future date. Total return swaps (TRS) are another type of derivative that involve the exchange
of cash flows based on the performance of a particular asset or benchmark. TRS are commonly
used by hedge funds and other institutional investors to gain exposure to specific investments
without owning the underlying asset. Fixed-for-floating interest rate swaps (IFRS) involve
exchanging fixed interest rate payments for floating interest rate payments based on a
predetermined benchmark. Currency swaps are another type of swap that involves the
exchange of cash flows in different currencies at predetermined rates.
 Advantages and disadvantages

There are both advantages and disadvantages associated with using financial derivatives
depending on whether they are used for hedging or speculation purposes. Hedging allows
investors to protect themselves against potential losses while speculative investments can lead
to greater returns but carry a higher-level risk profile than other traditional investments. On
one hand it can be argued that derivates can facilitate trading between parties since they allow
participants access into new markets otherwise inaccessible and increase liquidity due to their
flexibility when it comes down to being able to transfer risk between parties quickly and
efficiently. On the other hand, there have been several cases where too much reliance has been
placed on derivative contracts resulting in large losses due excessive volatility within these
markets-highlighting the need for better risk management strategies when dealing with these
markets. Another advantage of financial derivatives is that they can offer investors access to a
wide range of assets and markets, including those that may not be available through traditional
investments. This can allow investors to diversify their portfolios and spread their risk across
multiple asset classes, potentially reducing their overall level of risk. Additionally, derivatives
can provide a cost-effective means of gaining exposure to certain assets. For example, instead
of buying physical commodities such as gold or oil, investors can buy futures contracts or
options on those commodities, which can be more cost-effective and efficient.

Another benefit of financial derivatives is their flexibility. Derivatives contracts can be tailored
to meet the specific needs of individual investors, allowing them to customize their exposure to
different risks and return profiles. For example, an investor may use an interest rate swap to
convert a variable-rate loan into a fixed-rate loan, thereby reducing their exposure to interest
rate risk. However, as previously mentioned, financial derivatives also come with certain
disadvantages and risks. One major risk is the potential for large losses if the market moves in
an unfavorable direction. This risk can be amplified if investors use leverage to magnify their
exposure to derivatives contracts, which can lead to significant losses if the market moves
against them. Another risk associated with derivatives is the potential for counterparty risk,
which refers to the risk that one party to the contract will default on their obligations. This risk
can be mitigated by using derivatives clearinghouses, which act as intermediaries between the
parties to the contract and help to reduce counterparty risk. Furthermore, the complexity of
derivatives contracts can make them difficult to understand and value accurately. This can
make it challenging for investors to assess the risks associated with a particular derivative
contract and to make informed investment decisions. Overall, therefore there needs to be a
balance between taking sensible risks without being overly exposed by not diversifying enough
across multiple positions as well as understanding all potential implications before entering into
any contractual agreement involved with derivative trading.

Options

Stock options are a type of asset and financial tool that allow investors to capitalize on stock
market fluctuations and make profits or hedge against loss. A stock option is a contract
between two parties, the seller and buyer, where the seller agrees to sell a specified quantity of
underlying assets at a predetermined price within a specific time frame. Investors use stock
options as an investment strategy, as it can provide them with higher returns when used
correctly. There are various types of stock options available for investors, each with their own
unique advantages and disadvantages which must be understood to take advantage of the
opportunities they present. One of the primary benefits that stock options offer is their
potential for higher returns than other investments. By buying an option at a lower strike price
and selling it at a higher strike price later, investors can profit from movements in the
underlying asset over time. Moreover, stock options provide greater flexibility in portfolio
management as they give investors more control over when and how much they can invest or
divest in any given asset. For instance, using put or call options allows investors to exit their
positions quickly if they feel their investments will go down in value or enter positions which
may appreciate faster than other investments without allocating too many resources upfront
(Hallock & Olson 2008). The various types of stock options available to investors include call
options, put options and covered calls.

A call option gives the holder the right but not obligation to buy an underlying asset at a
predetermined strike price before expiration date. Put Options give holders the right but not
obligation to sell an underlying asset at a predetermined strike price before expiration date
whereas covered calls involve writing call option contracts against existing stocks owned by
investor (Hallock & Olson 2008). Other less common types of options contracts are straddles,
collars etc., each with its own features and benefits depending on individual investor
requirements. to note that stock options can be used for both speculative and hedging
purposes. Speculative investors use options to take advantage of potential price movements in
the underlying asset, while hedgers use options to protect against potential losses.

Call options are a popular choice for speculative investors because they offer the potential for
unlimited profit with limited risk. If an investor buys a call option and the underlying stock price
goes up, the investor can exercise the option and buy the stock at the lower strike price, then
sell it at the higher market price for a profit. If the stock price does not go up, the investor can
simply let the option expire and only lose the premium paid for the option. Put options are a
popular choice for hedgers because they offer protection against potential losses in the
underlying asset. If an investor holds a stock and fears that its price may go down, they can buy
a put option to protect themselves against that loss. If the stock price does go down, the
investor can exercise the option and sell the stock at the higher strike price, thus limiting their
losses.

Covered calls are another popular option strategy that can generate income for investors. In
this strategy, the investor sells call options on a stock they already own, earning a premium for
selling the option. If the stock price does not go up, the investor keeps the premium and the
stock. If the stock price does go up and the call option is exercised, the investor sells the stock
at the higher price, but loses out on any additional gains above the strike price. Overall, stock
options are a complex but useful tool for investors who want to manage their portfolio risk or
take advantage of potential price movements in the stock market. It's important for investors to
fully understand the risks and benefits of each type of option before investing, and to use them
as part of a larger investment strategy that aligns with their financial goals and risk tolerance.

Swaps

Financial swaps are a complex financial instrument that allows parties to exchange cash flows
based on predetermined terms. These agreements can be used for hedging or speculative
purposes and can involve a wide range of financial assets, including interest rates, currencies,
and commodities. Financial swaps enable parties to manage their risk exposure and optimize
their financial position. One of the most common types of financial swaps is an interest rate
swap. This involves the exchange of fixed-rate interest payments for floating-rate interest
payments or vice versa. For example, a company with a variable-rate loan may want to swap
those variable-rate payments for fixed-rate payments to reduce their risk of rising interest
rates. This would involve the company agreeing to pay a fixed rate of interest to the
counterparty, who would agree to pay a floating rate of interest in return. By doing this, the
company can effectively convert their variable-rate loan into a fixed-rate loan and reduce their
exposure to interest rate fluctuations. Another type of financial swap is a currency swap. This
involves the exchange of cash flows in different currencies. For example, a multinational
corporation may need to convert revenue earned in one currency to another currency to pay
expenses in that currency. Currency swaps can be used to manage currency risk and reduce
exposure to currency exchange rate fluctuations. They can also be used to obtain financing in a
foreign currency, which may be more advantageous than borrowing in the domestic currency.
Commodity swaps are another type of financial swap that involves the exchange of cash flows
based on the price of a commodity, such as oil or gold. These swaps can be used by companies
that produce or consume commodities to manage their exposure to price fluctuations.

For example, an oil producer may enter into a swap agreement to lock in a price for their oil
production, while an airline may enter into a swap agreement to lock in a price for their jet fuel
expenses. In addition to these types of swaps, there are many other types of financial swaps
available, including equity swaps, credit default swaps, and total return swaps. Equity swaps
involve the exchange of cash flows based on the performance of an underlying stock or equity
index, while credit default swaps involve the exchange of cash flows based on the
creditworthiness of a particular borrower or bond issuer. Total return swaps involve the
exchange of cash flows based on the total return of an underlying asset, such as a stock or
bond. Financial swaps can be used for both hedging and speculative purposes. Hedging involves
using swaps to reduce risk, while speculation involves using swaps to take on risk in the hopes
of making a profit. For example, a company may use a swap agreement to hedge against a
potential interest rate increase, while a hedge fund may use a swap agreement to take a
leveraged position in a particular asset class. So financial swaps are a powerful financial tool
that can be used to manage risk, optimize financial positions, and take advantage of market
opportunities. However, they are also complex instruments that require a deep understanding
of the underlying assets and the terms of the agreement. As such, it is important for parties to
carefully evaluate the risks and benefits of entering into a swap agreement and to seek expert
advice when necessary.

Futures and forwards contracts

A futures contract is an agreement between two parties to buy or sell an asset at a
predetermined price on a specific date in the future. This type of contract is commonly used in
financial markets to hedge against price fluctuations or to speculate on future prices. The buyer
and seller both agree on the terms of the contract, including the quantity, quality, delivery date
and price. Futures contracts have several advantages over other types of investments such as
lower transaction costs and greater liquidity. Additionally, they can be used as a method for
hedging against risks associated with changes in market prices. However, there are some
disadvantages such as high leverage which can lead to significant losses if not managed
properly. In addition, there are also some risks associated with these contracts including
counterparty risk and market risk which should be taken into consideration when investing in
futures contracts.
Forward contracts are an essential tool used in the financial market, providing security and
flexibility for parties wishing to manage risk and conduct business. Forwards are derivatives that
require two parties to agree on a certain price for an asset or currency at some point in the
future. This agreement is documented as a “forward contract” and serves as a legally binding
obligation between the buyer and seller. There are several types of forward contracts, all with
their own distinct characteristics. Currency forwards are commonly used in foreign exchange
markets, allowing parties to hedge against movements in currency prices. Commodity forwards
allow parties to buy or sell commodities at a predetermined price over a certain period,
providing protection against fluctuations in market prices. Equity forwards, meanwhile, allow
parties to transfer equity ownership by buying or selling securities at an agreed-upon price on
an agreed-upon date.

Using forward contracts has numerous advantages for both buyers and sellers. These contracts
allow for risk management strategies that can be beneficial in volatile markets where prices
may fluctuate significantly over short periods of time. By ensuring a predetermined price for
the asset over the contract period, the risk of loss due to changing market conditions is reduced
significantly. Moreover, forward contracts can also provide increased liquidity by allowing
businesses to access capital more quickly than would otherwise be possible. However, there are
also some disadvantages associated with using forward contracts that should be taken into
consideration before entering into such agreements. One major disadvantage is that they can
find it difficult to liquidate due to their long-term nature and lack of secondary trading markets.

Conclusion

In conclusion, financial derivatives are complex but powerful instruments that have become
increasingly important tools for managing investment risk and hedging, enabling speculation on
prices movements and can offer investors a wide range of benefits, including increased access
to markets and assets, cost-effectiveness, and flexibility. Although they may carry certain risks if
used improperly. However, it is important to note that financial derivatives can be complex
instruments that require a certain level of expertise to use effectively. As such, individuals and
companies who invest in these instruments must have a thorough understanding of the
underlying assets and market conditions before engaging in any derivative transactions.
Moreover, derivative instruments can be highly leveraged, which can amplify both gains and
losses, making it essential to manage risk effectively.
 References
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Cinque grana, Piero. The Need for Transparency in Commodity and Commodity Derivatives Markets.
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https://core.ac.uk/download/5130083.pdf