Derivative markets

The derivative market is a financial market where various types of derivative instruments are
traded. Derivatives are financial contracts whose value is derived from an underlying asset or
benchmark. These instruments allow investors to speculate on price movements, hedge against
risks, or gain exposure to various financial variables.
1. Here are key points about the derivative market:

 Types of Derivatives: The derivative market encompasses a wide range of instruments,

including futures contracts, options, swaps, forwards, and other more complex derivatives. These
instruments can be based on various underlying assets, such as commodities, currencies, interest
rates, stocks, bonds, or indices.

 Trading Platforms: Derivatives can be traded on organized exchanges, such as the Chicago
Mercantile Exchange (CME) or the London International Financial Futures Exchange (LIFFE).
These exchanges provide standardized contracts and a centralized marketplace for buyers and
sellers to trade derivatives. Additionally, there is an over-the-counter (OTC) market where
customized derivatives are traded directly between parties.

 Speculation and Hedging: The derivative market serves as a platform for investors to
speculate on the future price movements of underlying assets. Speculators aim to profit from
their anticipated price changes. On the other hand, derivatives also provide risk management
tools for hedging. Market participants, such as businesses, investors, and financial institutions,
use derivatives to hedge against price volatility, interest rate fluctuations, foreign exchange risks,
and other market variables.

For the purposes of this module we are going to focus on the following derivative markets

1. Forward market
2. Futures market
3. Currency options market

2. Forward market
3. It facilitates the trading of forward contracts on currencies
4. A forward contract is an agreement between a corporation and commercial bank to
exchange a specified amount of a currency at a specified exchange rate called a forward
rate on a specified date in the future
5. When MNCs anticipate a future need for a future receipt of a foreign currency, they can
set up forward contracts to lock in the rate at which they purchase or sell a particular
foreign currency
6. Forward contracts are usually used by large corporations and they are worth $1million or
more
7. The most common forward contract are for 30, 60, 90,180 and 360 days although other
periods are available
 8. The forward rate of a currency will typically vary with the length of the forward period
9. MNCs use forward contracts to hedge their imports. They can lock in the rate at which
they obtain a currency needed to purchase imports.
10. A forward contract is a bilateral contract that obligates one party to buy and the other to
sell a specific quantity of an asset at a set price on a specific date in the future
11. The party to the forward contract that agrees to buy the financial or physical asset has a
long forward position and is often called the long.

Mechanics of the forward contract

A forward contract is a financial agreement between two parties to buy or sell an asset at a
predetermined price (the "forward price") on a specified future date. Here are the key mechanics
of a forward contract:

1. Parties: A forward contract involves two parties: the buyer (long position) and the seller
(short position). They are also referred to as the "counterparties" to the contract.
2. Underlying Asset: The forward contract specifies the underlying asset that will be bought
or sold in the future. It can be a commodity, currency, stock, bond, or any other financial
instrument.
3. Forward Price: The forward price is the agreed-upon price at which the underlying asset
will be bought or sold on the future date. The buyer and seller negotiate and agree on this
price at the time of entering into the contract.
4. Contract Expiration: The forward contract has a specified expiration or delivery date,
which is the date on which the buyer and seller are obligated to complete the transaction.
The delivery date is typically determined when the contract is established.
5. Contract Quantity: The forward contract specifies the quantity or volume of the
underlying asset that will be delivered on the delivery date. It could be expressed in units,
tons, barrels, shares, or any other relevant measure.
6. Contract Settlement: There are two common settlement methods for forward contracts:

a. Physical Delivery: In a physical delivery forward contract, the buyer pays the agreed-
upon forward price and takes delivery of the underlying asset on the delivery date. The
seller delivers the asset as specified in the contract.

b. Cash Settlement: In a cash settlement forward contract, the buyer and seller settle the
contract's financial obligations without physically exchanging the underlying asset. The
settlement amount is calculated based on the difference between the forward price and
the prevailing market price of the underlying asset on the delivery date.
 Example

Example of a currency forward contract:

Let's say Company A, based in the United States, is planning to import goods from Company B,
based in Europe, in six months. The purchase price for the goods is €100,000. However,
Company A is concerned about potential fluctuations in the exchange rate between the U.S.
dollar (USD) and the euro (EUR) over the next six months, which could affect the cost in USD.

To mitigate the exchange rate risk, Company A enters into a currency forward contract with a
bank. The contract specifies that in six months, Company A will buy €100,000 from the bank at
a forward exchange rate of 1 EUR = 1.20 USD. The settlement date of the contract is in six
months.

Here's how the currency forward contract works:

1. Hedging Decision: Company A decides to hedge its exposure to exchange rate

fluctuations by entering into the currency forward contract. By fixing the exchange rate at
1.20 USD/EUR, the company aims to protect itself from potential currency appreciation
of the euro against the U.S. dollar.
2. Spot Exchange Rate at Settlement: After six months, the spot exchange rate between the
USD and the EUR is 1 EUR = 1.15 USD. This means that if Company A had not hedged,
it would have had to purchase euros at the higher spot exchange rate, resulting in a higher
cost in USD.
3. Settlement of the Forward Contract: Since Company A entered into a currency forward
contract to buy euros, it can now purchase €100,000 from the bank at the predetermined
forward exchange rate of 1 EUR = 1.20 USD. So, Company A would pay 100,000 EUR *
1.20 USD/EUR = 120,000 USD.
4. Calculation of Hedge Effectiveness: To determine the effectiveness of the hedge, we
compare the total cost of the hedged position (including the forward contract) with the
cost of purchasing the euros at the spot exchange rate.

 Cost of Hedged Position: 120,000 USD (purchase cost based on the forward contract)
 Cost of Spot Purchase: 100,000 EUR * 1.15 USD/EUR = 115,000 USD (purchase cost at
the spot exchange rate)

By hedging with the currency forward contract, Company A saved 5,000 USD ($115,000 -
$120,000) compared to purchasing euros at the spot exchange rate. The hedge effectively locked
in a lower exchange rate, mitigating the impact of the euro's appreciation against the U.S. dollar.

It's important to note that while the hedge protected Company A from currency appreciation, it
also prevented the company from benefiting from currency depreciation. If the spot exchange
rate had been lower than the forward exchange rate, the company would have had to purchase
euros at a higher rate than the prevailing market rate. Hedging involves trade-offs and depends
on the company's risk tolerance and objectives.
This example demonstrates how a currency forward contract can be used to manage exchange
rate risk in international transactions.

4. Futures contract