FINANCIAL DERIVATIVES

By: Saad Hussain

Contents

History
Definition
Traders of Derivative Market
Derivatives Losses
OTC & ETD
Types of Derivatives Contracts
Derivative Markets in Pakistan
Derivatives Users in Pakistan
Need of Derivatives in Pakistan
Advantages & Disadvantages
History

In the 17th centaury the formers of Japan used the derivatives

contract for rice.
In 1848, a first derivatives exchange created in Chicago which is
known as Chicago Board of Trade (CBOT).
A rival futures exchange, the Chicago Mercantile Exchange (CME),
was established in 1919
$1.2 quadrillion is the so-called notional value of the worldwide
derivatives market. To put that in perspective, the world's annual
gross domestic product is between $50 trillion and $60 trillion.

A quadrillion is: 1,000 times a trillion

What are Derivatives?
A derivative is a financial instrument (Contract) whose value is derived
from the value of another asset, which is known as the underlying.
When the price of the underlying changes, the value of the derivative
also changes.
A Derivative is not a product. It is a contract that derives its value
from changes in the price of the underlying.
Example :
The value of a gold futures contract is derived from the
value of the underlying asset i.e. Gold.
Traders in Derivatives Market

There are 3 types of traders in the Derivatives Market :

Hedger
A hedger is someone who faces risk associated with price movement of an
asset and who uses derivatives as means of reducing risk. They provide
economic balance to the market.
Speculator
A trader who enters the futures market for pursuit of profits, accepting risk
in the endeavour. They provide liquidity and depth to the market.
Aarbitrageur
A person who simultaneously enters into transactions in two or
more markets to take advantage of the discrepancies between
prices in these markets.
Arbitrage involves making profits from relative mispricing.
Arbitrageurs also help to make markets liquid, ensure accurate
and uniform pricing, and enhance price stability
They help in bringing about price uniformity and discovery.
Losses in Derivatives

Procter & Gamble lost $150 million in 1994

Barings Bank lost $1.3 billion in 1995
Long-Term Capital Management lost $3.5 billion in 1998
The hedge fund Amaranth lost $6 billion in 2006
Societe Generale lost 5 billion GBP in 2008
AIGs $85 billion loss on credit default swaps during the
crises in 2008
OTC and ETD.
Over-the-counter
Over-the-counter (OTC) or off-exchange trading is to trade
financial instruments such as stocks, bonds, commodities or
derivatives directly between two parties without going through an
exchange or other intermediary.
The contract between thetwo parties are privately negotiated.
The contract can be tailor-made to the two parties liking.
Over-the-counter markets are uncontrolled, unregulated and have
very few laws. Its more like a freefall.
Exchange-traded Derivatives
Exchange traded derivatives contract (ETD) are those derivatives
instruments that are traded via specialized Derivatives exchange or
other exchanges. A derivatives exchange is a market where
individuals trade standardized contracts that have been defined by
the exchange.
The world's largest derivatives exchanges (by number of transactions)
are the Korea Exchange.
There is a very visible and transparent market price for the derivatives.
What is a Forward?
A forward is a contract in which one party commits to buy and the
other party commits to sell a specified quantity of an agreed upon
asset for a pre-determined price at a specific date in the future.

It is a customised contract, in the sense that the terms of the

contract are agreed upon by the individual parties.

Hence, it is traded on OTC.

 Forward Contract Example

I agree to sell Bread

Farmer 500kgs wheat at
Maker
Rs.40/kg after 3
months.

3 months Later

500kgs wheat Bread

Farmer Maker
Rs.20,000
What are Futures?
Future contracts are also agreements between two parties in which
the buyer agrees to buy an underlying asset from the other party (the
seller). The delivery of the asset occurs at a later time, but the price
is determined at the time of purchase.
A future is a standardized forward contract.
It is traded on an organized exchange.
Standardizations-
- quantity of underlying
- quality of underlying(not required in financial futures)
- delivery dates and procedure
- price quotes
Types of Futures Contracts

Stock Futures Trading (dealing with shares)

Commodity Futures Trading (dealing with gold futures, crude oil

futures)
 What are Options?

Contracts that give the holder the option to buy/sell specified

quantity of the underlying assets at a particular price on or before a
specified time period.
The word option means that the holder has the right but not the
obligation to buy/sell underlying assets.
Types of Options

Options are of two types call and put.

Call option give the buyer the right but not the obligation to buy a
given quantity of the underlying asset, at a given price on or
before a particular date by paying a premium.
Puts give the seller the right, but not obligation to sell a given
quantity of the underlying asset at a given price on or before a
particular date by paying a premium.
 Call Option Example

CALL OPTION Current Price = Rs.250

Premium =
Rs.25/share Right to buy 100
Nestle shares at a
Amt to buy Call option price of Rs.300 per Strike Price
= Rs.2500
share after 3 months.
Expiry
date
Suppose after a month, Market
price is Rs.400, then the option is Suppose after a month, market price
exercised i.e. the shares are is Rs.200, then the option is not
bought. exercised.
Net gain = 40,000-30,000- Net Loss = Premium amt
2500 = Rs.7500 = Rs.2500
 Put Option Example

PUT OPTION Current Price = Rs.250

Premium =
Rs.25/share Right to sell 100 Nestle
shares at a price of
Amt to buy put option Rs.300 per share after Strike Price
= Rs.2500
3 months.
Expiry
date
Suppose after a month, Market
price is Rs.200, then the option is Suppose after a month, market price
exercised i.e. the shares are sold. is Rs.400, then the option is not
Net gain = 30,000-20,000-2500 = exercised.
Rs.7500 Net Loss = Premium amt
= Rs.2500
What are SWAPS?

Is agreement between two parties that exchange sequence of cash

flows for a set period of time.
The two commonly used Swaps are:
1. Interest Rate Swaps : A interest rate swap entails swapping only the
interest related cash flows between the parties in the same currency.

2. Currency Swaps : A currency swap is a foreign exchange agreement

between two parties to exchange a given amount of one currency for
another and after a specified period of time, to give back the original
amount swapped.
 Derivative Market in Pakistan
In Pakistan, derivatives based on financial assets trade
on the Pakistan
Stock Exchange (PSX), while commodity-based derivatives trade on the
Pakistan Mercantile Exchange (PMEX).
Stock future introduced in Pakistan in 2001, initially this instrument could
not get attention in the investment community but only after 3 year Single
security future goes in rock pace growth. Eventually in 2007 it has
approximately above 36% of total trading volume of the stock exchange.
Individuals are more interested as financial institution and in 2007-2008 it
has 26% volume of total market. Up to 2011 only 42 companies has
permission to launch the stock futures which is now increase in numbers.
Index future operated in Pakistan after 2003 and got immense attraction of
investor. In Pakistan KSE30 index is available at 30, 60 and 90 day of
settlement.
Users of Derivatives in Pakistan

Lucky Cement Ltd

Kohinoor Mill Ltd
Attock Cement Ltd
National Bank of Pakistan
Standard Chartered Bank
AKD Ltd
In 2004-2005 during expansion cement sectors overcome risk by
accumulating 60% forward contracts.
NEED OF DERIVATIVES IN PAKISTAN

Need of growth in business and fluctuation of risk in the

economy
Financial , limited access to sources of funds and multi-
national business emergence
Financial engineering and risk mitigation focus of the
businesses
Advantages

Reduces risk
Enhance liquidity of the underlying asset
Lower transaction costs
Enhances the price discovery process.
Portfolio Management
Provides signals of market movements
Facilitates financial markets integration
Disadvantages

Increasing Speculation
Lack of Transparency
Uncontrollable Environment
References

http://www.pakistaneconomist.com/pagesearch/Search-
Engine2007/S.E567.php
EXPLORING DEVELOPMENT OF FINANCIAL DERIVATIVE IN
PAKISTAN
Questions