What is a Derivative?

 A derivative is a financial instrument that derives its

performance from the performance of an underlying asset
 Derivatives can be used for a number of purposes, including
insuring against price movements (hedging), increasing
exposure to price movements for speculation or getting access
to otherwise hard-to-trade assets or markets.
 Some of the more common derivatives include forwards,
futures, options, swaps, and variations of these such as
synthetic collateralized debt obligations and credit default
swaps.
 Underlying Asset

 An underlying asset is the security on which a derivative contract is based upon. The price
of the derivative may be directly correlated (e.g. call option) or inversely correlated (e.g.
put option), to the price of the underlying asset. An underlying asset can be a stock,
commodity, index, currency or even another derivative (E.g. volatility index, VIX) product.
Some exotic derivatives, like weather derivatives, may even have a non-financial entity as
their underlying asset.
 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.
 Common derivatives underlying assets are:
 Equities,, Fixed-income securities, , Currencies, and Commodities.
 Basic Derivative Concepts

A derivative is a financial instrument that derives its performance from the performance of an
underlying asset. The two principal types of derivatives are forward commitments and contingent
claims.

Forward Commitments Contingent Claims

A contingent claim is a derivative in
A forward commitment is an
which the outcome or payoff is
obligation to engage in a
determined by the outcome or payoff
transaction in the spot market at a
of an underlying asset, conditional
future date at terms agreed upon
on some event occurring. Contingent
today. There are three types of
claims include:
forward commitments:
• Options
• Forwards
• Credit Derivatives
• Futures
• Asset-Backed Securities
• Swaps
 Pricing the Underlying Asset

The four main types of underlying assets on which derivatives are based
include:
 Equities
 Fixed-income securities
 Currencies
 Commodities

The price of a financial asset is often determined using a present value of

future cash flows approach. Determining a rate at which to discount the
expected future cash flows is challenging.
 Derivative Markets

Derivatives can be traded on an organized exchange or in

over-the-counter (OTC) markets.

 Exchange-traded derivatives are standardized

 OTC derivatives are customized
To standardize a derivative contract means that its terms and conditions are precisely
specified by the exchange and there is very limited ability to alter those terms (quantity of
a contract, dates on which the contract expires, or the specification of the underlying
asset). Standardization of contract terms facilitates the creation of a more liquid market for
derivatives. Standardization facilitates the creation of a clearing and settlement operation.
Clearing refers to the process by which the exchange verifies the execution of a
transaction and records the participants’ identities.
Settlement refers to the related process in which the exchange transfers money.
The clearinghouse is able to provide this credit guarantee by requiring a cash deposit,
usually called the margin bond or performance bond, from the participants to the contract.
 Exchange markets are said to have transparency, which means that full information on all
transactions is disclosed to exchanges and regulatory bodies. All transactions are centrally
reported within the exchanges and their clearinghouses, and specific laws require that
these markets be overseen by national regulators.
Exchange-traded

 An exchange provide a centralized place where all trades are conducted

 An exchange plays the key role of acting as the counterparty to all trades. This means is
that when you are buying 100 shares of IBM, you are not directly buying it from
another party selling those shares. Instead, you are buying it from the stick exchange.
 An exchange removes counterparty risk, because it stands on the other side of all
trades.
 Since all the all trades flow through one central place, the price quoted for a security is
always the same regardless of who is making the trade. This, in theory, provides a level
playing field for all types of investors.
 Exchanges offer greater regulatory oversight, since only members can trade on the
exchange, and also only listed products can be traded on an exchange.
 Exchange-traded derivatives

Characteristics of derivatives traded on an exchange may include:

 Standardized contract features such as:
 Contract size
 Expiration date
 Underlying assets
 Exchange trades are guaranteed by a clearing house:
 The clearing house requires a margin bond from the contract
participants
 Transparency
 Regulation
 OTC derivatives markets

 The OTC derivatives markets comprise an informal network of market participants that are
willing to create and trade virtually any type of derivative that can legally exist. The
backbone of these markets is the set of dealers, which are typically banks.
 Following the financial crisis that began in 2007, new regulations began to blur the
distinction between OTC and exchange-listed markets. In both the United States (the Wall
Street Reform and Consumer Protection Act of 2010, commonly known as the Dodd–Frank
Act) and Europe (the Regulation of the European Parliament and of the Council on OTC
Derivatives, Central Counterparties, and Trade Repositories), regulations are changing the
characteristics of OTC markets.
 The degree of OTC regulation, although increasing in recent years, is still lighter than that
of exchange-listed market regulation. Many transactions in OTC markets will retain a
degree of privacy with lower transparency, and most importantly, the OTC markets will
remain considerably more flexible than the exchange-listed markets.
 Since there is no centralized exchange and little regulation, there is heavy
competition between different providers for gaining higher trading volume to
their firm.
 OTC markets generally have lower transaction costs compared to exchanges
 In OTC markets, the prices for the securities vary from trade to trade and
from firm to firm. Even the quality of execution varies from firm to firm.
This means that the deals are not always done at the best price.
 OTC markets are prone to counterparty risk because there is no centralized
exchange and the parties are directly dealing with each other.
 Characteristics of over-the-counter
(OTC) Derivatives

OTC derivatives are customized.

Key features may include:
 Flexibility in contract size and asset specification
 Flexibility in expiration date
 OTC derivative markets operate with less regulation and
oversight than do exchange-traded derivative markets:
 Since the financial crisis, OTC derivative activity has come
to the attention of lawmakers.
 Planned regulations may require OTC transactions to be
traded through a clearing agency and reported to regulators.
 Size of market

To give an idea of the size of the derivative market, The Economist has reported that
as of June 2011, the over-the-counter (OTC) derivatives market amounted to
approximately $700 trillion, and the size of the market traded on exchanges totaled
an additional $83 trillion. For the fourth quarter 2017 the European Securities Market
Authority estimated the size of European derivatives market at a size of €660
trillion with 74 million outstanding contracts.
However, these are "notional" values, and some economists say that this value greatly
exaggerates the market value and the true credit risk faced by the parties involved.
For example, in 2010, while the aggregate of OTC derivatives exceeded $600 trillion,
the value of the market was estimated much lower, at $21 trillion. The credit risk
equivalent of the derivative contracts was estimated at $3.3 trillion.
 Forward Commitments

A forward contract is an over-the-counter derivative contract in which two

parties agree that one party, the buyer, will purchase an underlying asset
from the other party, the seller, at a later date at a fixed price they agree on
when the contract is signed

Characteristics of a forward contract include:

 Underlying asset type and quantity to be traded
 Manner in which the contract will be executed or settled when it expires
 A fixed price, called the forward price, at which the underlying will be
exchanged
Payoffs

The value of a forward position at maturity depends on the relationship between the
delivery price ( K) and the underlying price at that time.

For a long position this payoff is:

For a short position, it is:

Since the final value (at maturity) of a forward position depends on the spot price
which will then be prevailing, this contract can be viewed, from a purely financial
point of view, as "a bet on the future spot price"
Assume that the buyer enters into the forward contract with the seller
for a price of F0(T), with delivery of one unit of the underlying asset
to occur at time T. Now, let us roll forward to time T, when the price
of the underlying is ST. The long is obligated to pay F0(T), for which
he receives an asset worth ST. If ST > F0(T), it is clear that the
transaction has worked out well for the long. He paid F0(T) and
receives something of greater value. Thus, the contract effectively
pays off ST ‒ F0(T) to the long, which is the value of the contract at
expiration. The short has the mirror image of the long.
 Payoff FROM a forward Contract

 Assumptions and Symbol definitions:

 Contract initiated at time t = 0
 Contract expiration at time t = T
 Spot price of the underlying asset at time 0 is S0
 Spot price of the underlying asset at time T is ST
 F0(T) is the forward price
The long party agrees to buy at the forward price, and the short party agrees to sell at
the forward price.
 Payoff to the long party at expiration (T) = ST ‒ F0(T)
 Payoff to the short party at expiration (T) = ‒[ST ‒ F0(T)]
Except in the extremely rare event that the underlying price at T equals the forward
price, one party will pay the other.
 Forward Payoff Example

Barbara Nix agrees to buy 1 kilogram of gold in 90 days at a price of

$38,000 from PM Metals Inc (short party). After 90 days, the spot price of
gold is $38,500 per kilo.

F0(T) = $38,000/kilo
ST = $38,500/kilo
Payoff to the long party (Nix) at expiration (T)
= ST ‒ F0(T) = $38,500 ‒ $38,000 = $500
Payoff to the short party at expiration (T) = ‒$500
 Forward Pricing example

Assume an asset sells in the spot market for a price of $94, the risk-free rate
is 4%, and the forward contract expires in six months. What is the initial
value of the contract and the correct forward price?
S0(T) = $94
The value of the contract at initiation is V0(T) = 0
T = 6 months = 0.5 years
Forward Pricing Equation
F0(T) = S0(1 + r)T = $94(1 + 0.04)0.5 = $95.86
The forward price established at the initiation date of the contract is $95.86
Valuation of Forward Contracts with Costs and Benefits

Forward Pricing Equation

F0(T) = (S0 – γ + θ)(1 + r)T
Where:
F0(T): The forward price established at the initiation date of contract
S0(T): The initial price of the underlying asset
T: The time to expiration of the forward contract
r: The risk-free rate of interest
θ: Costs to hold the spot asset:
Monetary costs include storage, insurance
γ: Benefits to hold the spot asset:
Monetary benefits include dividends, interest
Nonmonetary benefits include convenience yield
 Forward Pricing example with costs
And Benefits
Assume an asset sells in the spot market for a price of $94. The risk-
free rate is 4%, and the forward contract on the asset expires in six
months. If the asset pays a dividend of $2.25 and storage costs are $1
a year, what is the correct forward price?
S0(T) = $94 T = 6 months = 0.5 years r = 4%
θ = $1 (storage costs)
γ = $2.25 (dividend)
Forward Price with carrying costs and benefits:
F0(T) = (S0 – γ + θ) (1 + r)T = ($94 – $2.25+$1)(1.04)0.5
= $94.59
 Futures Contracts

A futures contract is a standardized derivative contract created and traded

on a futures exchange in which two parties agree that one party, the buyer,
will purchase an underlying asset from the other party, the seller, at a later
date and at a price agreed on by the two parties when the contract is
initiated and in which there is a daily settling of gains and losses and a
credit guarantee by the futures exchange through its clearinghouse.

A fixed price at which the underlying will be exchanged is set by the buyer
and seller when the contract is initiated. This agreed-upon price is called
the futures price.
 A futures contract is between two parties with an intermediary involved, the futures exchange. The contract
requires one of the parties to agree to make delivery of a commodity or financial asset and the other party to
take or accept delivery of the same commodity or financial asset.

 To be more precise, a futures contract allows a trader to undertake a contract to either make (deliver) or take
(accept) delivery of a commodity or some kind of financial asset (a) in the future on a known date, (b)
under specified conditions, (c) effectively for a price contracted today.

 The party to the contract who is agreeing to take delivery of the commodity is long in the position, whereas
the party who is agreeing to deliver the commodity is short in the position. A speculator will benefit when
she is long if the price rises, short if the price falls.
A futures contract is an exchange-traded,
standardized, forward-like contract that is
marked to the market daily. Futures contract can
be used to establish a long (or short) position in
the underlying commodity/asset.
Payoff Diagrams
The value of a futures position at
maturity is the difference between
the delivery price and the underlying
price at the time of maturity:
For a long position, the payoff is  ,
and it will benefit from a higher
underlying price.
For a short position, the payoff is ,
and it will benefit from a lower
underlying price.
 Features of Futures Contracts

1. The underlying asset, including its quality:

 The amount and quality of the underlying asset. For example, 1000 bushels of Grade 4 corn.
2. The time of maturity T:
 The date at which the underlying is to be delivered. This could be a specific date or a time range.
3. The place of delivery for physical underlying:
 The place(s) at which the underlying is to be delivered. This is often a centralized location that is close to the place of production or
transport.
 Some futures contract are cash settled, which means that the seller of the future transfers the associated payoff in cash. This avoids having to
deal with delivery or transportation concerns.
4. The initial margin and margin maintenance amount:
 This is determined by the exchange. Typically, the initial margin is 2 to 10 percent of the full value of the futures contract. When the position
moves against the trader leading to a drop below the maintenance amount, then the trader will receive a margin call to top up the margin
account, or be forcibly liquidated out of his position.
 This allows the exchange to limit the amount of counter-party risk involved.
 Daily Settlement of Futures

The clearinghouse determines the settlement price from the final trades
made that day. Positions are marked to market based on the settlement
price. Gains (losses) are added (subtracted) daily in the trader’s margin
account.
The exchange sets two margin requirements.
 Initial Margin: the deposit required to open the contract.
 Maintenance Margin: the amount of money that each participant
must maintain in the account after the trade is initiated. Accounts
below the maintenance margin will receive a margin call.
If a party receives a margin call, they must restore the account to the
initial margin by depositing more funds and/or by closing out positions.
 Example of Daily Settlement

A trader goes long at a futures price of $1200. The exchange requires an initial
margin (IM) of $150 and a maintenance margin (MM) of $75. The trader
deposits $150 into a margin account to open a long position at $1200.
 At the end of the day 1, the futures price settles at $1180.
 The account is marked to market at $1180, and $20 is withdrawn from the
trader’s account bringing the balance to $130.
 At the end of day 2, the futures price settles at $1120.
 The account is marked to market at $1120, and $60 is withdrawn from the
trader’s account bringing the balance to $70.
 The margin balance is below the MM, so the trader receives a margin call.
 To keep the long position opened, the trader must deposit enough money
to bring the account back the IM. In this case $80 must be deposited.
 ForwardS Vs. Futures
Forwards Futures

Agreement to buy or sell an underlying Agreement to buy or sell an underlying

asset at a later date asset at a later date

Exchange traded with standardized

Traded OTC with customized features
features

Not guaranteed by a clearinghouse; Regulated, transparent, and traded

Limited regulation and reporting through a clearinghouse

Gains and losses settled at maturity Daily settlement of gains and losses
 Swaps Definition

A swap is an over-the-counter derivative contract in which two parties agree

to exchange a series of cash flows whereby one party pays a variable series
that will be determined by an underlying asset or rate and the other party
pays either (1) a variable series determined by a different underlying asset or
rate or (2) a fixed series.

A swap is similar to a forward contract:

 A swap is an OTC contract
 A swap is subject to default risk
 A swap is negotiated between two parties and is customized
However, a Swap is used to hedge multi-period risk, whereas a forward
contract hedges only single-period risks.
 Swap Market

 In a swap, two counterparties agree to a contractual

arrangement wherein they agree to exchange cash flows at
periodic intervals.
 There are two basic types of swaps:
 Single Currency Interest rate swap
 “Plain vanilla” fixed-for-floating swaps in one currency.
 Cross Currency Interest Rate Swap (Currency swap)
 Fixed for fixed rate debt service in two (or more) currencies.
 2006 Notional Principal for:
 Interest rate swaps: US$ 229.2 trillion !!
 Currency swaps: US$ 10.8 trillion

 The most popular currencies are: US$, Yen, Euro, SF, BP

30
 Dealer Activity in the Financial
Markets
Certain types of financial instruments trade only in an over the counter
market are known dealer markets, because their existence depends on
dealers that are willing to play the role of market maker. Eg.
Swap: A swap is a derivative contract through which two parties exchange
financial instruments.
Mortgage backed Products: A mortgage-backed security (MBS) is a type of
asset-backed security that is secured by a mortgage or collection of mortgages.
These securities must also be grouped in one of the top two ratings as determined
by a accredited credit rating agency, and usually pay periodic payments that are
similar to coupon payments.
Interest rate caps and floors: An interest rate cap and floors 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 (caps) and the interest rate is below the
agreed strike price(floors)

© 2012 Pearson Prentice Hall. All rights reserved. 3-31

 Interest Rate Swaps

In an interest rate swap, the parties exchange cash flows based on a notional principal amount
(this amount is not actually exchanged) in order to hedge against interest rate risk or to speculate.
For example, say ABC Co. has just issued $1 million in five-year bonds with a variable annual
interest rate defined as the London Interbank Offered Rate (LIBOR) plus 1.3% (or 130 basis
points). LIBOR is at 1.7%, low for its historical range, so ABC management is anxious about an
interest rate rise.

They find another company, XYZ Inc., that is willing to pay ABC an annual rate of LIBOR​plus
1.3% on a notional principal of $1 million for 5 years. In other words, XYZ will fund ABC's interest
payments on its latest bond issue. In exchange, ABC pays XYZ a fixed annual rate of 6% on a
notional value of $1 million for five years. ABC benefits from the swap if rates rise significantly
over the next five years. XYZ benefits if rates fall, stay flat or rise only gradually.

Below are two scenarios for this interest rate swap: 1) LIBOR rises 0.75% per year, and 2) LIBOR
rises 2% per year.

©Scenario
2012 Pearson1Prentice Hall. All rights reserved. 3-32
 Scenario 1
If LIBOR rises by 0.75% per year, Company ABC's total interest payments to its bond
holders over the five-year period are $225,000:
225000=1000000*(5*0.013+0.017+0.0245+0.032+0.0395+0.047)
in other words, $75,000 more than the $150,000 ABC would have paid if LIBOR
had remained flat:
150000=1000000*5*(0.013+0.017)
ABC pays XYZ
$300,000: 300000=1000000*5*0.06 and
receives $225,000 in return (the same as ABC's
interest payments to bond holders).
ABC's net loss on the swap comes to $75,000.

© 2012 Pearson Prentice Hall. All rights reserved. 3-33

 Scenario 2
In the second scenario, LIBOR rises by 2% a year. This brings ABC's total
interest payments to bond holders to $350,000
350000=1000000*(0.013*5+0.017+0.037+0.057+0.077+0.097)
XYZ pays this amount to ABC, and ABC pays XYZ $300,000 in return. ABC's net
gain on the swap is $50,000.

© 2012 Pearson Prentice Hall. All rights reserved. 3-34

 The Swap Bank

 A swap bank is a generic term to describe a financial

institution that facilitates swaps between counterparties.
 The swap bank can serve as either a broker or a dealer.
 As a broker, the swap bank matches counterparties but

does not assume any of the risks of the swap.

 As a dealer, the swap bank stands ready to accept either

side of a currency swap, and then later lay off their risk,
or match it with a counterparty.

35
 Currency Swaps

 Most often used when companies make cross-

border capital investments or projects.
 Ex., U.S. parent company wants to finance a project
undertaken by its subsidiary in Germany. Project
proceeds would be used to pay interest and principal.
 Options:
1. Borrow US$ and convert to Euro – exposes company to exchange
rate risk.
2. Borrow in Germany – rate available may not be as good as that in
the U.S. if the subsidiary is relatively unknown.
3. Find a counterparty and set up a currency swap.
36
 Currency Swaps
 Typically, a company should have a comparative
advantage in borrowing locally
Swap
pay foreign
Pay foreign Bank

Company
issue local Receive Receive
issue local Company
A local local B

Issue local Issue local

37
 An Example of a Currency Swap

 Suppose a U.S. MNC wants to finance a €40,000,000

expansion of a German plant.
 They could borrow dollars in the U.S. where they are well
known and exchange for dollars for euros.
 This will give them exchange rate risk: financing a euro

project with dollars.

 They could borrow euro in the international bond market, but
pay a premium since they are not as well known abroad.
 If they can find a German MNC with a mirror-image
financing need they may both benefit from a swap.
 If the spot exchange rate is S0($/ €) = $1.30/ €, the U.S. firm
needs to find a German firm wanting to finance dollar
borrowing in the amount of $52,000,000.
38
 An Example of a Currency Swap

 Consider two firms A and B: firm A is a U.S.–based multinational

and firm B is a Germany–based multinational.
 Both firms wish to finance a project in each other’s country of the
same size. Their borrowing opportunities are given in the table
below.

$ €
Company A 8.0% 7.0%
Company B 9.0% 6.0%
39
 An Example of a Currency Swap

Annual Swap Annual

Interest Interest
$4.16M Bank $4.16M
$8% $8%

€ 6% € 6%
$8% Firm Annual Annual Firm € 6%
Interest Interest
Borrow A €2.4 M €2.4 M B Borrow
$52M € 40M
$ €
Company A 8.0% 7.0%
Company B 9.0% 6.0%
40
 An Example of a Currency Swap

A’s net position is to Swap B’s net position is to

borrow at € 6% borrow at $8%
Bank
$8% $8%

€ 6% € 6%
$8% Firm Firm € 6%
A B
$52M € 40M
$ €
Company A 8.0% 7.0%
Company B 9.0% 6.0%

41
 Options
 An option gives the holder the right, but not the
obligation, to buy or sell a given quantity of an asset on
(or before) a given date, at prices agreed upon today.
 Exercising the Option
 The act of buying or selling the underlying asset
 Strike Price or Exercise Price
 Refers to the fixed price in the option contract at which the
holder can buy or sell the underlying asset.
 Expiry (Expiration Date)
 The maturity date of the option
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Options
 European versus American options
 European options can be exercised only at expiry.
 American options can be exercised at any time up to expiry.
 In-the-Money
 Exercising the option would result in a positive payoff.
 At-the-Money
 Exercising the option would result in a zero payoff (i.e.,
exercise price equal to spot price).
 Out-of-the-Money
 Exercising the option would result in a negative payoff.
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Call Options
 Call options gives the holder the right,
but not the obligation, to buy a given
quantity of some asset on or before
some time in the future, at prices
agreed upon today.
 When exercising a call option, you
“call in” the asset.

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Call Option Pricing at Expiry
 At expiry, an American call option is worth
the same as a European option with the same
characteristics.
 If the call is in-the-money, it is worth ST – E.
 If the call is out-of-the-money, it is worthless:
C = Max[ST – E, 0]
Where
ST is the value of the stock at expiry (time T)
E is the exercise price.
C is the value of the callCopyright
McGraw-Hill/Irwin
option© 2007
at byexpiry
The McGraw-Hill Companies, Inc. All rights reserved.
 Call Option Payoffs

a ll
60

ac
y
Option payoffs ($)

Bu
40

20

20 40 60 80 100 120
50
Stock price ($)
–20

–40
McGraw-Hill/Irwin Exercise price
Copyright © 2007 = $50 Companies, Inc. All rights reserved.
by The McGraw-Hill
 Call Option Profits
60
Option payoffs ($)

40 Buy a call

20
10

20 40 50 60 80 100 120
–10 Stock price ($)
–20

Exercise price = $50; option premium = $10

–40
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Put Options
 Put options gives the holder the right,
but not the obligation, to sell a given
quantity of an asset on or before some
time in the future, at prices agreed
upon today.
 When exercising a put, you “put” the
asset to someone.

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Put Option Pricing at Expiry
 At expiry, an American put option is
worth the same as a European option
with the same characteristics.
 If the put is in-the-money, it is worth
E – S T.
 If the put is out-of-the-money, it is
worthless.
McGraw-Hill/Irwin
P = Max[E – ST, 0]
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Put Option Payoffs
60
Option payoffs ($)

50
40

20

0 Buy a put
0 20 40 60 80 100
50
Stock price ($)
–20

–40
McGraw-Hill/Irwin Exercise price
Copyright © 2007 = $50 Companies, Inc. All rights reserved.
by The McGraw-Hill
 Put Option Profits
60
Option payoffs ($)

40

20

10
Stock price ($)
20 40 50 60 80 100
–10
Buy a put
–20

–40
McGraw-Hill/Irwin Exercise priceCopyright
= $50; option
© 2007 premium
by The McGraw-Hill = $10
Companies, Inc. All rights reserved.
 Option Value
 Intrinsic Value
 Call: Max[ST – E, 0]
 Put: Max[E – ST , 0]
 Speculative Value
 The difference between the option premium and
the intrinsic value of the option.
Option Intrinsic + Speculative
=
Premium Value Value
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 The Purposes and Benefits of
Derivatives
1. Price Discovery.
Price discovery is the process of determining the proper price of a security, commodity and good or
service by studying markets supply and demand and other factors associated with transactions.
Future Markets can provide information about prices of the underlying assets on which future
contracts are based in two ways:
a) The underlying assets are traded in geographically dispersed markets this gives a high possibility for
many different spot prices( current price of the underlying asset) to exist. In Futures Market, the price
of the future contract with the shortest time to expiration often seves as a proxy for the price of the
underlying asset.
b) All future contracts serve as prices that can be accepted by those who trade contracts in lieu of facing
the risk of uncertain future prices.
For example, Consider an Airline Company such as Kenya Airways that need to restock its fuel in four
months but uncertain about oil prices. Thus to hedge against rise in oil prices, Kenya Airways can buy a
futures contract on oil expiring in four months time, which locks in the price of oil in four months later.
This way, the four-month futures price substitutes for the uncertainty of price of oil over the next four
months.
2. Risk Management
Risk management is the process of identifying the desired level of risk, identifying
the actual level of risk and altering the latter to equal to the former. This is through
hedging (a strategy for reducing risk by holding an offsetting market position).
For example, Consider an Insurance company that currently borrows at a floating
rate in order to expand its operations.The risk of borrowing at floating rates is
rising interest rates. So a company may use an interest rate swap in which it wil
make payments at fixed rate and receive payments at floating rate. This way the
company engages in a swap by designing to align its risk with the risk it wants,
given its outlook for interest rates. Thus the company is managing risk.
3. Improve the market efficiency for the underlying assets.
Efficient markets are fair and competitive and do not allow one party to easily take money
from the other. Derivatives ensure that there are no arbitrage opportunities especially in the
cash market
For example:
Buying a stock index fund can be replicated by buying futures on the fund and investing in
risk-free bonds the money that otherwise would have been spent on the fund. The Fund and the
combination of the futures and risk free bond will have the same performance. But if the fund
costs more than the combination of the futures and risk free bond, investors will have the
opportunity to avoid the overpriced fund and take the combination. This decreased demand for
the fund will lower its price. Thus investors who do not use derivatives can invest in the fund
at a more attractive price, because the derivatives market forced the price back to its
appropriate level.
4. Help to Reduce Market Transaction Costs
Derivatives reduce market transaction costs in the following ways:
a) Derivatives are a form of insurance.
To encourage people to take on insurance , the costs must be low relative to the value of the insured asset.
b) Individuals may face high transaction costs for certain types of financial trades, but larger firms will have
lower transaction costs in securities market because of large volume of trades they undertake For these large
firms, markets will be effectively complete since they can create different securities by engaging in carefully
constructed trading over time (Dynamic Trading) at low cost. The large firms can sell claims on these dynamic
trades as derivatives securities to individuals passing on the lower transaction costs.
c) Derivatives offer easy and cheap access to classes of assets such as commodities like oil, gold by buying
futures on commodities indexes diversifying portfolios. To purchase these underlying commodities in the cash
market would require a large investment.
d) Some derivatives can be used as a way of diversifying portfolios. For example stock index options allow
their users to trade an entire portfolio of stocks as a single financial products which could be expensive to trade
a basket of stocks.
5. To Speculate.
Speculators are traders who want to take a position in the market; they are betting
that the price of the underlying asset will move in a particular direction over the
life of the contract.
Due to their view of future direction, derivatives markets provides liquidity which
enables other investors who may be using derivatives to hedge risks to easily buy
and sell derivatives contracts. In general, hedgers seek to eliminate risk and need
speculators to assume risk though there are exceptions to this.
 Criticisms and Misuses of
Derivatives
Speculation and Gambling
Derivatives are often compared to gambling as it involves a lot of speculation and risk taking.
An important distinction between speculation and gambling is that a very few benefit from
gambling. But speculation makes the whole financial markets more efficient.
Destabilization and Systemic Risk
Derivatives are often blamed to have destabilizing consequences on the financial markets. This
is primarily due to the high amount of leverage taken by speculators. If the position turns against
them, then they default. This triggers a ripple effect causing their creditors to default, creditors’
creditors to default and so on. A default by speculators impacts the whole system. For example,
the credit crisis of 2008.
Complexity
Another criticism of derivatives is their complexity. The models are highly complex and are not
easily comprehensible by everyone.
Hedging

Hedging is a technique or strategy that comes as a form of

investment designed to avoid market volatility or to protect another
investment or portfolio against potential investment risk or loss. Loss
can be in the form of profit loss or risk loss. When it comes to profit
loss, the hedging strategy safeguards the capital but fails to
accumulate profits in the process when the risk didn’t happen.
Meanwhile, a risk loss is what the hedging aims to protect against in
the volatile and unpredictable financial market.

Hedging works and acts like an insurance because it serves as a

preventive measure against negative or unexpected events such as
risks and market situations.
There are two types of hedging: classical hedging and natural hedging. Classical
hedging involves stocks and shares. In this type, the main goal is for the investor to
balance the high-stakes share with the secured shares. The secure shares create the
profit and act like a safety net for the loss, which is created by the high-stakes shares.
On the other hand, unlike classic hedging, natural hedging doesn’t involve stocks and
shares; instead, it involves many investment and managing techniques. It doesn’t
involve instruments but strategy and the process.
In hedging, a variety of techniques are used. Among these techniques are: foreign
exchange forwards, currency futures, debt, currency options, options trading,
exchange-traded fund (ETF), and quant trading.
Hedging is not a guarantee against any kind of risk in the risk and return trade-off.
Investors in hedge funds are also not covered by government protection, regulation,
or oversight as personified by the SEC (Securities and Exchange Commission).
Speculation

 Speculation is a method of short-term investing whereby traders essentially

bet on the direction an asset's price will move.
 Speculation entails running the risk of a loss in the expectation of a high
reward. A pure investment is devoid of risk and, therefore, of any
speculative element. Financial speculation involves the buying, holding,
selling, and short-selling of stocks, bonds, commodities, currencies, real
estate, derivatives, or of any other financial instrument, in order to profit
from fluctuations in its price.
 For example, if a speculator believes XYZ Company stock is overpriced,
they may short the stock, wait for the price to fall, and make a profit. It's
possible to speculate on virtually every security, though speculation is
especially concentrated in the commodities, futures, and derivatives markets.
 Arbitrage

In well-functioning markets with low transaction costs and a free flow of

information, identical assets must sell for the same price. This is referred to as
the Law of One Price.
 If identical assets do not sell at the same price, a trader could buy the
cheaper asset and sell it in the more expensive market, earning a riskless
profit. This is known as arbitrage (capturing price differences on identical
assets to earn a riskless profit).
 The combined action of arbitrageurs continues until the prices of identical
assets converge.
 Arbitrage is a relative valuation methodology. It tells us the correct price of
one asset or derivative relative to another asset or derivative.
 Arbitrage and Market Efficiency

The forces of arbitrage in financial markets assure us that:

 the same asset cannot sell for different prices
 nor can two equivalent combinations of assets that produce the same
results sell for different prices
Markets in which arbitrage opportunities are either nonexistent or quickly
eliminated are relatively efficient markets.
 Efficient markets fairly compensate investors for risk.
 Arbitrage opportunities give investors a return above the risk-free rate
without taking risk.
 The abnormal returns generated by arbitrage are a violation of market
efficiency.
 Derivatives Summary

 A derivative is a financial instrument that derives its

performance from the performance of an underlying asset.
 The underlying asset, called the underlying, trades in the cash
or spot market and its price is called the cash or spot price.
 Derivatives consist of two general classes: forward
commitments and contingent claims.
 Derivatives can be created as standardized instruments on
derivatives exchanges or as customized instruments in the over-
the-counter market.
Thank
You…