Derivatives and

Hedging Risk

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 There is no universally satisfactory answer to
the question of what a derivative is, however
one explanation ......

 A financial derivative is a ‘financial instrument or

security whose payoff depends on another financial
instrument or security’ ......the payoff or the value
is derived from that underlying security
 derivatives are agreements or contracts between
two parties

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A derivative is a contract between two or more
parties whose value / payoff is based on an
agreed-upon underlying financial instrument,
index or security. Common underlying
instruments include bonds , commodities,
currencies, interest rates, market indexes and
stock

A derivative's value is based on an asset, but

ownership of a derivative doesn't mean
ownership of the asset.
Derivatives can be used either
for risk management (i.e. to “hedge” by

providing offsetting compensation in case of an

undesired event, “insurance”) or
for speculation (i.e. making a financial "bet").

Enhance returns
Derivatives are used for different type of risk
management purpose. It includes

Currency Risk
Interest Rate Risk
Marke
Price Risk i.e stocks, commodities
t Risk
Credit Risk
Currency Risk

A form of risk that arises from the change in

price of one currency against another. Whenever
investors or companies have assets or business
operations across national borders, they face
currency risk if their positions are not hedged.
 
For example, if you are a U.S. investor and you
have stocks in Canada, the return that you will
realize is affected by both the change in the price
of the stocks and the change in the value of the
Canadian dollar against the U.S. dollar. So, if you
realize a 15% return in your Canadian stocks but
the Canadian dollar depreciates 15% against the
U.S. dollar, this will amount to no gain at all.
Interest Rate Risk
 
The risk that an investment's value will change due to a
change in the absolute level of interest rates, in the spread
between two rates, in the shape of the yield curve or in any
other interest rate relationship. Such changes usually affect
securities inversely and can be reduced by diversifying
(investing in fixed-income securities with different durations)
or hedging (e.g. through an interest rate swap). 
 
Interest rate risk affects the value of bonds more directly
than stocks, and it is a major risk to all bondholders. 
As interest rates rise, bond prices fall and vice versa. The
rationale is that as interest rates increase, the opportunity
cost of holding a bond decreases since investors are able to
realize greater yields by switching to other investments that
reflect the higher interest rate. For example, a 5% bond is
worth more if interest rates decrease since the
bondholder receives a fixed rate of return relative to the
market, which is offering a lower rate of return as a result of
the decrease in rates.
Price Risk

The risk of a decline in the value of a security or a

portfolio. Price risk is the biggest risk faced by all
investors. Although price risk specific to a stock
can be minimized through diversification, market
risk cannot be diversified away. Price risk, while
unavoidable, can be mitigated through the use of
hedging techniques

Price risk also depends on the volatility of the

securities held within a portfolio. For example, an
investor who only holds a handful of junior mining
companies in his or her portfolio may be exposed
to a greater degree of price risk than an investor
with a well-diversified portfolio of blue-chip stocks.
Investors can use a number of tools and techniques
to hedge price risk.
Credit Risk

The risk of loss of principal or loss of a financial reward stemming

from a borrower's failure to repay a loan or otherwise meet a
contractual obligation. Credit risk arises whenever a borrower is
expecting to use future cash flows to pay a current debt. Investors
are compensated for assuming credit risk by way of interest
payments from the borrower or issuer of a debt obligation.
 
The higher the perceived credit risk, the higher the rate of interest
that investors will demand for lending their capital.
Credit risks are calculated based on the borrowers' overall ability to
repay. This calculation includes the borrowers' collateral assets,
revenue-generating ability and taxing authority (such as for
government and municipal bonds).
Creditrisks are a vital component of fixed-income investing, which
is why ratings agencies evaluate the credit risks of thousands of
corporate issuers and municipalities on an on going basis. 
Speculation

Derivatives can be used to acquire risk, rather than to hedge against

risk. Thus, some individuals and institutions will enter into a
derivative contract to speculate on the value of the underlying asset,
betting that the party seeking insurance will be wrong about the
future value of the underlying asset. Speculators look to buy an
asset in the future at a low price according to a derivative contract
when the future market price is high, or to sell an asset in the future
at a high price according to a derivative contract when the future
market price is low.

Arbitrage

Locking the profit by simultaneously entering into contacts in

multiple markets i.e. buy instrument in one market and sell in
another market. Benefit from the spread in the markets.
 Derivative markets neither create nor destroy
wealth - they provide a means to transfer risk
◦ zero sum game in that one party’s gains are equal to
another party’s losses
◦ participants can choose the level of risk they wish to take
on using derivatives
◦ with this efficient allocation of risk, investors are willing to
supply more funds to the financial markets, enables firms
to raise capital at reasonable costs

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 Derivatives are powerful instruments - they
typically contain a high degree of leverage,
meaning that small price changes can lead to
large gains and losses
 this high degree of leverage makes them

effective but also ‘dangerous’ when misused.

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 Options
 Futures contracts
 Forward contracts
 Swaps

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 An option is the right to either buy or sell
something at a set price, within a set period
of time
◦ The right to buy is a call option
◦ The right to sell is a put option

 You can exercise an option if you wish, but

you do not have to do so

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 Futures contracts involve a promise to
exchange a product for cash by a set delivery
date - and are traded on a futures exchange
 Futures contracts deal with transactions that

will be made in the future

 contracts traded on a wide range of financial

instruments and commodities

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 Are different from options in that:

◦ The buyer of an option can abandon the option if

he or she wishes - option premium is the maximum
$ exposure
◦ The buyer of a futures contract cannot abandon the
contract - theoretically unlimited exposure

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 A futures contract involves a process known
as marking to market
◦ Money actually moves between accounts each day
as prices move up and down
 A forward contract is functionally similar to a
futures contract, however:
◦ it is an arrangement between two parties as
opposed to an exchange traded contract
◦ There is no marking to market
◦ Forward contracts are not marketable

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Futures contract- a contract traded on an
exchange, that allows a company to buy or
sell a specified quantity of a commodity or a
financial security at a specified price on a
specified future date.
 Futures contracts are similar to forward,
difference is that a forward contract is private
and futures are traded on an exchange.
 Forward contract- an agreement between two
parties to exchange a specified amount of a
commodity, security, or foreign exchange at a
specified date in the future with the price or
exchange rate being set now.
On November 1, 2008, Clayton Company sold
machine parts to Maruta Company for ¥30,000,000 to
be received on January 1, 2009. The current exchange
rate is ¥120 = $1. Clayton enters into a forward
contract with a large bank that guarantees this
exchange rate.
 Exchange Rate on January 1
¥118 = $1 ¥120 = $1 ¥122 = $1
Variable of
¥30,000,000 $254,237 $250,000 $245,902
Clayton receipt
(payment) to settle
forward contract (4,327) 0 4,098
Net dollar receipt
by Clayton $250,000 $250,000 $250,000
Forwards
 
A forward contract is a customized contract between two entities,
where settlement takes place on a specific date in the future at
today's pre-agreed price.
 
Futures

A futures contract is an agreement between two parties to buy or

sell an asset at a certain time in the future at a certain price. Futures
contracts are special types of forward contracts in the sense that the
former are standardized exchange-traded contracts.

Primary difference between Forwards and Futures

Forwards can be tailored to meet the specific needs of counter
parties but have higher default risk and less liquidity.

Futures are standardized, so they are less likely to be exactly what

two parties need; however, they trade on exchange, so the risk of
default is minimal.
 Introduction
 Interest rate swap
 Foreign currency swap

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 Swaps are arrangements in which one party
trades something with another party.
 The swap market is very large, with trillions

of dollars outstanding in swap agreements.

 Currency swaps
 Interest rate swaps
 Commodity & other swaps - e.g. Natural gas

pricing

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 In an interest rate swap, one firm pays a fixed
interest rate on a sum of money and receives
from some other firm a floating interest rate
on the same sum

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 Interest Rate on January 1, 2009
7% 10% 13%
Variable-rate interest
payment in 2009 $ (7,000) $(10,000) $(13,000)
Receipt (payment) for
interest rate swap (3,000) 0 3,000
Net interest
payment in 2009 $(10,000) $(10,000) $(10,000)
 In a foreign currency swap, two firms initially
trade one currency for another
 Subsequently, the two firms exchange

interest payments, one based on a foreign

interest rate and the other based on a U.S.
interest rate
 Finally, the two firms re-exchange the two

currencies

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 Similar to an interest rate swap in that one
party agrees to pay a fixed price for a
notional quantity of the commodity while the
other party agrees to pay a floating price or
market price on the payment date(s)

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 Both options and futures contracts exist on a wide
variety of assets
◦ Options trade on individual stocks, on market indexes, on
metals, interest rates, or on futures contracts
◦ Futures contracts trade on agricultural commodities such
as wheat, live cattle, precious metals such as gold and
silver and energy such as crude oil, gas and heating oil,
foreign currencies, U.S. Treasury bonds, and stock market
indexes

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 Listed derivatives trade on an organized
exchange such as the Chicago Board Options
Exchange or the Chicago Board of Trade, the
NYMEX or the Montreal Exchange

 OTC derivatives are customized products that

trade off the exchange and are individually
negotiated between two parties

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 Include those who use derivatives for:
◦ Hedging
◦ Speculation/investment
◦ Arbitrage

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 If someone bears an economic risk and uses
the futures market or other derivatives to
reduce that risk, the person is a hedger

 Hedging is a prudent business practice; today

a prudent manager has an obligation to
understand and apply risk management
techniques including the use of derivatives

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 A person or firm who accepts the risk the
hedger does not want to take is a speculator
 Speculators believe the potential return
outweighs the risk
 The primary purpose of derivatives markets is
not speculation. Rather, they permit or enable
the transfer of risk between market
participants as they desire

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 Arbitrage is the existence of a riskless profit
 Arbitrage opportunities are quickly exploited

and eliminated in efficient markets

◦ Arbitrage then contributes to the efficiency of
markets

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 Persons actively engaged in seeking out
minor pricing discrepancies are called
arbitrageurs
 Arbitrageurs keep prices in the marketplace
efficient
 An efficient market is one in which securities are
priced in accordance with their perceived level of
risk and their potential return
 The pricing of options incorporates this
concept of arbitrage

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Thank You!!

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