Introduction To Derivatives

DERIVATIVES:
INTRODUCTION AND
OVERVIEW
Chapter Objectives
• This Chapter intends to introduce the concept of derivatives and trading.
• On completion of this chapter you should have an overview of the evolution of

Derivatives and their rationale.
• You should also have knowledge of different categories of derivative

instruments and market players.
• You should have an appreciation of the role of derivatives in managing

different types of risk.
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DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright © 2017 by McGraw-Hill Education (Malaysia) Sdn. Bhd.
What are Derivatives
• Derivative instruments are financial instruments that derive their value from
the value of an underlying asset.
• A derivative instrument in itself holds little value, and its entire value is
dependent on the underlying asset.
o Example: Suppose I buy and hold a Crude Palm Oil (CPO) futures contract. The value of
this contract will rise and fall as the value or price of spot CPO rises or falls. Should the
underlying asset, CPO in this case, rise in value, then the value of the CPO futures
contract that I am holding will also increase in value.
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Controversy on Derivatives
• Derivatives have been blamed for financial disasters
o Sumitomo Corporation’s lost $2.6 billion on Copper derivatives
o Metallgesellchaft AG’s lost DM 1.8 billion on oil futures
o Orange County California’s losses on interest rate derivatives
o US Hedge Fund, Long Term Capital Management, lost $4 Billion in late 1998
o French bank Societe Generale lost €4 billion in futures related transactions in 2008
• Owing to large scale losses, derivatives are misconstrued as inherently risky.
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Common Derivative Instruments
• Forward Contract
o It is a contract between two parties agreeing to carry out a transaction at a future date
but at a price determined today.
• Futures Contract
o A futures contract is simply a standardized and exchange traded form of forward
contract.
o Similar to forward contract, futures contract represents an agreement between two

parties to carry out a transaction at a future date but at a price determined at contract
initiation.
o The difference is that futures are standardized and exchange traded. 5

Common Derivative Instruments
• Option Contract
o An option contract provides the holder the right but not the obligation to buy or sell
the underlying asset at a predetermined price.
o A call option provides the right to buy, and a put option would provide the right to sell.
• Swap Contract
o It is a transaction between two parties which simultaneously exchange cash-flows based
on a notional amount of the underlying asset.
o The rate at which the amounts are exchanged is predetermined based on either a fixed
amount or an amount to be based on a reference measure.
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Evolution of Derivatives
• Similar to all other products, derivatives evolved through innovation in
response to growing demands of businesses.
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• Chronologically Forward contracts are probably the first derivative
instruments.
o Forward contracts tends to mitigate price risk between two parties.
 Example: A commodity producer is afraid of fall in prices when his commodity is ready in
future, while a consumer is fearful of an increase in prices in future. Both parties meet,
negotiate and agree on a price at which the transaction can be carried out at the future date,
thus a Forward Contract.
o The benefit of this contract is that both parties have eliminated price risk by locking in
their price/cost.
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• The forward contract has inherently three limitations
o Multiple Coincidence: Both parties should have opposite needs with respect to underlying
asset, and matching timing and quantity.
o Unfair Pricing: In forward contract, the price is reached through negotiation. Stronger
bargaining position of one party may lead to imposition of the price.
o Counterparty Risk: Though it is a legally binding contract, the recourse is slow and costly. This
increases the default risk in forward contract.
• As these shortcomings of forward contracts became apparent the Need for

Futures Contract developed.
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• Futures Contract are essentially a standardized forward contract traded on an
exchange.
• The problems in forwards contracts are addressed via :

o Multiple Coincidence is resolved via exchange trading. Buyers and Sellers would transact in
the futures contract maturity closest to needed maturity and in as many contracts as needed
to fit the underlying asset size.
o Unfair pricing is resolved since each party is a price taker on the exchange with the futures
price being that which prevails in the market at the time of contract initiation.
o Counterparty risk is overcome via the exchange acting as the intermediary guarantees each
trade by being the buyer to each seller and seller to each buyer
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• Futures while overcoming flaws of forwards were inadequate for later day
business needs.
o Futures enabled hedging against unfavourable price movement, BUT being locked-in also
meant that one could not benefit from subsequent favorable price movements.
• This precise inadequacy is addressed by Option Contracts. It has three marked

benefits over its predecessors:
o Options provide cover against both upward and downward movement of asset prices.
o They are extremely flexible and can be combined to achieve different objectives/cash flows.
o Complicated business situations cannot be handled by futures and forwards, but by Options
only.
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• Advent of Swaps
o Swaps are one of the fastest growing category of derivatives.
o They are customized bilateral transaction where both parties agree to exchange cash flows at periodic
intervals.
o Being customized in nature, Swap contracts are over the counter instruments.
o Kinds of Swaps
• Currency Swaps – Parties exchange once currency for another
• Commodity Swaps – Both parties exchange cash flows based on an underlying commodity index or total return of a
commodity in exchange for a return based on a market yield.
• Equity Swaps – It constitute an exchange of cash flows based on different equity indices.
• Interest Rate Swaps – It involves exchange of cash flows based on two different interest rates. It is one of the most
popular instrument since its inception in 1981. Transaction Volume crossed $50 trillion according to ISDA.
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Exchange Traded Derivatives
• Exchange Traded Derivatives
o It is one that is listed and traded on an official exchange.
o They are of standard contract size, maturity, delivery process and in the case of commodity derivatives also of
standard quality.
o In exchange traded derivatives, the exchange becomes the intermediary between buyers and sellers and
guarantees the contract.
o Exchange trading shifts the counterparty risk to the exchange.
o Benefits include enhanced liquidity via increased trading volumes reducing transaction costs and price discovery.
o Examples: Futures and Option Contracts
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Over the Counter Derivatives
• Over the Counter (OTC) Derivatives
o It is a customized transactions between parties in a bilateral arrangement.
o All elements of the transaction are negotiable, including pricing.
o Usually between corporate clients and financial institutions.
 Example – An exporter expects to receive foreign currency payment. Fearing a potential depreciation of
the currency, the exporter would want to hedge its position by using currency derivatives like forwards or
swaps or in some cases. The counterparty for this hedging may be a financial institution.
o Being customized and bilateral transaction, counterparty or default risk by either party is possible in
OTC.
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Exchange Traded v/s Over the Counter
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Main Players in Derivative Market
• Hedgers
o Hedgers are players whose objective is risk reduction.
o Hedgers use derivative markets to manage or reduce risks.
o They are usually businesses who want to offset exposures resulting from their business activities.
• Speculators
o They are players who establish positions based on their expectations of future price movements.
o They take positions in assets or markets without taking offsetting positions, expecting market to
perform according to their expectation.
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• Arbitrageurs
o Arbitrageurs are players whose objective is to profit from pricing differentials mispricing.
o Arbitrageurs closely follow quoted prices of the same asset/instruments in different

markets looking for price divergences. Should the divergence in prices be enough to
make profits, they would buy in the market with the lower price and sell in the market
where the quoted price is higher.
o Arbitrageurs also arbitrage between different product markets. For example, between
the spot and futures markets or between futures and option markets or even between
all three markets.
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• Societal impact of different categories of market players.
o Hedging enables businesses to plan better, and reduction in fluctuation of their product prices can
help reduce costs. This reduction in costs is passed on to consumers in the form of lower prices.
o Arbitrageurs, by means of their activities, ensure no divergence exists between different markets
(spot, futures, options) for same asset class.
o Arbitrage activity enhances the price discovery process.

 Example: arbitrage between markets in different countries ‘internationalizes’ product prices. This forces
less efficient producers to enhance productivity in order to remain competitive in business.
o Speculative activities is considered disruptive and creating inefficiencies in the market. But the
enhanced volume due to speculators reduces transaction costs and increases liquidity.
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Commodity v/s Financial Derivatives
• Commodity Derivatives
o Commodity derivatives have tangible underlying assets like agricultural produce and metals.
o All commodity derivatives have actual and physical settlement of underlying commodity at
maturity.
• Financial Derivatives
o Financial derivatives have financial instruments as underlying assets.
o Unlike commodity derivatives, financial derivatives are cash-settled at maturity.
o Cash settlement involves not the exchange of actual underlying asset but the monetary
equivalent of the asset.
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Commodity v/s Financial Derivatives
• Examples of Commodity (Physical) and Financial Derivatives.
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Types of Risks
• Key Function of Derivatives is risk management.
• Risk in finance refers to the uncertainties associated with returns from an investment.
• Market Risk: It is changes in an asset’s price due to changes in market conditions; either
demand/supply conditions and/or sentiments.
• Inflation risk: It refers to the loss of purchasing power resulting from inflationary conditions. In
high inflationary environment, future investment returns would be worth much less, given the loss
in purchasing power.
• Interest rate risk: It refers to the changes in asset values due to changes in nominal interest rates.
It is particularly important for fixed income securities due to discounting to find prices.
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Types of Risks
• Default/Credit Risk: It refers to the changes in financial integrity of the counterparty or
the issuer of the asset and its ability to deliver on its commitment.
• Liquidity risk: It is the risk arising from thin or illiquid trading. Thinly traded instruments
have higher price volatility, and are difficult to dispose off quickly.
• Exchange rate risk: It refers to changes in investment income due to exchange rate
fluctuation. It is of utmost importance in cross border transactions.
• Political Risk: It refers to risks faced by international investors. It mostly arises due to
regulatory aspects, and refers to risks such as expropriation/ nationalization, imposition
of exchange controls
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DERIVATIVES:

• On completion of this chapter you should have an overview of the evolution of

• You should also have knowledge of different categories of derivative

• You should have an appreciation of the role of derivatives in managing

• Owing to large scale losses, derivatives are misconstrued as inherently risky.

o Similar to forward contract, futures contract represents an agreement between two

o The difference is that futures are standardized and exchange traded. 5

• As these shortcomings of forward contracts became apparent the Need for

• The problems in forwards contracts are addressed via :

• This precise inadequacy is addressed by Option Contracts. It has three marked

o Exchange trading shifts the counterparty risk to the exchange.

o Examples: Futures and Option Contracts

o All elements of the transaction are negotiable, including pricing.

o Usually between corporate clients and financial institutions.

o Hedgers use derivative markets to manage or reduce risks.

o Arbitrageurs closely follow quoted prices of the same asset/instruments in different

o Arbitrage activity enhances the price discovery process.

o Unlike commodity derivatives, financial derivatives are cash-settled at maturity.

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