Chapter 1 Derivatives Introduction and Overview

DERIVATIVES: INTRODUCTION AND
OVERVIEW
CHAPTER 1
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.
DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright © 2017 by McGraw-Hill Education (Malaysia) Sdn. Bhd.
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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.
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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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The state of global derivative markets
• Over the period 2004-2014, equity derivatives appear to be the most dominant,
accounting for 54% of total traded derivative contracts.
o Equity futures and options, both single stock and stock index, have had impressive growth.
o The biggest star has been ETF options
• Interest rate derivatives appeared to have lost ground, declining from 25% of all
exchange traded derivatives in 2004 to 15% in 2014.
o Zero or negative interest rates in several developed countries are the cause
• Commodity derivatives account for about 20% of total exchange traded derivatives in
2014, up from about 7% in 2004
• Currency derivatives account for about 10%, falling since 2011.
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The state of global derivative markets
• The composition of futures and options of all categories have changed:
o Futures 38% vs options 62% in 2004

o Futures 55% vs options 45% in 2014
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Global Derivatives Trading
• Trading originated in Chicago, United States.
Global Traded Volume of Futures and Options
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Total Traded Volume of Financial vs Non Financials
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Traded Volume by Financial Derivative Category
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Traded Volume of Exchange Traded Derivative Contracts
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DERIVATIVES: INTRODUCTION AND

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

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

• 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.

 Example – An exporter expects to receive foreign currency payment. Fearing a potential

o Hedgers use derivative markets to manage or reduce risks.

o Arbitrageurs, by means of their activities, ensure no divergence exists between different

o Arbitrage activity enhances the price discovery process.

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

• Risk in finance refers to the uncertainties associated with returns from an

• Currency derivatives account for about 10%, falling since 2011.

o Futures 38% vs options 62% in 2004

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