TOPIC 7

Derivatives as financial market instruments.

Necessity and diversity of derivatives.
 Introduction

 Futures, options and swap markets are very useful,

perhaps even essential, parts of the financial system
 hedging or risk management
 speculate or strive for enhanced returns
 price discovery - insight into future prices of
commodities
 Futures and options markets, and more recently
swap markets have a long history of being
misunderstood -

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 Introduction
How many have heard of the following:

 Nick Leeson and Barings Bank $1.3B (1995)

 Orange County – California - $1.7B (1994)
 Sumitomo Copper $2.6 B (1996)
 Procter & Gamble – $102 M (1994)
 Govt. of Belgium - $1.2B (1997)

....market type losses have often been attributed to the use of ‘derivatives’ - in many of these
situations this has been the case i.e a speculative application of derivatives that has gone
against the user

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 What Fueled the Growth in
Derivatives?
 Change in volatility in markets
 Exchange rates became floating
 Active control of interest rates
 Commodity prices
• Globalization
– Revenues in different currencies
– Operating Costs in different currencies
– Liabilities in different currencies
• Technological advances
– Level of computerization
– Modeling abilities
• Regulatory changes
• Changes in transactions costs
 Background on Derivatives
The reality show us that people no longer live and invest in the simple world of stocks and
bonds. Many new instruments have emerged, several – if not most – of which no longer
represents a direct investment in an asset but ones that offer a return based on the return of
another underlying asset.
Managers of financial institutions have become more concerned with reducing the risk their
institutions face. Given the greater demand for risk reduction, the process of financial
innovation came to the rescue by producing new financial instruments.
These are called derivatives.
Derivative: A financial instrument that offers a return based on the return of
some other underlying asset.

Derivatives are called thus as their value is

derived from the return of the underlying asset

A derivative is a contract that

initiates on a certain date and
terminates on a later date. Often
(but not always) the payoff is
determined on the expiration date

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 Derivatives
• A derivative is a financial instrument whose value derives
from the value of something else.
• Consider an agreement/contract between A and B:
If the price of a oil in one year is greater than $50 per
barrel, A will pay B $10.
If the price of a oil in one year is less than $50, B will pay
A $10.
• This agreement is a derivative.
 Derivatives
Why might A and B make such an
agreement?
1. To hedge or reduce risk.
Suppose A is an oil producer and B is a
refinery.
A will earn $10 if the price of oil goes
down.
B will earn $10 if the price of oil goes up.
2. To speculate on the price of oil.
 Definition of Derivatives
• A derivative is a financial instrument
whose value derives from the value of
something else, generally called the
underlying(s).
• Underlying: a barrel of oil, a financial
asset, an interest rate, the temperature at
a specified location.
 Derivatives
Example Underlying
Stock option, such as option on A stock, such as the stock of
the stock of Nortel Networks Nortel Networks
Stock index option, such as an A portfolio of stocks, such as the
option on the S&P 100 index portfolio of stocks comprising the
S&P 100 index
Treasury bill futures contract A Treasury bill

Foreign currency forward contract A foreign currency

Gold futures contract Gold

Futures option on gold A gold futures contract

Weather derivative Snowfall at a specified site

 Derivative markets

• Have a long history.

• Futures markets: date back to the Middle
Ages.
• Options markets: date back to 17th century
Holland.
• Last 35 years: extraordinary growth
worldwide.
• Today: derivatives are used to manage risk
exposures in interest rates, currencies,
commodities, equity markets, the weather.
 Derivatives
Types of Market of Derivatives

There are two distinct but ultimately related markets for derivatives. Derivatives
may be:

Exchange traded contracts: which Over-the-counter contracts: which

have standard terms and features
and are traded on an organized
trading facility/exchange such as a
futures exchange or an options
exchange.
are transactions created by two
parties but not traded on an
exchange and usually representing
a “private” deal vis a vis an
underlying. This could be a wide
array of deals including purchasing
of insurance.
 Derivatives
Forms of Derivatives
There are two distinct forms of derivatives. Derivatives may be:

Forward commitments: which are Contingent claims: which are

agreements between two parties in
which one party agrees to buy from
the other party an underlying asset
at a future date at a price
established at the start.
derivatives in which the payoff
occurs if a specific event occurs.
We generally call these types of
claims as options.
 Derivatives
Forms of Derivatives
Forward Commitments

Forward commitments come in three categories:

Forward contracts or Forwards: This is a Futures contracts: which are a variation

forward commitment in which the two
parties “privately” design and therefore
customize the deal. The underlying could
be anything
Swaps: which are a variation of a forward
contract (actually it is simply a series of
forward contracts) in which the parties
agree to swap a series of future cash
flows. Generally at least one cash flow’s
value is determined by a later outcome
of a forward commitment that is a
public, exchange-traded, standardized
transaction the protection re the default
on which is guaranteed by the
exchange. Futures are available on a
wide range of commodities, currencies,
stocks, funds, etc.
 Categories of Derivatives

Futures Options
Listed, OTC futures Calls
Forward contracts Puts

Derivatives

Swaps
Interest rate swap
Foreign currency swap
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 Derivatives
• Basic instruments:
– Forward contracts
– Options
• Hybrid instruments:
– Futures contracts
– Swaps
Types of derivatives
 Three basic characteristics of Derivative Instruments

1. The instrument has one or more underlyings and an

identified payment provision.

2. The instrument requires little or no investment at the

inception of the contract.

3. The instrument requires or permits net settlement.

 Three basic characteristics of Derivative Instruments

1. The instrument has one or more underlyings and an identified

payment provision.
An underlying is a specified stock price, interest rate, commodity
price, index of prices or rates, or other market-related variable.
The interaction of the underlying, with the face amount or the
number of units specified in the derivative contract (the notional
amounts), determines payment.
Example:
The underlying is the stock price of Laredo stocks.
The value of the call option increased in value when the value of
the Laredo stock increased.
Payment Provision = Change in the stock price x Number of Shares
 Three basic characteristics of Derivative Instruments

2. The instrument requires little or no investment at the

inception of the contract.
Example:
The company paid a small premium to purchase the call option –
an amount much less than if purchasing the Laredo shares as a
direct investment.

3. The instrument requires or permits net settlement.

Example:
The Laredo stock Call Option allows the company to realize a
profit on the call option without taking possession of the
shares.
This Net Settlement feature reduces the transaction costs
associated with derivatives.
 Derivatives
• Derivatives are contracts, agreements
between two parties: a buyer and a seller.

Buyer Seller
 Forward contract
• A forward contract is an agreement between
two parties to buy or sell an asset at a certain
future time for a certain future price.
• This price is called the delivery price.
• Trades in the OTC market.
• Example: interest rate forwards
• Forwards are highly customized, and are much
less common than the futures
 Forward Contracts

– Forward contracts are normally not exchange

traded.
– The party that agrees to buy the asset in the
future is said to have the long position.
– The party that agrees to sell the asset in the
future is said to have the short position.
– The specified future date for the exchange is
known as the delivery (maturity) date.

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 Forward Contract:
Gives holder the right and obligation to purchase
an asset at a preset price for a specified period of time.

Example:
Dell enters into a contract with a broker for delivery of
10,000 shares of Google stock in three months at its
current price of $110 per share. => $1,100,000

Dell has received the right to receive 10,000 shares in

three months and incurred an obligation to pay $110
per share at that time.
 Futures contract
• A futures contract is an agreement between two parties, a buyer
and a seller, to exchange an asset at a later date for a price
agreed to in advance, when the contract is first entered into.
• We call this price the futures price.
• Trades on a futures exchange.
• A future is a forward contract that has been standardized
• Structure of a futures contract:
–Seller (has short position) is obligated to deliver the commodity or
a financial instrument to the buyer (has long position) on a specific
date
–This date is called settlement, or delivery, date
 Futures Contracts
• A futures contract is similar to a forward contract in that it is an
agreement between two parties to buy or sell an asset at a
certain time for a certain price.
• Futures, however, are usually exchange traded and, to facilitate
trading, are usually standardized contracts. This results in more
institutional detail than is the case with forwards.
• The long and short party usually do not deal with each other
directly or even know each other for that matter. The exchange
acts as a clearinghouse. As far as the two sides are concerned
they are entering into contracts with the exchange. In fact, the
exchange guarantees performance of the contract regardless of
whether the other party fails.

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 Futures Contracts
• The largest futures exchanges are the Chicago
Board of Trade (CBOT) and the Chicago Mercantile
Exchange (CME).
• Futures are traded on a wide range of commodities
and financial assets.
• Usually an exact delivery date is not specified, but
rather a delivery range is specified. The short
position has the option to choose when delivery is
made. This is done to accommodate physical
delivery issues.
– Harvest dates vary from year to year, transportation
schedules change, etc. 27
 Futures/Forward Contracts - History
• Forward contracts on agricultural products began in
the 1840’s
– producer made agreements to sell a commodity to a
buyer at a price set today for delivery on a date
following the harvest
– arrangements between individual producers and buyers
- contracts not traded
– by 1870’s these forward contracts had become
standardized (grade, quantity and time of delivery) and
began to be traded according to the rules established by
the Chicago Board of Trade (CBT)
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 Futures/Forward Contracts
• Key point is that commodity futures (evolving from forward
contracts) developed in response to an economic need by
suppliers and users of various agricultural goods initially and
later other goods/commodities - e.g metals and energy
contracts
• Financial futures - fixed income, stock index and currency
futures markets were established in the 70’s and 80’s -
facilitated the sale of financial instruments and risk (of price
uncertainty) in financial markets.

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 Product Characteristics
• Both futures and options 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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 Hedging and Speculating with Futures

Often, agents hedge against adverse events in the market using futures
–E.g., a manager wishes to insure the firm against the rise in interest rates and the
resulting decline in the value of bonds the firm holds
–Can sell a futures contract and lock in a price
• Producers and users of commodities use futures extensively to hedge their risks
• –Farmers, oil drillers (producers) sell futures contracts for their commodities and
insure themselves against price declines
• –Food processing companies, oil refineries (users) buy futures contracts to
insure themselves against price increases
Speculators try to use futures to make a profit by betting on price movements:
• –Sellers of futures bet on price decreases
• –Buyers of futures bet on price increases
Futures are popular because they are cheap
An investor only needs a relatively small amount –the margin –to purchase a
contract that is worth a great deal
 Options
• An option gives the buyer the right, but not
the obligation, to buy/sell the underlying at a
later date for a price agreed to in advance,
when the contract is first entered into.
• We call this price the strike/exercise price.
• The option buyer pays the seller a sum of
money called the option price or premium.
• Trades OTC or on an exchange.
 Option Contract
Gives the holder the right, but not the obligation, to buy
share at a preset price for a specified period of time.

Example:
Dell enters into a contract with a broker for an option (right)
to purchase 10,000 shares of Google shares at its current
price of $110 per share.

The broker charges $3,000 for holding the contract open for
two weeks at a set price.

Dell has received the right, but not the obligation to

purchase this stock at $110 within the next two weeks.
 Types of options
• Call option: an option to buy the underlying at
the strike price
• Put option: an option to sell the underlying at
the strike price
• Put Option
• An option contract giving the owner the right,
but not the obligation, to sell a specified amount
of an underlying security at a specified price
(STRIKE PRICE) within a specified time.
• A put becomes more valuable as the price of the
underlying stock depreciates (falls) relative to the
strike price.
•

This is the opposite of a call option.

•Note that unlike a forward or futures contract, the holder of

the options contract does not have to do anything - they have
the option to do it or not.
• Put Option
• Example:
• On March 1, 2020, you purchased a March 21 Taser 10 put.
• That means, you have the right to sell 100 shares of Taser at
$10 until March 2021 (usually the third Friday of the month).
• If shares of Taser fall to $5 and you exercise the option, you
can purchase 100 shares of Taser for $5 in the market and
sell the shares to the option's writer for $10 each, which
means you make $500 = (100 x ($10-$5)) on the put option.

• Note that the maximum amount of potential profit in this

example ignores the premium paid to obtain the put option.
https://www.youtube.com/watch?v=EfmTWu2
yn5Q
 Option Contracts - History
• Chicago Board Options Exchange (CBOE) opened in
April of 1973
– call options on 16 common stocks
• The widespread acceptance of exchange traded
options is commonly regarded as one of the more
significant and successful investment innovations
of the 1970’s
• Today we have option exchanges around the world
trading contracts on various financial instruments
and commodities
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 Options Contracts
• Chicago Board of Trade
• Chicago Mercantile Exchange
• New York Mercantile Exchange
• Montreal Exchange
• Philadelphia exchange - currency options
• London Traded Options Market (LTOM)
• Others- Australia, Switzerland, etc.

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 Introduction to SWAPS contracts
• 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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 Swap Market - History
• Similar theme to the evolution of the other
derivative products - swaps evolved in response
to an economic/financial requirement
• Two major events in the 1970’s created this
financial need....
– Transition of the principal world currencies from
fixed to floating exchange rates - began with the
initial devaluation of the U.S. Dollar in 1971
• Exchange rate volatility and associated risk has been with
us since

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 Swap Market - History
– The second major event was the change in policy of
the U.S. Federal Reserve Board to target its money
management operations based on money supply vs
the actual level of rates
• U.S interest rates became much more volatile hence
created interest rate risk
• With the prominence of U.S dollar fixed income
instruments and dollar denominated trade, this created
interest rate or coupon risk for financial managers around
the world .
– The swap agreement is a ‘creature’ of the 80’s and emerged via the
banking community - again in response to the above noted need

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 Interest Rate Swap
• 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
• Interest swap allow the institutions to convert
fixed-rate assets into rate sensitive assets
without effecting the balance sheet.

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Process of Interest Rate Swap
 Advantages of Interest Rate Swap

(1) allow the institutions to convert fixed-rate assets

into rate sensitive assets without effecting the
balance sheet.

(2) they can be written for very long horizons, therefore

if a financial institution need to hedge interest rate risk
for a long horizon, it can turn to the swap market.
 Commodity Swap
• 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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 Basic purpose of derivatives

• In derivatives transactions, one party’s loss is

always another party’s gain
• The main purpose of derivatives is to transfer risk
from one person or firm to another, that is, to
provide insurance
• If a farmer before planting can guarantee a certain
price he will receive, he is more likely to plant
• Derivatives improve overall performance of the
economy
 Uses of derivatives
• Derivatives can be used by individuals,
corporations, financial institutions, and
governments to reduce a risk exposure or to
increase a risk exposure.
 The Uses of Financial Derivatives

• Speculation
– Play on forecast
• Arbitrage
– Play on mispricing
• Risk Management
– Reduce exposure
Derivatives somehow allow investors to better control
the level of risk that they bear.
– They can help eliminate diversifiable risk.
– They can decrease or increase the level of systematic
risk.
 Traders of derivatives
• Hedgers
• Speculators
• Arbitrageurs
 Hedging
• If someone bears an economic risk and uses
the futures market to reduce that risk, the
person is a hedger

• Hedging is a prudent business practice and a

prudent manager has a legal duty to
understand and use the futures market
hedging mechanism

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 Speculation
• 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 the
transfer of risk between market participants
as they desire

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 Arbitrage
• Arbitrage is the existence of a riskless profit

• Arbitrage opportunities are quickly exploited

and eliminated

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 Arbitrage (cont’d)
• 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

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 Questions
• 1. What are the advantage and disadvantages of
forward contract.
• 2.What are the difference between forward and
futures contract.
• 3.What are the difference between option and
futures contract.
• 4.How can we use interest rate swap to hedge?
• 5.What are the difference between option and
futures contract.
• 6.Which factors can affect the prices of option
premium?
• 7.How can we use interest rate swap to
hedge?
• 8.What are the disadvantages of interest rate
swap?
 References:
• P.J. Hunt, J.E. Kennedy: Financial Derivatives in
Theory and Practice , John Wiley and Sons
Ltd., 2004