What is Derivatives Market?
➢ Derivative market is a market where derivative instruments are traded (OTC, Exchanges)
Over The Counter (OTC) Derivatives
➢ Are those which are privately traded between two parties and involves no exchange or
intermediary.
➢ Non-standard products are traded in the so-called over-the-counter(OTC) derivative
markets
➢ The OTC derivative market consist of the investment banks and include clients like
hedge funds, commercial banks, government sponsored enterprises etc.
Exchange Traded Derivatives Market
➢ A derivative exchange is a market where individuals trade standardized contracts that
have been defined by the exchange.
➢ A Derivatives Exchange acts as an intermediary to all related transactions, and takes
initial margin from both sides of the trade to act as a guarantee.
Participants in a Derivative Market
Hedgers- these are investors with a present or anticipated exposure to the underlying asset which is
subject to price risks. Hedgers use derivatives markets primarily for price risk management of assets and
portfolios. Use futures to reduce price risks.
Speculators – these individuals who take a view of the future direction of the markets. They
take a view whether prices would rise or fall in future and accordingly buy or sell futures and
options to try and make a profit from the future price movements. Assume risk in the hope of
making a profit.
Arbitrageurs – They take the positions in financial markets to earn riskless profits. The Arbitrageurs take
short and long positions in the same or different contracts at the same time to create a position which
can generate a riskless profit.
Economic Functions of Derivative Market
▪
▪
▪
▪
Helps in discovery of future as well as current prices
Helps to transfer risks from those who have them but do not like them to those who have
an appetite for them
With the introduction of derivatives, the underlying market witnesses higher trading
volumes.
Speculative trades shift to a more controlled environment in derivatives market. In the
absence of an organized derivatives market, speculators trade in the underlying cash
markets.
Purpose of Derivative Markets
▪
▪
▪
▪
▪
Price discovery.
Market completeness.
Risk management.
Market efficiency.
Trading efficiency
What is Derivatives?\
➢ Derivatives are instruments whose value is derived from other asset.
➢ the term Derivative stands for a contract whose price is derived from or is dependent
upon an underlying assets could be Financial asset such as currency, stock and market
index, and interest bearing security or physical commodity
➢ A derivative is a financial instrument whose price is derived from that of another asset,
and the other asset is generally referred to as the ‘underlying asset’, or sometimes just
‘the underlying.
➢ Derivatives are useful for risk management because the fair values or cash flows of these
instruments can be used to offset the changes in fair values or cash flows of assets that
are at risk.
➢ Entities use derivative financial instruments to manage financial risk.
Characteristics of a Derivatives
▪ The value of the derivative changes in response to the change in an “underlying” variable
▪ The derivative requires either no initial net investment or an initial small net investment.
▪ The derivative is readily settled at a future date by a net cash payment
What are the Uses of Derivatives?
▪ Risk management : The equity manager’s market risk or the bond manager’s interest rate
risk is analogous to the farmer’s price risk.
▪ Risk transfer : Derivatives provide a means for risk to be transferred from one person to
some other market participant who, for a price, is willing to bear it.
▪ Income generation : Some people use derivatives as a means of generating additional
income from their investment portfolio.
▪ Financial engineering : Derivatives can be stable or volatile depending on how they are
combined with other assets.
What is Financial Risk?
Financial risk is the possibility of losing money on an investment or business venture.
Types of Financial Risk:
▪
▪
▪
▪
Price Risk
Credit Risk
Interest Rate Risk
Foreign Currency Risk
Price risk
➢ is the uncertainty about the future price of an asset.
Entities are exposed to a price risk with respect to existing assets such as:
a. Investment in trading securities
b. Assets to be acquired in the future such as purchase commitments
c. Equipment to be imported at a future date.
Credit risk
➢ is the uncertainty over whether a counterparty or the party on the other side of the
contract will honor the terms of the contract.
Banks and other financial institutions are usually exposed to a credit risk by granting loans to
borrowers. There is always the possibility of non-payment of the loans
Interest rate risk
➢ is the uncertainty about future interest rates and their impact on cash flows and the fair
value of the financial instruments.
For example, a borrower with a variable-rate loan is exposed to an interest rate risk by reason of
the fluctuation of interest rate in the future. Even a borrower with fixed-rate loan is also exposed
to an interest rate risk because there is always the possibility that interest rate will decrease in the
future.
Foreign currency risk
➢ is the uncertainty about future Philippine peso cash flows stemming from assets and
liabilities denominated in foreign currency.
Types of Derivative Assets (Instruments)
▪
▪
▪
▪
Forward Contract
Futures Contract
Swap
Option
A Forward Contract
➢ an informal agreement traded through a broker-dealer network to buy and sell specified
assets, typically currency, at a specified price at a certain future date.
➢ Forwards are over the counter derivatives that enable the buying or selling of an
underlying security on a future date, at an agreed price.
➢ Just like Futures contract, is an agreement for the future delivery of something at a
specified price at the end of a designated period of time.
➢ Parties in a forward contract are exposed to counterparty risk because either party may
default on the obligation.
A Futures contract
➢ A futures contract is a contract between two parties where both parties agree to buy and
sell a particular asset of specific quantity and at a predetermined price, at a specified
date in future
➢ Counterparty risk is minimal in the case of futures contract because the clearinghouse
associated with exchange guarantees the other side of the transactions.
➢ The underlying asset in a futures contract could be commodities, stocks, currencies,
interest rates and bond. The futures contract is held at a recognized stock exchange.
➢ Is an agreement that requires a party to the agreement either to buy or sell something at a
designated future date at a predetermined price.
➢ The basic economic function of future markets is to provide an opportunity for market
participants to hedge against risk of adverse price movements
Two Categories of Futures Contracts:
▪ Commodity Futures – involve traditional agricultural commodities such as grain and
live stocks, imported foodstuff such as coffee, cocoa, and sugar, and industrial
commodities
▪ Financial Futures – is based on a financial instrument or a financial index.
Underlying Assets of Futures Commodities Contracts:
▪ Agricultural Products:
Food, Grain, Oils & Oilseeds, Meat & livestock, Fiber
▪ Metals:
Precious metals, Industrial metals
▪ Others:
Energy products, Forest products
Financial Futures can be classified as:
Stock index futures
Interest rate futures
Currency futures
Stock Index Futures
➢ A stock index future is a promise to buy or sell the standardized units of a specific index
at a fixed price at a predetermined future date.
➢ Unlike most other commodity contracts, there is no actual delivery mechanism when the
contract expires. For practicality, all settlements are in cash.
Interest Rate Futures
➢ Interest rate futures contracts are customarily grouped into short-term, intermediateterm, and long-term categories.
➢ The two principal short-term contracts are Eurodollars and U.S. Treasury bills.
Foreign Currency Futures
➢ Foreign currency futures contracts call for delivery of the foreign currency in the
country of issuance to a bank of the clearing house’s choosing.
➢ Most major corporations face at least some foreign exchange risk and quickly discovered
the convenience of these futures as a hedging vehicle, while speculators saw the
contracts as easy to understand and use.
Futures Contract-For Illustration
▪ Suppose a futures contract is traded on an exchange where the something to be bought or
sold is asset XYZ, and the settlement is 3 months from now. Assume further that Bob
buys this futures contract, and Sally sells this futures contract, and the price at which
they agree to transact in the future is $100. Then $100 is the futures price. At the
settlement date, Sally will deliver asset XYZ to Bob; Bob will give Sally $100, the
futures price.
Futures price – the price at which the parties agree to transact in the future
Settlement date or Delivery date – the designated date at which the parties must
Futures Contract vs. Forward Contract
transact.
What is a 'Swap‘?
➢ A swap is a derivative contract through which two parties exchange financial
instruments. The most common kind of swap is an interest rate swap. Swaps do not
trade on exchanges, and retail investors do not generally engage in swaps. Rather, swaps
are over-the-counter contracts between businesses or financial institutions.
➢ Are private agreements between two parties to exchange cash flows in the future
according to a prearranged formula. They can be regarded as portfolios of forward
contracts.
The Two commonly used swaps are:
▪ Interest rate swaps – these entail swapping only the interest related cash flows between
the parties in the same currency.
▪ Currency Swaps – these entail swapping both principal and interest between parties,
with the cash flows in one direction, being in a different currency, than those in the
opposite direction.
Other types of Swap, Commodity Swap, Equity Swaps, Credit Default Swap
What is an Options contract?
➢ An Option contract is an agreement between a buyer and seller that gives the purchaser of
the option the right to buy or sell a particular asset at a later date at an agreed upon
price. Options contracts are often used in securities, commodities, and real estate
transactions.
➢ Is a derivative financial instrument that specifies a contract between two parties for a
future transaction on an asset at a reference price.
➢ Call options give you the right to buy the underlying asset.
➢ Put options give you the right to sell the underlying asset.
Note: The owner of an option will ultimately do one of three things with it:
▪
sell it to someone else;
▪
let it expire; or
▪
exercise it.
Option Styles:
▪ European option – an option that may only be exercised on expiration
▪ American option – an option that may be exercised on Any trading day on or before
expiry.
▪ Bermudan option – an option that may be exercised only on specified dates on or before
expiration
Some Options Terminology:
Call option – right but not the obligation to buy
Put option – right but not the obligation to sell
Option price (or Premium)– the amount per share that an option buyer pays the seller
Expiration date – the day on which option is no longer valid
Strike price (or exercise price) – the reference price at which the underlying asset may be
traded
Long position –buyer of an option assumes long position
Short position – seller of an option assumes short position