Understanding Derivative –
Beyond Accounting
Presented By
Safwat Khalid
Session Objective
• Understand characteristics of different types known
derivative tools and its application
• How derivative instrument can be an effective tool to
manage risk and enhance our investment portfolio
• Provide sufficient understanding such that the user
can make an informed and intelligent decision
regarding the role of derivatives in a particular
situation and to identify the need for better
understanding before proceeding
Topic Coverage
Ahmad is the owner of
Healthy Hen Farms
Risk – Price
Volatility of the
chicken market.
Bird Flu Scare
Enter into Forward Contract.
Pay off
MP > SAR 10 - the investor will get the benefit as he will be able to buy
the birds for less than market cost and sell them on the market at a higher
price for a gain.
MP< SAR 10 - Ahmad will get the benefit because he will be able to sell
his birds for more than the current market price.
Terms of the contract
The investor agrees to pay SAR 10 per
bird when the birds are ready for
slaughter in six months' time
By hedging with a future contract,
Ahmad is able to focus on his business
and limit her worry about price
Ahmed aspiration is to grow
the business
Ahmed obtained huge
variable interest loan for
acquiring small farms
Acquire loan SAR 50 million
at 3 months Sibor. Interest
payment quarterly
Risk – Anticipates
increase in
varaible rate
Enter into Swap agreement
with dealer or borrower who
has similar terms except
interest payments is fixed
Pay off
Sibor > Fixed – Ahmad will benefit because his cost of fund is less than the
Sibor < Fixed – Dealer or other borrower will benefit because his cost is
less than fixed.
Terms –
Ahmed - Pay Fixed Rec. Sibor
Dealer – Rec Fixed Pay Sibor
Healthy Hen Farms (HEN) is
a publicly traded corporation
Sami is one of the major
investor in HEN invested SAR
1 million
Enter into Option contract
with Option writer
Pay off
Stock price > SAR 25 – Sami will not be
exercise option.
Stock price < SAR 25 – Sami will exercise
option . Similar to insurance protection
Risk – Sami is
nervous as he
anticipates dip in
stocks because of
bird flu scare
Terms –
Sami – pay option premium
Writer – protects Sami from
loss if Stock price fall below
SAR 25. (Put Option)
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.
Types of Derivatives
Most common derivative products are
• Forward / Future Contract
• Options
• Swaps
• Credit Derivative
Derivative Utility
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
Risk Management
Derivatives are used for different type of risk
management purpose. It includes
Currency Risk
Interest Rate Risk
Price Risk i.e stocks, commodities
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
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
• 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, ranging from relatively
conservative decisions such as buying put options, to more
aggressive strategies including short-selling and inverse ETFs.
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).
Credit risks are a vital component of fixed-income investing, which is why
ratings agencies such as S&P, Moody's and Fitch evaluate the credit risks
of thousands of corporate issuers and municipalities on an ongoing basis.
Risk Management
Currency Risk
• Forward
• Futures
• Options
Interest Rate Risk
Price Risk
• Forward
• Future
• Options
Credit Risk
• Credit Derivative (Credit Options,
Credit Default Swaps)
Equity Risk
• Future
• Options
• Equity Swaps
Forward rate agreement
Future contracts
Options (Swaptions, Call, Floor, Collar)
Speculation & Arbitrage
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.
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.
• 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.
• These derivatives are zero sum game, yet they allow a
firms to hedge risk for which they have no expertise.
• The value of a forward position at maturity depends on
the relationship between the delivery price ( K) and the
underlying price (ST) at that time.
• For a long position this payoff is: ST - K
• For a short position, it is: K - ST
• A forward contract is a customized contract between two entities, where
settlement takes place on a specific date in the future at today's preagreed price.
• 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 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
Future Payoff
Future Long Position
When an investor goes long - that is, enters a contract by agreeing to
buy and receive delivery of the underlying at a set price - it means that
he or he is trying to profit from an anticipated future price increase.
Future Short Position
A speculator who goes short - that is, enters into a futures contract by
agreeing to sell and deliver the underlying at a set price - is looking to
make a profit from declining price levels. By selling high now, the
contract can be repurchased in the future at a lower price, thus
generating a profit for the speculator.
Payoff Diagram
Short Future P&L = K - St
Long Future P&L = St - K
Strategy for Hedging
Currency Position
Contractual Agreement
Receiving foreign currency
Sell Forward Contract
Paying foreign currency
Buy Forward Contract
Future Strategies includes
• To achieve target portfolio duration for bonds
(Duration Management) and Beta For Stocks
• Creating synthetic position such as convert long
stock position into synthetic risk free investment
or vice versa
• Adjust the allocation of a portfolio across equity
• Pre -investing using future
An option gives the buyer the right to buy from or sell to the
writer a designated futures contract at the strike price at any
time during the life of the option
• Options are of two types - calls and puts.
• Calls give the buyer the right but not the obligation to buy a
given quantity of the underlying asset, at a given price on
or before a given future date.
• Puts give the buyer the right, but not the obligation to sell a
given quantity of the underlying asset at a given price on or
before a given date.
Option Payoff
Long Option Payoff
The loss for the buyer of an Option is limited to the extent of
premium paid by him for the right. This loss would accrue in
the event of the option not being exercised by the buyer. The
profit for the buyer would be dependant on the asset price in
relation to the Strike rate.
Short Option Payoff
The seller of the option would receive an upfront premium
which would be his gain from the option. However, in the
event of the option being exercised by the buyer, the loss
accrues would be to the extent of the difference between the
asset price and the strike rate.
Option Payoff - Diagram
Put Option
Call Option
Option Strategies also includes
Covered Call
Protective Put
Bull Call Spread
Bear Call Spread
Bear Put Spread
Long Straddle
Butterfly Spread
A swap is an agreement between two parties to exchange sequences of cash flows for a set
period of time.
At the time the contract is initiated, at least one of these series of cash flows is determined
by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity
price or commodity price.
Swaps help companies hedge against interest rate exposure by reducing the uncertainty of
future cash flows.
Swapping allows companies to revise their debt conditions to take advantage of current or
expected future market conditions.
Currency and interest rate swaps allow companies to take advantage of the global markets
more efficiently by bringing together two parties that have an advantage in different markets.
There is some risk associated with the possibility that the other party will fail to meet its
obligations, the benefits that a company receives from participating in a swap far outweigh
the costs.
Cash Flow and Market Value Risk
• Cash flow risk is reduced by entering the swap because the
uncertain future floating rate receipts on the investment
are essentially converted to fixed receipts that can be more
easily planned and budgeted. However, the low duration of
the floating rate instrument is now converted to higher
duration of fixed rate instrument. The market value will
now fluctuate more as interest rate change
• Duration - A measure of the sensitivity of the price (the
value of principal) of a fixed-income investment to a change
in interest rates. Rising interest rates mean falling bond
prices, while declining interest rates mean rising bond
prices. The bigger the duration number, the greater the
interest-rate risk or reward for bond prices.
Swap Strategies includes
Interest Rate swap
Currency Swap
Equity Swaps
Commodity Swaps
Credit Derivative
Credit risk can be sold to another party. In return for a fee, another
party will accept the credit risk of an underlying financial asset or
institution. This party, called the credit protection seller, may be willing
to take on this risk for several reasons. Perhaps the credit protection
seller believes that the credit of an issuer will improve in a favorable
economic environment because of a strong stock market and strong
financial results.
There are three types of credit risk: default risk, credit spread risk, and
downgrade risk.
• Default risk is the risk that the issuer may fail to meet its
• Credit spread risk is the risk that the spread between the rate for a
risky bond and the rate for a default risk-free bond (like U.S.
treasury securities) may vary after the purchase.
• Downgrade risk is the risk that one of the major rating agencies will
lower its rating for an issuer, based on its specified rating criteria
Credit Derivative Products
Binary Credit options
Credit Spread Option
Credit Forward
Credit Default Swaps
Future / Forward Valuation Basics
As per no arbitrage principle – the forward price
determined makes the values of long and short position
zero at contract initiation.
A cash and carry arbitrage consist of buying the asset,
storing the asset and selling the asset at future price
when the contract expires.
General form for calculating forward contracts
•  =  (1 + )

• So =
Cash – and – carry Arbitrage
At initiation of the contract
• Borrow money for the term of the contract at market
interest rates.
• Buy the underlying asset at the spot price
• Sell (short) a future contract at the current future
• If Future contract is equal to principal plus interest
then there is no arbitrage.
• If future contract is above the principal plus interest
then there is opportunity of gain
Bonds Forward without coupon
Long position at
So -

During the Life
of contract
St -

At expiration
at initiation long
and short position
value is zero
St - FP
During the Life
of contract
At expiration
(So – PVC) 
(St – PVC) -
Long position at
(So – PVD) -
During the Life of
(St – PVD) 
St - FP
Currency Forward
at initiation long
and short position
value is zero
Currency Forward
So x
During the Life of



St - FP
at initiation long
and short position
value is zero

At expiration
Bonds Forward with coupon
Long position at
Equity Forward with dividends
At expiration
St - FT
at initiation long
and short position
value is zero
Future / Forward Valuation Basics
Future Contract Value
Risk free rate
Contract period
Current price after 9m
101.5 −
1.04 12
SAR 104/4%
1 year
SAR 101.5/-
= − 1.4852
Short is in the money
Swap Valuation Basics
PV of FRA must be equal to Swap Fixed Rate
Floating Rate Bond 4 year, Par Value SAR 1,000
Both Fixed and Floating rate notes have same
par values to replicate the swap and principal
values match at maturity
• For Swap to have zero value at initiation, the
notes must have same market price
• 1000 =

• C=
1+1 1+2 1+3 1+4
• C=
1+1 1+2 1+3 1+4
∗ 1,000
• Value of Pay Fixed = PV (Floating) – PV (Fixed)
• Value of Pay Fixed = PV (Fixed) – PV (Floating)
SWAP Valuation Basics
$ 30,000,000
1 year quarterly payment, Fixed Pay
and receive variable
Fixed Rate pay
Variable rate at initiation 5.5%
30 days passed
PV factor
60 day Libor
150 day Libor
240 day Libor
330 day Libor
Quarterly payment per $ 0.06052 * 90 = $0.01513
Quarterly payment per $ 0.05500 * 90 = $0.01375
Cash Flows
Present Value
$ 0.01513
$ 0.014980
$ 0.01513
$ 0.014731
$ 0.01513
$ 0.014455
$ 1.01513
$ 0.949827
$ 0.993993
$ 0.01375
$ 1.00000
Fixed Rate payer
Swap Value
1.0037138 – 0.993993
$ 0.0097208
Swap Value
$ 30,000,000 * $ 0.0097208
$ 291,624
Option Valuation Basics
• intrinsic value of in-the-money options = the payoff that could be
obtained from the immediate exercise of the option
• for a call option: stock price – exercise price St •
for a put option: exercise price – stock price


- St
the intrinsic value for out-the-money or at-the money options is
equal to 0
• time value of an option = difference between actual call price and
intrinsic value
• as time approaches expiration date, time value
• goes to zero
Derivative Market – Brief Introduction
Financial derivatives have emerged as one of the biggest markets of the world during the past
two decades.
History –
1848 - A group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT
was to provide a centralized location (which would be known in advance) for buyers and sellers to negotiate forward contracts.
1865 - The CBOT went one step further and listed the first ‘exchange traded” derivatives contract in the US. These contracts were
called ‘futures contracts”.
1919 - Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its name was changed to
Chicago Mercantile Exchange (CME). Initially, the Chicago Butter and Egg Board traded only two types of contracts, butter and
eggs. Over several decades, it evolved into the Chicago Mercantile Exchange (CME or the "Merc") which now trades futures
contracts and options contracts on over 50 products, from pork bellies to eurodollars and stock market indices.
1972 - The first exchange-traded financial derivatives emerged due to the collapse of fixed exchange rate system and adoption of
floating exchange rate systems. To help participants in foreign exchange markets hedge their risks under the new floating
exchange rate system.
1973 - The Chicago Board of Trade (CBOT) created the Chicago Board Options Exchange (CBOE) to facilitate the trade of options on
selected stocks
Mid 80’s - Financial futures became the most active derivative instruments generating volumes many times more than the
commodity futures. Index futures, futures on T-bills and Euro- Dollar futures are the three most popular futures contracts traded
today. Other popular international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE
in Japan, MATIF in France, Eurex etc.
Thirty Years of Financial Deregulation Transformed the
World Economy into a Global Financial Casino
In 1970, about 95% of the capital in
international exchanges was related to
the real economy in some fashion, (that
is they were either investments or trade
of goods and services).
By 1990, however, the proportion of
foreign exchange transactions that
involved speculations or short-term
investments reached about 98%, while
only 2% involved the exchange of goods
and services
Warren Buffett once called derivatives,
"financial weapons of mass destruction,"
Like all other financial instruments,
derivatives have their own set of pros and
cons, but they also hold unique potential to
enhance the functionality of the the overall
financial system
Types of Derivative Contracts
Underlying Asset
Type of Derivative Contract
Exchange Traded
Exchange Traded
Index Future
Stock Future
Interest Rate
rate Options on futures
future linked to
Bond Future
Foreign Exchange Currency futures
Index Option
Stock Option
OTC Swap
OTC Forward
OTC option
Equity Swap
Back to Back repo Stock options
Interest rate swaps
Bond Credit Default Swap
Total Return Swap
Currency forward
Currency option
Option on currency Currency swap
rate Interest rate cap,
floors & collars.
Should My Company Use Derivatives?
• Answer – Yes, provided one fully understand the
complexity of financial derivatives contracts and the
accompanying risks.
• It provides risk reduction efficient mechanism
• It provides value enhancing opportunities i.e increased
• It provides flexibility to manage different exposure i.e.
it can be used with respect to commodity price,
interest, exchange rates, and equity price.
How do I buy and sell?
• Buying or selling contracts can only be done
through a financial intermediary.
• Financial intermediaries meeting regulatory
requirements who are member of an exchange
can enter clients order into the market.
• Before selecting an intermediary to process your
order, review both fees structure and the services
offered. It is vitally important to have real time
information and tools to complete transactions
completely and swiftly
Contract Execution Flow
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