THE SLOVAK UNIVERSITY OF AGRICULTURE IN NITRA
FACULTY OF ECONOMICS AND MANAGEMENT
International Trade with Agrarian Commodities
Financial derivatives as tools of risks elimination in foreign
payment system
Veronika Jablonická
2008
Katarína Kotrusová
2.class, 11. study group
C ONTENT
Introduction ....................................................................................................................................... 3
Financial derivatives ....................................................................................................................... 4
1.1 Financial derivatives............................................................................................................ 4
1.2 The use of derivatives ......................................................................................................... 5
1.2.1 Speculation and arbitrage ...................................................................................................... 5
1.3 Types of derivatives ............................................................................................................ 6
1.3.1 OTC and exchange-traded ...................................................................................................... 6
1.3.2 Common Derivative contract types........................................................................................ 6
1.4 Options............................................................................................................................... 7
1.4.1 Types of options ..................................................................................................................... 8
1.4.2 Option styles........................................................................................................................... 8
1.5 Swap .................................................................................................................................. 9
1.5.1 Types of swaps ....................................................................................................................... 9
1.6 Futures and forwards ........................................................................................................ 10
Conclusion ........................................................................................................................................ 12
Resources .......................................................................................................................................... 13
2
I NTRODUCTION
What are derivatives? It is difficult to answer this question because the derivatives have
different meanings. Definition is not easy. Economists and accountants, lawyers, and
government regulators have all struggled to develop a precise definition. It also is a real
problem for firms that must operate in a regulatory environment where the meaning of the
term often depends on which regulator is using it.
The main definition is that derivative is a contract that derives most of its value from some
underlying asset, reference rate, or index. We know several different types of derivatives,
including commodity derivatives and financial derivatives.
In our semestral work, we are concerned with financial derivatives. In practise, financial
derivatives cover a diverse spectrum of underlyings, including stocks, bonds, exchange rates,
interest rates, credit characteristics, or stock market indexes.
We briefly discuss the major types of financial derivatives and describe some of the ways
in which they are used. We discuss four types of financial derivatives – forward contracts,
futures, options, and swaps.
3
F INANCIAL DERIVATIVES
1.1 F INANCIAL
DERIVAT IVES
Derivatives are financial instruments whose value is derived from the value of something
else. They generally take the form of contracts under which the parties agree to payments
between them based upon the value of an underlying asset or other data at a particular point in
time. The main types of derivatives are futures, forwards, options, and swaps. (Wikipedia,
n.d.)
Derivatives pose unsuitably high amounts of risk for small or inexperienced investors.
Because derivatives offer the possibility of large rewards, they offer an attraction even to
individual investors. Derivatives are complex instruments devised as a form of insurance, to
transfer risk among parties based on their willingness to assume additional risk, or hedge
against it. (Davies, 2008)
Derivatives typically have a large notional value1. As such, there is the danger that their
use could result in losses that the investor would be unable to compensate for. The possibility
that this could lead to a chain reaction ensuing in an economic crisis, has been pointed out by
legendary investor Warren Buffett in Berkshire Hathaway's annual report. Buffet stated that
he regarded them as 'financial weapons of mass destruction'. The problem with derivatives is
that they control an increasingly larger notional amount of assets and this may lead to
distortions in the real capital and equities markets. Investors begin to look at the derivatives
markets to make a decision to buy or sell securities and so what was originally meant to be a
market to transfer risk now becomes a leading indicator. Many economists are worried that
derivatives may cause an economic crisis at some point in the future.(Davies, 2008)
Derivatives massively leverage the debt in an economy, making it ever more difficult for
the underlying real economy to service its debt obligations and curtailing real economic
activity, which can cause a recession or even depression.(Davies, 2008)
1
Notional amount: The nominal or face amount that is used to calculate payments made on swaps and other risk
management products. This amount generally does not change hands and is thus referred to as notional.
4
1.2 T HE
USE OF DERIVAT IVE S
The main use of derivatives is to reduce risk for one party while offering the potential for
a high return (at increased risk) to another. The diverse range of potential underlying assets
and payoff alternatives leads to a huge range of derivatives contracts available to be traded in
the market. Derivatives can be based on different types of assets such as commodities,
equities (stocks), bonds, interest rates, exchange rates, or indexes (such as a stock market
index, consumer price index (CPI) or even an index of weather conditions, or other
derivatives. Their performance can determine both the amount and the timing of the payoffs.
(Wikipedia, n.d.)
One use of derivatives is as a tool to transfer risk by taking the opposite position in the
futures market against the underlying commodity. For example, a farmer can sell futures
contracts on a crop to a speculator before the harvest. By taking a position in the futures
market, the farmer hopes to minimize his or her price risk. (Wikipedia, n.d.)
1.2.1 S P EC U LA T IO N A ND AR B IT R AG E
Speculators may trade with other speculators as well as with hedgers. In most financial
derivatives markets, the value of speculative trading is far higher than the value of true hedge
trading. As well as outright speculation, derivatives traders may also look for arbitrage
opportunities between different derivatives on identical or closely related underlying
securities. (Wikipedia, n.d.)
Other uses of derivatives are to gain an economic exposure to an underlying security in
situations where direct ownership of the underlying security is too costly or is prohibited by
legal or regulatory restrictions, or to create a synthetic short position. In addition to directional
plays (i.e. simply betting on the direction of the underlying security), speculators can use
derivatives to place bets on the volatility of the underlying security. This technique is
commonly used when speculating with traded options. Speculative trading in derivatives
gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings Bank, made
poor and unauthorized investments in index futures. Through a combination of poor judgment
on his part, lack of oversight by management, a naive regulatory environment and unfortunate
outside events like the Kobe earthquake, Leeson incurred a $1.3 billion loss that bankrupted
the centuries-old financial institution. (Wikipedia, n.d.)
Nevertheless, the use of derivatives has its benefits:
5
Derivatives facilitate the buying and selling of risk, and thus have a positive impact on the
economic system. Although someone loses money while someone else gains money with a
derivative, under normal circumstances, trading in derivatives should not adversely affect the
economic system because it is not zero sum in utility.
Former Federal Reserve Board chairman Alan Greenspan commented in 2003 that he
believed that the use of derivatives has softened the impact of the economic downturn at the
beginning of the 21st century.
1.3 T YPES
OF DERIVATIVES
1.3.1 OTC A ND E XC H AN GE - TR A DE D
Broadly speaking there are two distinct groups of derivative contracts, which are
distinguished by the way they are traded in market.
Over-the-counter (OTC) derivatives are contracts that are traded (and privately
negotiated) directly between two parties, without going through an exchange or other
intermediary. Products such as swaps, forward rate agreements, and exotic options are almost
always traded in this way. The OTC derivatives market is huge.
Exchange-traded derivatives (ETD) are those derivatives products that are traded via
specialized derivatives exchanges or other exchanges. 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. The world's largest derivatives exchanges (by number of transactions) are
the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide
range of European products such as interest rate & index products), and CME Group (made
up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade).
Some types of derivative instruments also may trade on traditional exchanges.
1.3.2 C O M MO N D ER I VA TIV E
There are three major classes of derivatives:

C O N TR AC T T Y P ES
Futures/Forwards, which are contracts to buy or sell an asset at a
specified future date.

Options, which are contracts that give a holder the right (but not the
obligation) to buy or sell an asset at a specified future date.

Swaps, where the two parties agree to exchange cash flows.
6
Other examples of underlyings are:

Economic derivatives

Energy derivatives

Commodities

Freight derivatives

Inflation derivatives

Insurance derivatives

Weather derivatives

Credit derivatives

Sports derivatives

Property derivatives

Portfolio
An individual or a corporation should carefully weigh the risks of using derivatives since
losses can be greater than the money put into these instruments. It should be understood that
derivatives themselves are not to be considered investments since they are not an asset class.
They simply derive their values from assets such as bonds, equities, currencies etc. and are
used to either hedge those assets or improve the returns on those assets. (wikipedia, n.d.)
1.4 O PT IONS
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell
an underlying asset at a specific price on or before a certain date. An option, just like a stock
or bond, is a security. It is also a binding contract with strictly defined terms and
properties.(Investopedia, n.d.)
The power of options lies in their versatility. They enable to adapt or adjust position
according to any situation that arises. Options can be as speculative or as conservative as
someone wants. This means he can do everything from protecting a position from a decline to
outright betting on the movement of a market or index. This versatility, however, does not
come without its costs. Options are complex securities and can be extremely risky.
Options involve risks and are not suitable for everyone. Option trading can be speculative
in nature and carry substantial risk of loss. Only invest with risk capital.
On the other hand, being ignorant of any type of investment places you in a weak position.
Perhaps the speculative nature of options doesn't fit your style. No problem - then don't
speculate in options. But, before you decide not to invest in options, you should understand
7
them. Not learning how options function is as dangerous as jumping right in: without
knowing about options you would not only forfeit having another item in your investing
toolbox but also lose insight into the workings of some of the world's largest corporations.
Whether it is to hedge the risk of foreign-exchange transactions or to give employees
ownership in the form of stock options, most multi-nationals today use options in some form
or another. (Investopedia, n.d.)
1.4.1 T Y P ES O F OP T IO NS
The primary types of financial options are:
Exchange traded options (also called "listed options") are a class of exchange traded
derivatives. Exchange traded options have standardized contracts, and are settled through a
clearing house with fulfillment guaranteed by the credit of the exchange. Since the contracts
are standardized, accurate pricing models are often available. Exchange traded options
include:

stock options

commodity options

bond options and other interest rate options

index (equity) options

options on futures contracts
Over-the-counter options (OTC options, also called "dealer options") are traded between
two private parties, and are not listed on an exchange. The terms of an OTC option are
unrestricted and may be individually tailored to meet any business need. In general, at least
one of the counterparties to an OTC option is a well-capitalized institution. Option types
commonly traded over the counter include:

interest rate options

currency cross rate options, and

options on swaps or swaptions
Employee stock options are issued by a company to its employees as compensation.
(Wikipedia, n. d.)
1.4.2 O P TIO N S TY LE S
Naming conventions are used to help identify properties common to many different types
of options. These include:
8

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 expiration.

Bermudan option - an option that may be exercised only on specified
dates on or before expiration.

Barrier option - any option with the general characteristic that the
underlying security's price must reach some trigger level before the exercise can
occur. (Wikipedia, n. d.)
1.5 S WAP
A swap plays a very important role in international finance. A swap is the exchange of one
set of cash flows for another. A swap is a contract between two parties in which the first party
promises to make a payment to the second and the second party promises to make a payment
to the first. Both payments take place on specified dates. Different formulas are used to
determine what the two sets of payments will be. (Wikipedia, n. d.)
1.5.1 T Y P ES O F S WA P S
Classification of swaps is done on the basis of what the payments are based on. The
different types of swaps are as follows:

Interest rate swaps

Currency Swaps

Commodity swaps

Equity swaps

Interest rate swaps
The interest rate swap is the most frequently used swap. An interest rate swap generally
involves one set of payments determined by the Eurodollar (LIBOR) rate. Although, it can be
pegged to other rates. The other set is fixed at an agreed-upon rate. This other agreed upon
rate usually corresponds to the yield on a Treasury Note with a comparable maturity.
Although, this can also be variable. (Wikipedia, n. d.)
A currency swap is an agreement between two parties in which one party promises to
make payments in one currency and the other promises to make payments in another
currency. Currency swaps are similar yet notably different from interest rate swaps and are
9
often combined with interest rate swaps. Currency swaps help eliminate the differences
between international capital markets. Swaps are not traded or listed on exchange but they do
have an informal market and are traded among dealers. A swap is a contract, which can be
effectively combined with other type of derivative instruments. An option on a swap gives the
party the right, but not the obligation to enter into a swap at a later date. (Wikipedia, n. d.)
In commodity swaps, the cash flows to be exchanged are linked to commodity prices.
Commodities are physical assets such as metals, energy stores and food including cattle. E.g.
in a commodity swap, a party may agree to exchange cash flows linked to prices of oil for a
fixed cash flow. (Wikipedia, n. d.)
Under an equity swap, the shareholder effectively sells his holdings to a bank, promising
to buy it back at market price at a future date. However, he retains a voting right on the
shares. (Wikipedia, n. d.)
1.6 F UTURES
AND FORWARDS
A futures contract is a form of forward contract, a contract to buy or sell an asset of any
kind at a pre-agreed future point in time, that has been standardised for a wide range of uses.
It is traded on a futures exchange. Futures may also differ from forwards in terms of margin
and delivery requirements. (Wikipedia, n. d.)
A forward contract is an agreement between two parties to buy or sell an asset (which can
be of any kind) at a pre-agreed future point in time. Therefore, the trade date and delivery date
are separated. Beside other instruments, such as Options or Futures, it is used to control and
hedge risk, for example currency exposure risk (e.g. forward contracts on USD or EUR) or
commodity prices (e.g. forward contracts on oil). The forward price will usually give a good
market estimation of the price in the future. (Wikipedia, n. d.)
One party agrees to buy, the other to sell, for a forward price agreed in advance. In a
forward transaction, no actual cash changes hands. If the transaction is collaterised, exchange
of margin will take place according to an pre-agreed rule or schedule. Otherwise no asset of
any kind actually changes hands, until the maturity of the contract.
The forward price of such a contract is commonly contrasted with the spot price, which is
the price at which the asset changes hands (on the spot date, usually next business day). The
difference between the spot and the forward price is the forward premium or forward
discount.
10
While futures and forward contracts are both a contract to deliver a commodity on a future
date at a prearranged price, they are different in several respects:
Forwards transact only when purchased and on the settlement date. Futures, on the other
hand, are rebalanced, or "marked to market," every day to the daily spot price of a forward
with the same agreed-upon delivery price and underlying asset.
The fact that forwards are not rebalanced daily means that, due to movements in the price
of the underlying asset, a large differential can build up between the forward's delivery price
and the settlement price.
This means that one party will incur a big loss at the time of delivery (assuming they must
transact at the underlying's spot price to facilitate receipt/delivery).
This in turn creates a credit risk. More generally, the risk of a forward contract is that the
supplier will be unable to deliver the required commodity, or that the buyer will be unable to
pay for it on the delivery day.
The rebalancing of futures eliminates much of this credit risk by forcing the holders to
update daily to the price of an equivalent forward purchased that day. This means that there
will usually be very little additional money due on the final day to settle the futures contract.
In addition, the daily futures-settlement failure risk is borne by an exchange, rather than an
individual party, limiting credit risk in futures.
Futures are always traded on an exchange, whereas forwards always trade over-thecounter, or can simply be a signed contract between two parties.
Futures are highly standardised, whereas some forwards are unique.
In the case of physical delivery, the forward contract specifies to whom to make the
delivery. The counterparty for delivery on a futures contract is chosen by the clearinghouse.
(Wikipedia, n. d.)
11
C ONCLUSION
Derivatives play a very important role in international finance, because they massively
leverage the debt in an economy, they are tool of reducing and transfering of risk but they are
also a subject of criticisms.
They are criticised because the use of derivatives can result in large losses due to the use
of leverage. Derivatives allow investors to earn large returns from small movements in the
underlying asset's price. However, investors could lose large amounts if the price of the
underlying moves against them significantly. There have been several instances of massive
losses in derivative markets, including:

The Nick Leeson affair in 1994.

The bankruptcy of Long-Term Capital Management in 2000.

The loss of $6.4 billion in the failed fund Amaranth Advisors, which
was long natural gas in September 2006 when the price plummeted

The loss of $7.2 Billion by Société Générale in January 2008 through
mis-use of forward contracts.
The bankruptcy of Orange County, CA in 1994, the largest municipal bankruptcy in U.S.
history. On December 6, 1994, Orange County declared Chapter 9 bankruptcy, from which it
emerged in June 1995. The county lost about $1.6 billion through derivatives trading. Orange
County was neither bankrupt nor insolvent at the time; however, because of the strategy the
county employed it was unable to generate the cash flows needed to maintain services.
Orange County is a good example of what happens when derivatives are used incorrectly and
positions liquidated in an unplanned manner, had they not liquidated they would not have lost
any money as their positions rebounded. (Wikipedia,n.d)
12
R ESOURCES
1. Davies, R.: Hedging Risk or Courting Disaster? 2008 [online]. Retrieved at: 2008-02-27
2. Investopedia, a Forbes media company. n.d. [online]. Retrieved at: 2008-02-27 Available
at: <http://www.investopedia.com/university/options/option.asp>
3. Wikipedia,The Free Encyclopedia. n.d. [online]. Retrieved at: 2008-02-27 Available at: <
http://en.wikipedia.org/wiki/Derivative_(finance)>
4. Wikipedia,The Free Encyclopedia. n.d. [online]. Retrieved at: 2008-02-27 Available at: <
http://en.wikipedia.org/wiki/Swap_(finance)>
5. Wikipedia,The Free Encyclopedia. n.d. [online]. Retrieved at: 2008-02-27 Available at: <
http://en.wikipedia.org/wiki/Option_(finance)>
6. Wikipedia,The Free Encyclopedia. n.d. [online]. Retrieved at: 2008-02-27 Available at: <
http://mynoz.spaces.live.com/blog/cns!2AAF032065B8040B!188.entry>
13