Tutorial 1: Introduction and Overview of Derivatives
Question 1
Briefly explain the derivative instrument, and how is it different from stocks and bonds.
A derivative is a financial instrument whose value is derived from the value of an underlying asset,
index, or rate. Unlike stocks and bonds, which are direct investments in a company or a debt
instrument, derivatives are contracts that derive their value from the performance of underlying
entities such as assets, interest rates, or indices. Examples of derivatives include options, futures,
forwards, and swaps.
Question 2
Discuss the key categories of players in derivatives markets, and briefly describe the objective of
each category of players.
Hedgers (risk reduction): These are individuals or firms that use derivatives to protect themselves
from adverse price movements in the underlying asset. Their objective is to reduce risk.
Speculators (expectation): They aim to profit from price movements in the underlying asset by taking
on risk. They have no interest in the underlying asset itself but are betting on its future price
movements.
Arbitrageurs (: These players look for price discrepancies between different markets or derivatives
and aim to profit from the price differences without taking on much risk.
Question 3
Explain how might the absence of speculators/speculation hurt hedgers.
Speculators provide liquidity and depth to the market, which is crucial for hedgers. Without
speculators, hedgers might find it difficult to find counterparties(transfer risk) for their transactions,
leading to less liquid markets and wider bid-ask spreads. This could increase the cost of hedging and
make it less effective.
Question 4
Using appropriate example, differentiate between commodity and financial derivatives.
Commodity Derivatives: These are derivatives whose underlying asset is a physical commodity like
oil, gold, or agricultural products. For example, a farmer might use a futures contract to lock in a
price for their crop, protecting against price fluctuations.
Financial Derivatives: These are derivatives whose underlying asset is a financial instrument like
stocks, bonds, or interest rates. For example, an investor might use a stock option to hedge against
potential losses in their stock portfolio.
Question 5
Explain the benefit(s) do arbitrageurs and speculators bring to derivatives markets.
Arbitrageurs help ensure that prices across different markets are consistent, which contributes to
market efficiency. They take advantage of price discrepancies without taking on much risk, which
can help correct market inefficiencies.
Speculators provide liquidity and depth to the market, making it easier for other participants to
enter and exit positions. Their willingness to take on risk can help stabilize prices and reduce
volatility.
Question 6
Explain the types of risk associated with derivatives.
Market Risk: The risk of losses due to unfavorable movements in the underlying asset's price.
Credit Risk: The risk that the counterparty to the derivative contract will default on its obligations.
Liquidity Risk: The risk that a position cannot be easily closed or unwound without significantly
affecting the market price.
Operational Risk: The risk of losses due to failures in systems, processes, or controls.
Legal Risk: The risk of losses due to legal uncertainties or contract enforceability issues.
Basis Risk: The risk that the derivative and the underlying asset do not move in perfect correlation,
leading to imperfect hedging.
