CHAPTER 1:
DERIVATIVES: INTRODUCTION
AND OVERVIEW
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Chapter Objectives
• This Chapter intends to introduce the concept of derivatives
and trading.
• On completion of this chapter you should have an overview
of the evolution of Derivatives and their rationale.
• You should also have knowledge of different categories of
derivative instruments and market players.
• You should have an appreciation of the role of derivatives in
managing different types of risk.
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What are Derivatives
• Derivative instruments are financial instruments that derive
their value from the value of an underlying asset.
• A derivative instrument in itself holds little value, and its
entire value is dependent on the underlying asset.
• Example: Suppose I buy and hold a Crude Palm Oil (CPO) futures contract.
The value of this contract will rise and fall as the value or price of spot CPO
rises or falls. Should the underlying asset, CPO in this case, rise in value, then
the value of the CPO futures contract that I am holding will also increase in
value.
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Controversy on Derivatives
• Derivatives have been blamed for financial disasters
• Sumitomo Corporation’s lost $2.6 billion on Copper derivatives
• Metallgesellchaft AG’s lost DM 1.8 billion on oil futures
• Orange County California’s losses on interest rate derivatives
• US Hedge Fund, Long Term Capital Management, lost $4 Billion in late
1998
• French bank Societe Generale lost €4 billion in futures related transactions
in 2008
• Owing to large scale losses, derivatives are misconstrued
as inherently risky.
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Common Derivative Instruments
• Forward Contract
• It is a contract between two parties agreeing to carry out a transaction at a
future date but at a price determined today.
• Futures Contract
• A futures contract is simply a standardized and exchange traded form of
forward contract.
• Similar to forward contract, futures contract represents an agreement between
two parties to carry out a transaction at a future date but at a price determined
at contract initiation.
• The difference is that futures are standardized and exchange traded.
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Common Derivative Instruments
• Option Contract
• An option contract provides the holder the right but not the obligation to buy or
sell the underlying asset at a predetermined price.
• A call option provides the right to buy, and a put option would provide the
right to sell.
• Swap Contract
• It is a transaction between two parties which simultaneously exchange cash-
flows based on a notional amount of the underlying asset.
• The rate at which the amounts are exchanged is predetermined based on
either a fixed amount or an amount to be based on a reference measure.
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Evolution of Derivatives
• Similar to all other products, derivatives evolved through
innovation in response to growing demands of businesses.
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Evolution of Derivatives
• Chronologically Forward contracts are probably the first
derivative instruments.
• Forward contracts tends to mitigate price risk between two parties.
• Example: A commodity producer is afraid of fall in prices when his commodity is
ready in future, while a consumer is fearful of an increase in prices in future. Both
parties meet, negotiate and agree on a price at which the transaction can be
carried out at the future date, thus a Forward Contract.
• The benefit of this contract is that both parties have eliminated price risk by
locking in their price/cost.
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Evolution of Derivatives
• The forward contract has inherently three limitations
• Multiple Coincidence: Both parties should have opposite needs with respect to
underlying asset, and matching timing and quantity.
• Unfair Pricing: In forward contract, the price is reached through negotiation.
Stronger bargaining position of one party may lead to imposition of the price.
• Counterparty Risk: Though it is a legally binding contract, the recourse is slow
and costly. This increases the default risk in forward contract.
• As these shortcomings of forward contracts became
apparent the Need for Futures Contract developed.
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Evolution of Derivatives
• Futures Contract are essentially a standardized forward
contract traded on an exchange.
• The problems in forwards contracts are addressed via :
• Multiple Coincidence is resolved via exchange trading. Buyers and Sellers
would transact in the futures contract maturity closest to needed maturity and
in as many contracts as needed to fit the underlying asset size.
• Unfair pricing is resolved since each party is a price taker on the exchange with
the futures price being that which prevails in the market at the time of contract
initiation.
•
• Counterparty risk is overcome via the exchange acting as the intermediary
guarantees each trade by being the buyer to each seller and seller to each
buyer
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Evolution of Derivatives
• Futures while overcoming flaws of forwards were inadequate
for later day business needs.
• Futures enabled hedging against unfavourable price movement, BUT being
locked-in also meant that one could not benefit from subsequent favorable
price movements.
• This precise inadequacy is addressed by Option Contracts. It
has three marked benefits over its predecessors:
• Options provide cover against both upward and downward movement of asset
prices.
• They are extremely flexible and can be combined to achieve different
objectives/cash flows.
• Complicated business situations cannot be handled by futures and forwards,
but by Options only.
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Evolution of Derivatives
• Advent of Swaps
• Swaps are one of the fastest growing category of derivatives.
• They are customized bilateral transaction where both parties agree to
exchange cash flows at periodic intervals.
• Being customized in nature, Swap contracts are over the counter instruments.
• Kinds of Swaps
• Currency Swaps – Parties exchange once currency for another
• Commodity Swaps – Both parties exchange cash flows based on an underlying
commodity index or total return of a commodity in exchange for a return based on a
market yield.
• Equity Swaps – It constitute an exchange of cash flows based on different equity
indices.
• Interest Rate Swaps – It involves exchange of cash flows based on two different
interest rates. It is one of the most popular instrument since its inception in 1981.
Transaction Volume crossed $50 trillion according to ISDA.
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Exchange Traded Derivatives
• Exchange Traded Derivatives
• It is one that is listed and traded on an official exchange.
• They are of standard contract size, maturity, delivery process and in the case
of commodity derivatives also of standard quality.
• In exchange traded derivatives, the exchange becomes the intermediary
between buyers and sellers and guarantees the contract.
• Exchange trading shifts the counterparty risk to the exchange.
• Benefits include enhanced liquidity via increased trading volumes reducing
transaction costs and price discovery.
• Examples: Futures and Option Contracts
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Over the Counter Derivatives
• Over the Counter (OTC) Derivatives
• It is a customized transactions between parties in a bilateral arrangement.
• All elements of the transaction are negotiable, including pricing.
• Usually between corporate clients and financial institutions.
• Example – An exporter expects to receive foreign currency payment. Fearing a
potential depreciation of the currency, the exporter would want to hedge its position by
using currency derivatives like forwards or swaps or in some cases. The counterparty
for this hedging may be a financial institution.
• Being customized and bilateral transaction, counterparty or default risk by
either party is possible in OTC.
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Exchange Traded v/s Over the Counter
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Main Players in Derivative Market
• Hedgers
• Hedgers are players whose objective is risk reduction.
• Hedgers use derivative markets to manage or reduce risks.
• They are usually businesses who want to offset exposures resulting from their
business activities.
• Speculators
• They are players who establish positions based on their expectations of future
price movements.
• They take positions in assets or markets without taking offsetting positions,
expecting market to perform according to their expectation.
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Main Players in Derivative Market
• Arbitrageurs
• Arbitrageurs are players whose objective is to profit from pricing differentials
mispricing.
• Arbitrageurs closely follow quoted prices of the same asset/instruments in
different markets looking for price divergences. Should the divergence in prices
be enough to make profits, they would buy in the market with the lower price
and sell in the market where the quoted price is higher.
• Arbitrageurs also arbitrage between different product markets. For example,
between the spot and futures markets or between futures and option markets
or even between all three markets.
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Main Players in Derivative Market
• Societal impact of different categories of market players.
• Hedging enables businesses to plan better, and reduction in fluctuation of their
product prices can help reduce costs. This reduction in costs is passed on to
consumers in the form of lower prices.
• Arbitrageurs, by means of their activities, ensure no divergence exists between
different markets (spot, futures, options) for same asset class.
• Arbitrage activity enhances the price discovery process.
• Example: arbitrage between markets in different countries ‘internationalizes’ product
prices. This forces less efficient producers to enhance productivity in order to remain
competitive in business.
• Speculative activities is considered disruptive and creating inefficiencies in the
market. But the enhanced volume due to speculators reduces transaction costs
and increases liquidity.
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Commodity v/s Financial Derivatives
• Commodity Derivatives
• Commodity derivatives have tangible underlying assets like agricultural
produce and metals.
• All commodity derivatives have actual and physical settlement of underlying
commodity at maturity.
• Financial Derivatives
• Financial derivatives have financial instruments as underlying assets.
• Unlike commodity derivatives, financial derivatives are cash-settled at maturity.
• Cash settlement involves not the exchange of actual underlying asset but the
monetary equivalent of the asset.
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Commodity v/s Financial Derivatives
• Examples of Commodity (Physical) and Financial
Derivatives.
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Types of Risks
• Key Function of Derivatives is risk management.
• Risk in finance refers to the uncertainties associated with
returns from an investment.
• Market Risk: It is changes in an asset’s price due to changes in market
conditions; either demand/supply conditions and/or sentiments.
• Inflation risk: It refers to the loss of purchasing power resulting from inflationary
conditions. In high inflationary environment, future investment returns would be
worth much less, given the loss in purchasing power.
• Interest rate risk: It refers to the changes in asset values due to changes in
nominal interest rates. It is particularly important for fixed income securities due
to discounting to find prices.
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Types of Risks
• Default/Credit Risk: It refers to the changes in financial integrity of the
counterparty or the issuer of the asset and its ability to deliver on its
commitment.
• Liquidity risk: It is the risk arising from thin or illiquid trading. Thinly traded
instruments have higher price volatility, and are difficult to dispose off quickly.
• Exchange rate risk: It refers to changes in investment income due to exchange
rate fluctuation. It is of utmost importance in cross border transactions.
• Political Risk: It refers to risks faced by international investors. It mostly arises
due to regulatory aspects, and refers to risks such as expropriation/
nationalization, imposition of exchange controls
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Derivatives in Emerging Markets
• Emerging Market Economies (EME) derivatives markets are
relatively small relative to developed countries.
• According to Bank of International Settlements (BIS):
• Between 2001 and April 2010 average daily turnover in EME’s grew by 300%
to value of $1.2 trillion in April 2010.
• For developed markets the average daily turnover in April 2010 was $13.8
trillion.
• Brazil and Korea accounted for almost 90% of all trading in EMEs.
• Interest Rate derivatives accounted for 20% of total turnover in EMEs as
compared to 77% in developed economies.
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Global Derivatives Trading
• Trading originated in Chicago, United States.
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Global Derivatives Trading
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Global Derivatives Trading
THANK YOU
