DERIVATIVES

What, Why and How…

What is Derivative?

  • A derivative can be define as a financial instrument whose value depends on (or derives from) the values of other, more basic, underlying variables.
  • Very often the variables underlying derivatives are the prices of traded assets. However, derivatives can be dependent on almost any variable.
  • The best-known derivative assets are futures and options contracts.
  • Derivatives are not all the same. Some are inherently speculative, while some are highly conservative.

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.
  • Derivatives may provide financial leverage.
  • 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.

Benefits of Derivative Markets

  • Derivative markets provide risk sharing, liquidity, and information.
  • Derivative instruments are liquid because they are standardized.
  • Anonymous trading reduces information costs.
  • Derivative markets provides signals of market movements

Forward Transactions:

  • Forward contract is relatively a simple derivative. It is an agreement to buy or sell an asset at a certain future time for a certain price.
  • A forward contract is traded in the over-the-counter market—usually between two financial institutions or between a financial institution and one of its clients.
  • One of the parties to a forward contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price.
  • The other party assumes a short position and agrees to sell the asset on the same date for the same price.
  • Forward contracts on foreign exchange are very popular, and can be used to hedge foreign currency risk.

Future Contracts:

  • Futures contracts involve a promise to exchange a product for cash by a set delivery date
  • A futures contract is a promise.
  • A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price.
  • Futures contracts are different from options in that:
    • The buyer of an option can abandon the option if he or she wishes
    • The buyer of a futures contract cannot abandon the contract
  • A futures contract involves a process known as marking to market. Money actually moves between accounts each day as prices move up and down
  • Unlike forward contracts, futures contracts are normally traded on an exchange.

Examples of Futures Markets

– Interest Rates

– (on T-bills, notes, bonds, Munis, Eurodollars)

– Stock Indices, stocks

– Currencies

Why Futures with Options.

Why use Futures?

  • Price Discovery – Due to its highly competitive nature, the futures market has become an important economic tool to determine prices, based on today’s and tomorrow’s estimated amount of supply and demand. Futures market prices depend on a continuous flow of information from around the world and thus require a high amount of transparency
  • Risk Reduction – Futures markets are also a place for people to reduce risk when making purchases. Risks are reduced because the price is pre-set, therefore letting participants know how much they will need to buy or sell

Types of Traders

  • Hedgers – Hedgers use derivatives to reduce the risk that they face from potential future movements in a market variable.
  • Speculators – Speculators use them to bet on the future direction of a market variable.
  • Arbitrageurs – Arbitrageurs take offsetting positions in two or more instruments to lock in a profit.

Other sorts of Derivatives

  • Credit Derivatives
  • A credit derivative is a financial contract that transfers the credit risk of a reference asset, also known as a “name,” from one counterparty to the other in exchange for payment.
  • Example Credit Default Swap
  • I insure my GM bond by buying a CDS agreement with AIG whom I pay a premium to if GM doesn’t pay me, AIG will.

Options

  • An option is the right to either buy or sell something at a set price, within a set period of time
    • The right to buy is a call option
    • The right to sell is a put option
    • You can exercise an option if you wish, but you do not have to do so
    • Strike price: the price at which the asset is bought or sold.
    • Option premium: the fee for option.
    • American options can be exercised at any time up to the expiration date.
    • European options can be exercised only on the expiration date itself.
  • Options are traded both on exchanges and in the over-the-counter market.
  • Most of the options that are traded on exchanges are American.

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