OVERVIEW
CHAPTER 1
What are Derivatives
Derivative instruments are financial instruments that derive their
value from the value of an underlying asset.
o 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.
Futures Contract
o A futures contract is simply a standardized and exchange traded form of
forward contract.
o A call option provides the right to buy, and a put option would provide
the right to sell.
Swap Contract
o It is a transaction between two parties which simultaneously exchange
cash-flows based on a notional amount of the underlying asset.
o The benefit of this contract is that both parties have eliminated price risk
by locking in their price/cost.
o 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.
o They are extremely flexible and can be combined to achieve different objectives/cash
flows.
o They are customized bilateral transaction where both parties agree to exchange
cash flows at periodic intervals.
o Being customized in nature, Swap contracts are over the counter instruments.
o 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.
o They are of standard contract size, maturity, delivery process and in the
case of commodity derivatives also of standard quality.
o They are usually businesses who want to offset exposures resulting from
their business activities.
Speculators
o They are players who establish positions based on their expectations of
future price movements.
Arbitrageurs
o Arbitrageurs are players whose objective is to profit from pricing
differentials mispricing.
Financial Derivatives
o Financial derivatives have financial instruments as underlying assets.
o Cash settlement involves not the exchange of actual underlying asset but the
monetary equivalent of the asset.
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.
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.
Interest rate derivatives appeared to have lost ground, declining from 25%
of all exchange traded derivatives in 2004 to 15% in 2014.
o Zero or negative interest rates in several developed countries are the cause