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Introduction

Existence of Derivatives

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A. Introduction

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1. Derivative instruments are relatively newinstruments.

2. Interest rate futures, is hardly 30 years old.

3. But derivatives turned out to be very popular.4. The volume of trading in several derivative

contracts outpaced the trading volume of theunderlying assets.

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5. Derivative instruments have been blamedfor having precipitated several financialscandals as resulting in spectacular losses.

6. Derivatives reducing risks and flexible but

improperly used will cause seriousproblems.

7. Some take huge speculative positions,almost all of which were irrational.

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B. What are Derivative Instruments?

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1. A derivative instrument has little value in andof itself. Its value is entirely dependent on thevalue of its underlying asset.

2. Derivative market transactions allow for futuretransactions at prices determined today.

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3. The analysis and pricing of derivativeinstruments can be complicated and highlyquantitative.

4. There is a broad spectrum of derivativeinstruments, many names and highlyspecialized purposed.

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C. Common Derivative Instruments

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1. Forwards, Futures, Options and Swaps areprobably derivative instruments.

2. Forward Contract:

A contract between two parties agreeing tocarrying out a transaction at a future date butat a price determined today.

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3. Futures Contract:

a. A futures contract can be simply defined as astandardized and exchange traded form offorward contract.

b. A futures contract represents a formalagreement between two parties.

c. The futures are standardized and exchange

traded.

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4. Option Contract:

a. A option contract provides the holder, theright but not the obligation to buy or sell theunderlying asset at a predetermined price.

b. While a Call option provides the right to buy, aPut oprion would provide the right to sell.

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5. Swap Contract:

a. A swap can be defined as a transaction inwhich two parties simultaneously exchangecash-flows based on a notional amount of the

underlying asset.b. The rate at which the amount or an amounts

are exchanged is predetermined based oneither a fixed amount or an amount to be

based on a reference measure.

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D. Evoluation of Derivative Instruments

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1. Derivative instruments evolved as a result ofproduct innovation. Innovation which was inresponse to increase complex needs.

2. New and better financial products were neededto manage changed needs.

3. The requirement that every newly evolvedproduct must provide increased benefits over

existing products.

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4. Forward Contracts:a. Forwards were the simplest and traditional

derivatives.

b. Two parties undertake to complete a transaction

at a future date but a price determined today.

c. The two parties could be a producer who promiseto supply and a consumer who needs the product

at a future date.

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d. Both parties here are faced with risk,essentially price risk.

e. The parties have eliminated price risk bylocking their price or cost.

f. Problems of Forward contract:

i. Multiple Coincidence

ii. Price Setting

iii. Counterparty Risk

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5. Needs of Futures Contracts

a. A futures contract is standardized forwardcontract standardized in contract size, maturity,product quality, place of delivery.

b. With standardization, it was possible to tradethem on an exchange to increases liquidity andreduces transaction costs.

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c. The problem of multiple coincidence of

wants is overcome.

d. Unfair price may exist in Forward contractbut not exist in Futures.

e. The exchange mininizes the potentialdefault risk by means of the marginingprocess and by daily marking to market.

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3. Needs of Options

a. Inadequacies that stimulated searching forfurther product innovation:

i. Being locked-in means that one could not

benefit from subsequent favourable pricemovements.

ii. Option protests you from unfavourable pricemovements while take advantage of favourable

price movements.

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b. Options advantages:

i. provide the best of both worlds: downwardprotection and upside protection.

ii. Options are extremely flexible and cancombined in various ways to achieve different

objectives or cash flows.iii. complicated business risk situations that cannot

be handled with forwards or futures but easilyhandled with options.

c. Following the adventure of options, FinancialEngineering revolves around thee designing ofrisk management solutions to complex risks.

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E. Main Players in Derivative Markets

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1. Hedgers

a. Hedgers would obviously be major players.

b. Hedgers use derivative markets to manage or

reduce risk.c. They are typically businesses that use

derivatives to offset exposures resulting fromtheir business activities.

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2. Arbitrageurs

a. Arbitrage is the process of trying to takeadvantage of price differentials betweenmarkets.

b. Arbitrageurs closely follow quoted prices of thesame asset or instruments in different marketslooking for pricing divergences.

c. Should the divergence in prices be enough to

make profits, they would buy in the market withthe lower price and sell in the market where thequoted price is higher.

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3. Speculators

a. They take positions in assets or market withouttaking offsetting positions. If they expect acertain asset to fall in value, they would short

(sell) the asset.b. Should the price increase instead, they would

make losses on their short position.Speculators therefore expose themselves to

risk and hope to profit from taking on risk.

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F. Commodity vs. Financial Derivatives

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G. Types of Risks

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1. Market & Price Risk

2. Inflation Risk

3. Interest Rate Risk

4. Default & Credit Risk

5. Liquidity Risk

6. Currency & Exchange Rate Risk

7. Political Risk