DERIVATIVES: INTRODUCTION AND

OVERVIEW

CHAPTER 1
 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.

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.

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 Controversy on Derivatives
Derivatives have been blamed for financial disasters
o Sumitomo Corporations lost $2.6 billion on Copper derivatives
o Metallgesellchaft AGs lost DM 1.8 billion on oil futures
o Orange County Californias losses on interest rate derivatives
o US Hedge Fund, Long Term Capital Management, lost $4 Billion in late 1998
o 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
o 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
o A futures contract is simply a standardized and exchange traded form of
forward contract.

o 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.

o The difference is that futures are standardized and exchange traded.

DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright 2017 by McGraw-Hill Education

 Common Derivative Instruments
Option Contract
o An option contract provides the holder the right but not the obligation to
buy or sell the underlying asset at a predetermined price.

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 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.

DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright 2017 by McGraw-Hill Education

 Evolution of Derivatives
Chronologically Forward contracts are probably the first derivative
instruments.
o 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.

o 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
o Multiple Coincidence: Both parties should have opposite needs with respect
to underlying asset, and matching timing and quantity.

o Unfair Pricing: In forward contract, the price is reached through negotiation.

Stronger bargaining position of one party may lead to imposition of the
price.

o 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.

DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright 2017 by McGraw-Hill Education

 Evolution of Derivatives
Futures Contract are essentially a standardized forward contract traded
on an exchange.

The problems in forwards contracts are addressed via :

o 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.

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 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

DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright 2017 by McGraw-Hill Education

 Evolution of Derivatives
Futures while overcoming flaws of forwards were inadequate for later day
business needs.
o 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:
o Options provide cover against both upward and downward movement of asset prices.

o They are extremely flexible and can be combined to achieve different objectives/cash
flows.

o Complicated business situations cannot be handled by futures and forwards, but by

Options only.

DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright 2017 by McGraw-Hill Education

 Evolution of Derivatives
Advent of Swaps
o Swaps are one of the fastest growing category of derivatives.

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.

DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright 2017 by McGraw-Hill Education

 Exchange Traded Derivatives
Exchange Traded Derivatives
o It is one that is listed and traded on an official exchange.

o They are of standard contract size, maturity, delivery process and in the
case of commodity derivatives also of standard quality.

o In exchange traded derivatives, the exchange becomes the intermediary

between buyers and sellers and guarantees the contract.

o Exchange trading shifts the counterparty risk to the exchange.

o Benefits include enhanced liquidity via increased trading volumes reducing

transaction costs and price discovery.

o Examples: Futures and Option Contracts

DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright 2017 by McGraw-Hill Education

 Over the Counter Derivatives
Over the Counter (OTC) Derivatives
o It is a customized transactions between parties in a bilateral arrangement.

o All elements of the transaction are negotiable, including pricing.

o 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.

o 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

DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright 2017 by McGraw-Hill Education

 Main Players in Derivative Market
Hedgers
o Hedgers are players whose objective is risk reduction.

o Hedgers use derivative markets to manage or reduce risks.

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.

o They take positions in assets or markets without taking offsetting positions,

expecting market to perform according to their expectation.

DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright 2017 by McGraw-Hill Education

 Main Players in Derivative Market

Arbitrageurs
o Arbitrageurs are players whose objective is to profit from pricing
differentials mispricing.

o 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.

o 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.

DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright 2017 by McGraw-Hill Education

 Main Players in Derivative Market
Societal impact of different categories of market players.
o 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.

o Arbitrageurs, by means of their activities, ensure no divergence exists between

different markets (spot, futures, options) for same asset class.

o 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.

o Speculative activities is considered disruptive and creating inefficiencies in the

market. But the enhanced volume due to speculators reduces transaction costs
and increases liquidity.

DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright 2017 by McGraw-Hill Education

 Commodity v/s Financial Derivatives
Commodity Derivatives
o Commodity derivatives have tangible underlying assets like agricultural
produce and metals.

o All commodity derivatives have actual and physical settlement of underlying

commodity at maturity.

Financial Derivatives
o Financial derivatives have financial instruments as underlying assets.

o Unlike commodity derivatives, financial derivatives are cash-settled at maturity.

o Cash settlement involves not the exchange of actual underlying asset but the
monetary equivalent of the asset.

DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright 2017 by McGraw-Hill Education

 Commodity v/s Financial Derivatives
Examples of Commodity (Physical) and Financial Derivatives.

DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright 2017 by McGraw-Hill Education

 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 assets 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.

DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright 2017 by McGraw-Hill Education

 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

DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright 2017 by McGraw-Hill Education

 The state of global derivative
markets
Over the period 2004-2014, equity derivatives appear to be the most
dominant, accounting for 54% of total traded derivative contracts.
o Equity futures and options, both single stock and stock index, have had impressive
growth.
o The biggest star has been ETF options

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

Commodity derivatives account for about 20% of total exchange traded

derivatives in 2014, up from about 7% in 2004

Currency derivatives account for about 10%, falling since 2011.

DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright 2017 by McGraw-Hill Education

 The state of global derivative
markets
The composition of futures and options of all categories have
changed:

o Futures 38% vs options 62% in 2004

o Futures 55% vs options 45% in 2014

DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright 2017 by McGraw-Hill Education

 Global Derivatives Trading
Trading originated in Chicago, United States.
Global Traded Volume of Futures and Options

DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright 2017 by McGraw-Hill Education

 Global Derivatives Trading
Total Traded Volume of Financial vs Non Financials

DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright 2017 by McGraw-Hill Education

 Global Derivatives Trading
Traded Volume by Financial Derivative Category

DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright 2017 by McGraw-Hill Education

 Global Derivatives Trading
Traded Volume of Exchange Traded Derivative Contracts

DERIVATIVES: INTRODUCTION AND OVERVIEW Copyright 2017 by McGraw-Hill Education