Introduction to Derivatives and Financial Risk Management

Chapter 1 An Introduction to Derivatives 1

Financial risk results from uncertainty in interest rates, exchange rates, stock price and commodity. The chapter then introduced derivatives as a means of managing financial risk. 2

In the course of running a business, decisions are made in the presence of risk. A decision maker can confront one of two types of risk. Some risks are related to the underlying nature of the business and deal with such matters as the uncertainty of future sales or the cost of inputs. These risks are called business risks. Most business are accustomed to accepting business risks. 3

Indeed, the acceptance of business risks and its potential rewards are the foundations of capitalism. Another class of risks deals with uncertainties such as interest rates, exchange rates, stock price, and commodity price. Theses are called financial risks. 4

Financial risk management can be conducted in two rather distinct ways. The first approach is to employ a diversification strategy in the portfolio of businesses operated by the firm, while the second strategy is the firm s engagement in financial transactions. In the case of diversification, which was once a popular risk management strategy, firms that are concerned about the volatility of their earnings have turned to the financial markets. 5

This is because the financial markets have developed more direct approaches to risk management that transcend the need to directly invest in activities that reduce volatility. The task of financial risk management has been facilitated by the increasing availability of a variety of derivative instruments to transfer financial price risks to other parties. 6

Definition of Derivative A security whose price is derived from performance of something else , that is often referred to as the underlying assets. The derivative itself is merely a contract between two or more parties. 7

Derivative value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Derivatives are one of the three main categories of financial instruments, the other two being equities (i.e. stocks) and debt (i.e. bonds and mortgages). 8

DERIVATIVE MARKETS AND INSTRUMENTS An asset is an item of ownership having positive monetary value. A liability is an item of ownership having negative monetary value. The term instrument is the more general term encompass the underlying assets or liability of derivative contract. A contract is an enforceable legal agreement. A security is a tradable instrument representing a claim on a group of assets. 9

CONT In the markets for assets: purchases and sales require that the underlying asset be delivered either immediately or shortly thereafter. Payment usually is made immediately, although credit arrangements are sometimes used. Because of these characteristics, we refer to these markets as cash markets or spot markets. 10

In other situations, the good or security is to be delivered at a later date. Still other types of arrangements allow the buyer or seller to choose whether or not to go through with the sale. These types of arrangements are conducted in derivative markets. Derivative markets are markets for contractual instruments whose performance is determined by the way in which another instrument or asset performs. 11

The Most Common Types of Derivatives 1- Options: An option is a contract between two parties-a buyer and a seller-that gives the buyer the right, but not the obligation, to purchase or sell something at a later date at a price agreed upon today. 12

The option buyer pays the seller a sum of money called the price or premium. The option seller stands ready to sell or buy according to the contract terms if and when the buyer so desires. An option to buy something is referred to as a call, an option to sell something is called a put. 13

Although options trade in organized markets, a large amount of option trading is conducted privately between two parties who find that contracting with each other may be preferable to a public transaction on the exchange. This type of market, called an over- the-counter market, was actually the first type of options market. 14

The Most Common Types of Derivatives 2 - Forward contracts Is a contract between two parties -a buyer and a seller-to purchase or sell something at a later date at a price agreed upon today. A forward contract sounds a lot like an option but an option carries the right, not the obligation, to go through with the transaction. 15

If the price of the underlying good changes, the option holder may decide to forgo buying or selling at the fixed price. On the other hand, the two parties in a forward contract incur the obligation to ultimately buy and sell the good. 16

Although forward markets have existed for along time, they are somewhat less familiar. Unlike options markets, they have no physical facilities for trading. They trade strictly in an over- the-counter market. 17

The Most Common Types of Derivatives 3 Future contract: Is also a contract between two parties -a buyer and a seller-to purchase or sell something at a later date at a price agreed upon today. A futures contract differs from a forward contract in that the futures contracts trade on organized exchanges, called futures markets. 18

Unlike forward contracts, futures contracts are subject to a daily settlement procedure. In the daily settlement, investors who incur losses pay the losses every day to investors who make profits. Futures prices fluctuate from day to day, and contract buyers and sellers attempt both to profit from these price changes and to lower the risk of transacting in the underlying goods. 19

The Most Common Types of Derivatives 4 - Swaps Although options, forwards, and futures compose the set of basic instruments in derivative markets, there are many more combinations and variations. one of the most popular is called a swap. A swap is a contract in which two parties agree to exchange cash flows. 20

Some of these types of contracts are referred to as hybrids because they combine the elements of several other types of contracts. Swaption, commodity swap and interest rate swaps. 21

Types of Traders in the Derivatives Market 1. Hedger 2. Speculator 3. Arbitrageur 22

Types of Traders in a Derivatives Market 1 - Hedgers : Hedgers are those who protect themselves from the risk associated with the price of an asset by using derivatives. A person keeps a close watch upon the prices discovered in trading and when the comfortable price is reflected according to his wants, he sells futures contracts. In this way he gets an assured fixed price of his produce. 23

Hedgers are often businesses, or individuals, who at one point or another deal in the underlying cash commodity. Take an example: A Hedger pay more to the farmer or dealer of a produce if its prices go up. For protection against higher prices of the produce, he hedge the risk exposure by buying enough future contracts of the produce to cover the amount of produce he expects to buy. 24

Types of Traders in a Derivatives Market 2 - Speculators : Investors have different risk preferences. Some are more tolerant of risk than other. All investors want to keep their investments at an acceptable risk level. Derivative markets enable those who wish to reduce their risk to transfer it to those wishing to increase it. We call these latter investors speculators. 25

These investors are willing to supply more funds to the financial markets. This benefits the economy, because it enable more firms to raise capital and keeps the cost of the capital as low as possible. Derivative market participants seeking to increase their risk are called speculators. 26

Types of Traders in a Derivatives Market 3 - Arbitrators : arbitrage is a type of transaction in which an investor seeks to profit when the same good sells for two different price. The individual engaging in the arbitrage, called the arbitrageur, buys the good at the lower price and immediately sells it at the higher price. The low price will be driven up and the high price driven down until the two prices are equal. 27

Operational Advantages Derivative markets offer several operational advantages: 1 Entail lower transaction costs. This means that commissions and other trading costs are lower for traders in these markets. This markets it easy and attractive to use these markets either in lieu of spot market transactions or as a complement to spot positions. 28

2 - Derivative markets often have greater liquidity than the spot markets. 3 - Derivative markets allow investors to sell short in an easier manner. 29

Derivatives are used for the following: Hedge or mitigate risk, allow risk related to the price of the underlying asset to be transferred from one party to another. Create option ability where the value of the derivative is linked to a specific condition or event (e.g. the underlying reaching a specific price level). 30

Derivatives are used for the following: Speculate and make a profit if the value of the underlying asset moves the way they expect (e.g. moves in a given direction, stays in or out of a specified range, reaches a certain level) 31