FINANCIAL

DERIVATIVES
DR. ABDALLA USSI HAMAD

Senior Lecturer, Zanzibar University

 Meaning of derivative
• A derivative is anything that is valued based upon some other asset. In other
words, it derives its value from something else. OR

• A derivative is a contract between two or more parties whose value is based on

an agreed-upon underlying financial asset (like a security) or set of assets (like
an index).

• Common underlying instruments include bonds, commodities, currencies,

interest rates, market indexes and stocks.

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 Meaning of Financial Derivatives
•Financial derivatives are financial instruments whose value is
derived from an underlying asset, index, or reference rate.
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•These instruments are used by individuals and institutions for
various purposes, including hedging against risks, speculating on
price movements, and managing investment portfolios
 What is Derivatives market
• Derivative markets are investment markets that are geared toward the buying
and selling of derivatives.
• The market can be divided into two, that for exchange-traded derivatives and
that for over-the-counter derivatives.
• The legal nature of these products is very different as well as the way they are
traded, though many market participants are active in both.

Derivative markets

Exchange traded derivatives Over- the- counter derivatives

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 Derivatives and Commodity Markets
A derivative is a financial instrument whose price is derived from that of another asset, and the other asset is
generally referred to as the ‘underlying asset’, or sometimes just ‘the underlying’.

Physical Markets Derivatives Markets

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Simply the buying, selling and subsequent
delivery of commodities like oil, wheat,
Exists in parallel and enables the participants
in the physical markets to hedge the risk of
barley and aluminium. adverse price movements.

Dominated by major international trading

houses, governments, and the major
producers and consumers.
Derivative Markets
There are two distinct groups of derivatives, which are differentiated by how they are traded.
These are OTC derivatives and Exchange-Traded Derivatives (ETD).

Over the Counter Derivatives

Exchange Traded Derivatives (ETD)
(OTC)
Negotiated and traded privately between
Trades derivatives that have standardised
parties without the use of an exchange. Main
features. Main types traded are:
types traded are:
● Futures
● Interest rate swaps
● Options
● Foreign exchange forwards
Functions of the exchange:
The OTC market is the larger of the two in terms
of value of contracts traded daily.
● Provides a marketplace for trading to take
place
Trading takes place predominantly in Europe
and the UK
● Provides some sort of guarantee that the trade
will eventually be settled by using an
A large support for moving OTC trading on-
intermediary (known as the ‘central
exchange due to regulatory concerns
counterparty’) for their trades.
ETD vs. OTCD
 Need for Derivatives
➢ Transferring risks.
➢ Discovery of future as well as current prices.
➢ Increase saving and investments in long run.
 Primary Usage of Derivative Instruments

An instrument to hedge risk Speculative Arbitrage

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 Traders in Derivatives Market
HEDGER
• A hedger is someone who faces risk associated with price movement of an asset
and who uses derivatives as a means of reducing risk

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• They provide economic balance to the market
SPECULATOR
• A trader who enters the futures market for pursuits of profit, accepting risk in
the endeavour
• They provide liquidity and depth to the market
ARBITRAGEUR
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 Function of derivatives
Price
discovery

Hedging Transfer
risk of risk

Provide Lower
access transaction
market cost

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 Risks of the derivatives market
The derivatives market is also associated with a number of risks, including:
➢ Leverage: Derivatives contracts are often leveraged, which means that
they can amplify both gains and losses.
➢ Complexity: Derivatives contracts can be complex and difficult to
understand, which can make them risky for unsophisticated investors.
➢ Volatility: The derivatives market can be volatile, which means that prices
can fluctuate wildly
➢ Counterparty Risk: Derivative contracts involve two parties, and there is
always a risk that one party may default on their obligations
➢ Credit Risk: In OTC derivatives, credit risk arises when one party
defaults on its obligations, resulting in potential financial losses for the
other party
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Cont.
• Regulatory Risk: The derivatives market is subject to various regulations
designed to promote transparency and stability. Changes in regulations can
affect trading strategies and market dynamic
• Market Risk: Market risk, also known as price risk, is inherent in
derivatives trading. Prices of underlying assets can be highly volatile, and
derivative contracts are directly affected by these price movements
• Liquidity Risk: Some derivatives can be illiquid, meaning there may not
be a ready market for them.
• Credit Risk: In OTC derivatives, credit risk arises when one party defaults
on its obligations, resulting in potential financial losses for the other party.
• Interest Rate Risk: Derivative contracts such as interest rate swaps are
sensitive to changes in interest rates.
• Model Risk: Derivatives often rely on complex mathematical models to
 Current situation of derivative markets
• The derivatives market is the largest financial market in the world, with a
notional value of over $1 quadrillion. It is a complex and ever-evolving
market, and its current situation is shaped by a variety of factors, including:
➢ Global economic uncertainty: The global economy is currently facing a
number of challenges, including
➢ The ongoing war in Ukraine, high inflation, and rising interest rates.
➢ Increased regulation: Derivatives markets have become increasingly regulated in
recent years, in an effort to reduce risk and improve transparency. This regulation has
made it more costly and complex to trade derivatives, which has dampened activity in
some areas of the market.

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➢ Despite these challenges, the derivatives market is expected to continue to
grow in the coming years. This is due to a number of factors, including:
• Growing demand for risk management: As the global economy becomes
more complex and interconnected, there is a growing demand for risk
management tools. Derivatives can be used by businesses and individuals to
hedge against a variety of risks, including currency risk, interest rate risk,
and commodity price risk.
• Increased participation from retail investors: Retail investors are
increasingly participating in the derivatives market. This is due to the
availability of online trading platforms and the increasing popularity of
products such as cryptocurrency derivatives.
• Innovation: The derivatives market is constantly evolving, with new
products and services being developed all the time. This innovation is
helping
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participants.

Dark side of Derivatives

➢ A hedged position can become unhedged at the worst

times.

➢ Inflicting substantial losses on those who mistakenly

believe they are protected.

➢ The use of derivatives can result in large losses because

of the use of leverage, or borrowing.
 Big Loss in Derivatives Market
➢ American International Group (AIG) lost more than
US$18 billion through a subsidiary over the preceding
three quarters on credit default swaps.

➢ The loss of US$7.2 Billion by Societe General in

January 2008 through mis-use of futures contracts.

➢ The loss of US$1.2 billion equivalent in equity

derivatives in 1995 by Barings Bank.
 Types of Derivatives
Defined as a
An option contract provides
standardized and the holder the right but not
exchange-traded form the obligation to buy or sell
of forward contract the underlying asset at a
predetermined price

A swap can be defined as a

A contract between two transaction in which two parties
parties agreeing to carry out simultaneously exchange cash
a transaction at a future date flows based on a notional amount
but at a price determined of the underlying asset
today
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