Derivatives

Definition

 A Derivative is a financial instrument whose value is derived from the value of an

underlying asset, index, or rate. The underlying asset can be anything from stocks, bonds,
commodities, currencies, interest rates, or market indices.
 Derivatives are typically used for hedging risk, speculation, or gaining access to
additional assets or markets.

Types of Derivatives

1. Futures Contracts:
o A futures contract is an agreement to buy or sell an asset at a predetermined price
at a specified time in the future.
o Futures are standardized contracts traded on exchanges, with the underlying asset
typically being commodities, currencies, or financial instruments.
o Example: A farmer enters into a futures contract to sell 1,000 bushels of wheat at
$5 per bushel in three months to hedge against price fluctuations.
2. Options Contracts:
o An option gives the holder the right, but not the obligation, to buy (call option) or
sell (put option) an underlying asset at a specified price (strike price) before or on
a specified date (expiration date).
o Options can be used to hedge risks, generate income, or speculate on market
movements.
o Example: An investor buys a call option on a stock with a strike price of $50,
expiring in one month. If the stock price rises above $50, the investor can exercise
the option to buy the stock at the lower price.
3. Swaps:
o A swap is a derivative in which two parties agree to exchange cash flows or other
financial instruments over a specified period.
o Common types of swaps include interest rate swaps, currency swaps, and
commodity swaps.
o Example: In an interest rate swap, one party might agree to pay a fixed interest
rate while receiving a floating rate based on a benchmark like LIBOR.
4. Forward Contracts:
o A forward contract is similar to a futures contract but is traded over-the-counter
(OTC) and is customized between the two parties involved.
o Unlike futures, forward contracts are not standardized and are typically settled at
maturity.
o Example: A company enters into a forward contract to buy 10,000 euros at a
specific exchange rate in six months to lock in the price and hedge against
currency risk.
5. Credit Derivatives:
 o Credit derivatives are financial instruments used to manage credit risk. The most
common type is a credit default swap (CDS), which acts as insurance against the
default of a borrower.
o Example: A bank buys a CDS on a corporate bond, paying periodic premiums to
the seller of the CDS. If the bond issuer defaults, the bank receives a payout from
the seller.
6. Exchange-Traded Funds (ETFs) and Contracts for Difference (CFDs):
o ETFs are investment funds that are traded on stock exchanges, similar to stocks,
and often include derivatives to track specific indices or sectors.
o CFDs are agreements to exchange the difference in the value of an asset from the
time the contract is opened to the time it is closed. They allow investors to
speculate on price movements without owning the underlying asset.

Key Characteristics

1. Leverage:
o Derivatives often involve leverage, meaning a small initial investment (margin)
can control a large position. This magnifies both potential gains and losses.
2. Market Risk:
o The value of derivatives is directly tied to the value of the underlying asset,
making them sensitive to market fluctuations.
3. Counterparty Risk:
o In OTC derivatives, there is a risk that one party may default on its obligations,
known as counterparty risk.
4. Hedging and Speculation:
o Derivatives are widely used for hedging, which involves taking a position in a
derivative to offset potential losses in another investment.
o Speculators use derivatives to profit from market movements, often without
owning the underlying asset.
5. Maturity and Expiration:
o Derivatives have specific maturity dates or expiration dates, at which point the
contract must be settled, either through physical delivery of the underlying asset
or cash settlement.

Accounting for Derivatives

1. Initial Recognition:
o Derivatives are initially recognized at fair value on the balance sheet, with any
directly attributable transaction costs expensed as incurred.
2. Subsequent Measurement:
o Derivatives are measured at fair value at each reporting date.
o Hedge Accounting: If the derivative is designated as a hedging instrument,
changes in fair value may be recognized in profit or loss or in other
comprehensive income (OCI) depending on the type of hedge:
 Fair Value Hedge: Gains or losses on the derivative and the hedged item
are recognized in profit or loss.
  Cash Flow Hedge: Gains or losses on the effective portion of the
derivative are recognized in OCI and reclassified to profit or loss when the
hedged item affects profit or loss.
 Net Investment Hedge: Used to hedge the foreign currency risk of a net
investment in a foreign operation, with gains or losses recognized in OCI.
3. Derecognition:
o A derivative is derecognized when it is settled, expires, or is sold. Any gains or
losses on derecognition are recognized in profit or loss, unless hedge accounting
is applied.

Advantages and Disadvantages

 Advantages:
o Hedging: Derivatives provide an effective way to hedge against risks such as
price, interest rate, and currency fluctuations.
o Leverage: Allows investors to control large positions with relatively small
capital, potentially increasing returns.
o Market Efficiency: Derivatives contribute to market efficiency by allowing price
discovery and improving liquidity.
o Customization: OTC derivatives can be tailored to meet the specific needs of the
parties involved.
 Disadvantages:
o Complexity: Derivatives can be highly complex, requiring sophisticated
understanding and management.
o Leverage Risk: While leverage can amplify gains, it also amplifies losses,
leading to significant risk.
o Counterparty Risk: In OTC derivatives, there is a risk that one party may
default, potentially leading to significant losses.
o Market Volatility: Derivatives can increase market volatility, especially when
used for speculative purposes.

Examples of Derivatives in Practice

 Example 1: A company uses a currency forward contract to lock in the exchange rate for
a future payment in a foreign currency, protecting against adverse currency movements.
 Example 2: An investor buys a call option on a stock, betting that the stock's price will
rise above the strike price before the option's expiration date.
 Example 3: A financial institution enters into an interest rate swap, exchanging fixed
interest rate payments for floating rate payments to manage interest rate exposure on its
debt.
 Example 4: A bank purchases a credit default swap (CDS) to hedge against the risk of
default on a loan it has issued to a corporation.