CHAPTER FOUR

DERIVATIVE INSTRUMENTS

Introduction
Consider a company that relies heavily on oil for its production and is concerned about potential
future price increases. One effective way to hedge against this risk is by entering into contracts
with oil suppliers. These contracts allow the company to lock in a fixed price for a specified
quantity of oil to be purchased on a predetermined future date. By securing this price today, the
company protects itself from market fluctuations. In this scenario, the contract acts as a
derivative instrument, with oil serving as the underlying asset. This strategy stabilizes costs and
enhances financial predictability.
Derivative instruments are financial contracts whose value is derived from the performance of an
underlying asset, index, or entity. They can be based on various assets, including stocks, bonds,
commodities, currencies, interest rates, market indexes, or, as in this case, oil. Derivatives enable
investors to hedge against risk, speculate on price movements, and enhance portfolio
diversification, making them essential tools for managing financial risks and optimizing returns
in modern financial markets.
Purpose of Derivative Instruments:

 Risk Management: Derivatives help to manage financial risks, such as price volatility,
interest rate fluctuations, and currency exchange rate movements.
 Speculation: Investors use derivatives to take leveraged positions on price movements of
underlying assets, amplifying potential returns or losses.
 Enhanced Returns: Derivatives can be used strategically to increase portfolio returns
and diversify risk exposure.

Hedging: Businesses use derivatives to hedge against adverse price

Components of Derivative Marke

 Underlying Assets: These are the assets on which derivative contracts are based.
Examples include:
o Stocks: Stock options and futures based on companies like Apple or Google.
o Bonds: Interest rate swaps or bond futures based on U.S. Treasury or corporate
bonds.
o Commodities: Futures contracts on physical goods like gold, silver, crude oil,
wheat, or coffee.
o Currencies: Foreign exchange derivatives based on currency pairs like
EUR/USD or USD/JPY.
o Indices: Derivatives based on stock market indices like the S&P 500 or Dow
Jones.
 oInterest Rates: Derivatives based on benchmarks like LIBOR or the Federal
Funds Rate.
 Counter-Party Position Holders:
o Long-position holders: Those who agree to buy the underlying asset.
o Short-position holders: Those who agree to sell the underlying asset.
 Expiration or Maturity Date: The date when the derivative contract is settled, either
by physical delivery of the asset or cash settlement.

Types of Derivative Instruments

Derivative instruments are financial contracts whose value is derived from the performance of underlying
assets, indices, or entities. They are vital tools in modern finance, enabling investors to hedge risks, speculate
on price movements, and enhance portfolio diversification. The main types of derivative instruments include
futures, options, swaps, and forwards. Each type offers unique features and benefits, addressing different
investor needs and market conditions.

1. Forwards Contracts

Forward contracts are customized agreements between two parties to buy or sell an asset at a predetermined
price on a specific future date. Unlike standardized futures contracts traded on exchanges, forwards are
typically traded over the counter (OTC), allowing for flexibility in terms of quantity, price, and delivery dates.
These contracts help manage risks associated with price fluctuations in various assets, such as commodities,
currencies, and financial instruments. For instance, a farmer might lock in a fixed price for crops before
harvest, while a company could secure costs for raw materials.
However, forward contracts carry counterparty risk due to the absence of clearinghouse protections, meaning
that if one party defaults, the other could incur significant losses. Despite this risk, forwards remain valuable
for tailored risk management. They include various types, such as commodity forwards for assets like oil or
gold, currency forwards for managing foreign exchange risk, interest rate forwards for hedging future interest
rates, and equity forwards for trading shares at future prices.
2 Futures Contracts
Futures contracts are standardized agreements to buy or sell an underlying asset at a predetermined price on a
specified future date. Traded on regulated exchanges, they ensure transparency and liquidity, with fixed
contract sizes and expiration dates, making them accessible to a wide range of investors. The primary purpose
of futures contracts is to manage risk associated with price volatility in assets such as commodities, financial
instruments, and currencies.
A key feature of futures contracts is the involvement of clearinghouses, which act as intermediaries and reduce
counterparty risk. This structure enhances market stability and allows margin trading, enabling participants to
control large positions with less capital. Overall, futures contracts are essential for price discovery, risk
management, and speculative opportunities. They can be used for price discovery, risk management,
speculation, and providing liquidity. Examples include commodity futures for agricultural products, financial
futures for stock indices and currencies, and interest rate futures for securities. For example, a corn farmer may
enter a futures contract to lock in a price for their harvest, protecting against price fluctuations and ensuring
predictable income.
 Interactive exercise4

1. Which component of the derivative market refers to the assets on which derivative contracts are based?

Counter-party position holders

Expiration or maturity date

Underlying Assets

Derivative Securities
2. In a forward contract, what risk do the parties face that is not present in futures contracts?

Market volatility

Counterparty risk due to the lack of clearinghouse protections

Interest rate risk

Currency risk
3. What is the primary purpose of derivative instruments?

To eliminate all investment risks

To manage financial risks, speculate on price movements, and enhance returns

To guarantee profits in the stock market

To create new underlying assets

4. What is a key feature of futures contracts?

They are customized and traded over the counter.

They are standardized and traded on regulated exchanges

They require physical delivery of assets only

They eliminate counterparty risk entirely

5. Which of the following is NOT a type of derivative instrument?

Futures Contracts

Options Contracts
 Equity Stocks

Swaps

NoTypeQuestionsGiven AnswerCorrect AnswerResult1

Which component of the derivative market refers to the assets on which derivative contracts are based?
Underlying Assets
Underlying Assets
Correct 2
In a forward contract, what risk do the parties face that is not present in futures contracts?
Counterparty risk due to the lack of clearinghouse protections
Counterparty risk due to the lack of clearinghouse protections
Correct 3
What is the primary purpose of derivative instruments?
To manage financial risks, speculate on price movements, and enhance returns
To manage financial risks, speculate on price movements, and enhance returns
Correct 4
What is a key feature of futures contracts?
They are standardized and traded on regulated exchanges
They are standardized and traded on regulated exchanges
Correct 5
Which of the following is NOT a type of derivative instrument?
Equity Stocks
Equity Stocks
Correct

Options
Options contracts are financial derivatives that give the holder the right, but not the obligation, to
buy or sell an underlying asset at a predetermined price within a specified timeframe. There are
two main types: call options, which allow for purchasing the asset, and put options, which enable
selling it. This flexibility makes options attractive for hedging risks, speculating on price
movements, and enhancing investment strategies.
The primary advantage of options lies in their ability to leverage potential returns with a
relatively small initial investment, known as the premium. This allows investors to control larger
positions without significant upfront capital. For example, a trader expecting stock prices to rise
might buy call options, benefiting from price appreciation while limiting losses to the premium
paid. Options are traded on exchanges, ensuring transparency and liquidity, but they also involve
complexities like volatility and time decay. Overall, options are versatile tools for risk
management, speculation, income generation, and portfolio diversification.
Options give the holder the right, but not the obligation, to buy or sell an underlying asset at a
specified price (strike price) before a set expiration date. They offer flexibility
for speculation, hedging, and income generation without the obligation to trade the underlying
asset.
Types of Options
There are two main types of options:

 Call Options: These give the holder the right, but not the obligation, to buy an
underlying asset at the strike price.
 Put Options: These give the holder the right, but not the obligation, to sell an underlying
asset at the strike price.

Here’s a comparison of call options versus put options:

Call Option Put Option
The holder has the right, but not the
The holder has the right, but not the
Holder obligation, to exercise the option to
obligation, to exercise the option to buy.
sell
The writer receives a premium from the The writer received a premium from
Writer holder and is obliged to sell if called upon the holder and is obliged to buy if
to do so. called upon to do so.
Market Used when the investor expects the price of Used when the investor expects the
Outlook the underlying asset to rise. price of the underlying asset to fall.
Profit potential is limited to the
Profit Unlimited potential for profit as the asset strike price minus the premium paid,
Potential price increases. as the asset price cannot fall below
zero.
Limited to the premium paid for the
Risk Limited to the premium paid for the option.
option.
Methods of Exercising Options
There are two methods for exercising options:

 American Options: Can be exercised at any time before expiration.

 European Options: Can only be exercised at expiration.

Swaps
Swaps are financial derivatives that involve the exchange of cash flows between two parties,
primarily to manage risk or optimize financial performance. Corporations, financial institutions,
and investors use swaps to align cash flows with financial goals, such as reducing borrowing
costs or achieving predictable cash flows.
Typically traded over the counter (OTC), swaps offer flexibility and customization but also
introduce counterparty risk, as parties rely on each other to fulfill the agreement. Their main
purposes include:

 Risk Management: Hedging against interest rate, currency, or commodity price risks.
  Cost Reduction: Accessing better financing terms by swapping fixed-rate for floating-
rate payments.
 Customization: Tailoring agreements to specific needs and objectives.
 Liquidity Management: Providing flexibility in cash flow management.

Examples of Swaps:

 Interest Rate Swaps: Exchange fixed interest payments for floating-rate payments.
 Currency Swaps: Exchange cash flows in different currencies.
 Commodity Swaps: Cash flows based on commodity prices.
 Credit Default Swaps (CDS): Insurance against debt default.
 Equity Swaps: Exchange returns on equities for another asset’s returns.

For example, a company with a variable interest rate loan can enter into an interest rate swap to
convert their variable rate payments into fixed rate payments. By doing so, the company can
hedge against the risk of increasing interest rates, ensuring more predictable cash flows. This
demonstrates how swaps can be utilized to manage interest rate risks and customize financial
strategies to meet specific requirements

Chapter Key Points

 Derivative instruments derive their value from an underlying asset and are used
for hedging, speculation, and enhancing returns.
 Hedging: Derivatives allow businesses and investors to mitigate risks associated with
price volatility, interest rate fluctuations, and currency exchange rates.
 Speculation: Investors use derivatives to take leveraged positions on price movements,
with the potential to amplify gains or losses.
 Futures contracts: Standardized agreements obligating the buying or selling of an asset
at a future date. Commonly used for price discovery and risk management.
 Options contracts: Provide the right, but not the obligation, to buy or sell an asset, used
for speculative or hedging purposes.
 Swaps: Contracts between two parties to exchange cash flows or other assets, commonly
used to manage interest rate, currency, and commodity risks.
 Forwards contracts: Customized agreements between two parties to buy or
sell an asset at a future date for a set price.

Self-assessment questions
1. Which of the following types of derivative instruments involves agreements that are privately negotiated?

Futures contracts

Options contracts

Forward contracts
 Exchange-traded funds (ETFs)
2. A forward contract is best characterized by which of the following statements?

It is standardized and traded on an exchange

It locks in the price of an asset for future delivery and can be easily traded.

It is a customizable agreement to buy or sell an asset at a future date for a price agreed upon today

It gives the holder the right to purchase assets at market price

3. What is the primary advantage of options contracts?

Unlimited risk potential

Ability to buy or sell without any upfront cost

The right, but not the obligation, to buy or sell an underlying asset

Higher premium compared to other derivatives

4. Which of the following is NOT a purpose of derivative instruments?

Risk Management

Speculation

Income Generation

Guaranteed profits
5. Which method of exercising options allows the holder to exercise the option at any time before the
expiration date?

European Options

American Options

Derivative Options

Global Options
6. A farmer enters into a futures contract to sell their crops at a fixed price in the future. What is the primary
benefit of this contract?

To increase the price of the crops

To secure predictable income and protect against price fluctuations

 To speculate on the price of crops

To diversify their investment portfolio

7. Which of the following is an example of a swap?

Buying a call option on gold

Entering into a contract to exchange fixed interest payments for floating interest payments

Purchasing a put option on stock

. Buying a futures contract for oil

8. Which of the following is a benefit of using derivatives for hedging?

Amplifying returns on investment

Gaining guaranteed returns under all market conditions

Managing exposure to price fluctuations

Satisfying regulatory requirements

9. In a credit default swap (CDS), the buyer is essentially purchasing what?

Equity shares in a company

Protection against default on a debt instrument

A future cash flow from a commodity

A right to buy or sell currency

10. What type of derivative gives the holder the right, but not the obligation, to buy an asset?

Swap

Futures

Call Option

Put Option

NoTypeQuestionsGiven AnswerCorrect AnswerResult1

Which of the following types of derivative instruments involves agreements that are privately negotiated?
Forward contracts
Forward contracts
Correct 2
A forward contract is best characterized by which of the following statements?
It is a customizable agreement to buy or sell an asset at a future date for a price agreed upon today
It is a customizable agreement to buy or sell an asset at a future date for a price agreed upon today
Correct 3
What is the primary advantage of options contracts?
The right, but not the obligation, to buy or sell an underlying asset
The right, but not the obligation, to buy or sell an underlying asset
Correct 4
Which of the following is NOT a purpose of derivative instruments?
Guaranteed profits
Guaranteed profits
Correct 5
Which method of exercising options allows the holder to exercise the option at any time before the expiration
date?
American Options
American Options
Correct 6
A farmer enters into a futures contract to sell their crops at a fixed price in the future. What is the primary
benefit of this contract?
To secure predictable income and protect against price fluctuations
To secure predictable income and protect against price fluctuations
Correct 7
Which of the following is an example of a swap?
Entering into a contract to exchange fixed interest payments for floating interest payments
Entering into a contract to exchange fixed interest payments for floating interest payments
Correct 8
Which of the following is a benefit of using derivatives for hedging?
Managing exposure to price fluctuations
Managing exposure to price fluctuations
Correct 9
In a credit default swap (CDS), the buyer is essentially purchasing what?
Protection against default on a debt instrument
Protection against default on a debt instrument
Correct 10
What type of derivative gives the holder the right, but not the obligation, to buy an asset?
Call Option
Call Option
Correct