DERIVATIVE INSTRUMENTS

In the financial marketplace some instruments are regarded as

fundamentals, while others are regarded as derivatives.

Financial Marketplace

Derivatives Fundamentals

Simply another way to catagorize the diversity in the FM*.

 Financial Marketplace

Derivatives Fundamentals

• Futures • Stocks
• Forwards • Bonds
• Options • Etc.
• Swaps
What is a Derivative?

Options

The value of the

derivative instrument
Futures Forwards
is DERIVED from the
underlying security

Swaps

Underlying instrument such as a commodity, a stock, a stock index, an

exchange rate, a bond, another derivative etc..
 Definition of Financial Derivatives

• A financial derivative is a contract between two (or more)

parties where payment is based on (i.e., "derived" from)
some agreed-upon benchmark.
• Since a financial derivative can be created by means of a
mutual agreement, the types of derivative products are
limited only by imagination and so there is no definitive list
of derivative products.
• Some common financial derivatives, however, are
described later.
• More generic is the concept of “hedge funds” which use
financial derivatives as their most important tool for risk
management.
 Repayment of Financial Derivatives

• In creating a financial derivative, the means for, basis of,

and rate of payment are specified.
• Payment may be in currency, securities, a physical entity
such as gold or silver, an agricultural product such as
wheat or pork, a transitory commodity such as
communication bandwidth or energy.
• The amount of payment may be tied to movement of
interest rates, stock indexes, or foreign currency.
• Financial derivatives also may involve leveraging, with
significant percentages of the money involved being
borrowed. Leveraging thus acts to multiply (favorably or
unfavorably) impacts on total payment obligations of the
parties to the derivative instrument.
 Common Financial Derivatives
• Options
• Forward Contracts
• Futures
• Stripped Mortgage-Backed Securities
• Structured Notes
• Swaps
• Combined
• Hedge Funds
 Options

• The purchaser of an Option has rights (but not obligations)

to buy or sell the asset during a given time for a specified
price (the "Strike" price). An Option to buy is known as a
"Call," and an Option to sell is called a "Put. "
• The seller of a Call Option is obligated to sell the asset to the
party that purchased the Option. The seller of a Put Option
is obligated to buy the asset.
• In a “Covered” Option, the seller of the Option already owns
the asset. In a “Naked” Option, the seller does not own the
asset
• Options are traded on organized exchanges and OTC.
 Forward Contracts

• In a Forward Contract, both the seller and the purchaser

are obligated to trade a security or other asset at a
specified date in the future. The price paid for the
security or asset may be agreed upon at the time the
contract is entered into or may be determined at
delivery.
• Forward Contracts generally are traded OTC.
 Futures
• A Future is a contract to buy or sell a standard quantity and
quality of an asset or security at a specified date and price.
• Futures are similar to Forward Contracts, but are standardized
and traded on an exchange, and are valued daily. The daily
value provides both parties with an accounting of their
financial obligations under the terms of the Future.
• Unlike Forward Contracts, the counterparty to the buyer or
seller in a Futures contract is the clearing corporation on the
appropriate exchange.
• Futures often are settled in cash or cash equivalents, rather
than requiring physical delivery of the underlying asset.
 Stripped Mortgage-Backed Securities

• Stripped Mortgage-Backed Securities, called "SMBS,"

represent interests in a pool of mortgages, called
"Tranches", the cash flow of which has been separated
into interest and principal components.
• Interest only securities, called "IOs", receive the interest
portion of the mortgage payment and generally increase
in value as interest rates rise and decrease in value as
interest rates fall.
• Principal only securities, called "POs", receive the
principal portion of the mortgage payment and respond
inversely to interest rate movement. As interest rates go
up, the value of the PO would tend to fall, as the PO
becomes less attractive compared with other investment
opportunities in the marketplace.
 Structured Notes
• Structured Notes are debt instruments where the
principal and/or the interest rate is indexed to an
unrelated indicator. A bond whose interest rate is
decided by interest rates in England or the price of a
barrel of crude oil would be a Structured Note,
• Sometimes the two elements of a Structured Note are
inversely related, so as the index goes up, the rate of
payment (the "coupon rate") goes down. This instrument
is known as an "Inverse Floater."
• With leveraging, Structured Notes may fluctuate to a
greater degree than the underlying index. Therefore,
Structured Notes can be an extremely volatile derivative
with high risk potential and a need for close monitoring.
• Structured Notes generally are traded OTC.
 Swaps
• A Swap is a simultaneous buying and selling of the same
security or obligation. Perhaps the best-known Swap
occurs when two parties exchange interest payments
based on an identical principal amount, called the
"notional principal amount."
• Think of an interest rate Swap as follows: Party A holds a
10-year $10,000 home equity loan that has a fixed
interest rate of 7 percent, and Party B holds a 10-year
$10,000 home equity loan that has an adjustable interest
rate that will change over the "life" of the mortgage. If
Party A and Party B were to exchange interest rate
payments on their otherwise identical mortgages, they
would have engaged in an interest rate Swap.
 Swaps
• Interest rate swaps occur generally in three scenarios.
Exchanges of a fixed rate for a floating rate, a floating
rate for a fixed rate, or a floating rate for a floating rate.
• The "Swaps market" has grown dramatically. Today,
Swaps involve exchanges other than interest rates, such
as mortgages, currencies, and "cross-national"
arrangements. Swaps may involve cross-currency
payments (U.S. Dollars vs. Mexican Pesos) and
crossmarket payments, e.g., U.S. short-term rates vs.
U.K. short-term rates.
 Combined Derivative Products
• The range of derivative products is limited only by the
human imagination. Therefore, it is not unusual for
financial derivatives to be merged in various
combinations to form new derivative products.
• For instance, a company may find it advantageous to
finance operations by issuing debt, the interest rate of
which is determined by some unrelated index. The
company may have exchanged the liability for interest
payments with another party. This product combines a
Structured Note with an interest rate Swap.
 Hedge Funds
• A “hedge fund” is a private partnership aimed at very
wealthy investors. It can use strategies to reduce risk.
But it may also use leverage, which increases the level of
risk and the potential rewards.
• Hedge funds can invest in virtually anything anywhere.
They can hold stocks, bonds, and government securities
in all global markets. They may purchase currencies,
derivatives, commodities, and tangible assets. They may
leverage their portfolios by borrowing money against
their assets, or by borrowing stocks from investment
brokers and selling them (shorting). They may also invest
in closely held companies.
 Hedge Funds
• Hedge funds are not registered as publicly traded
securities. For this reason, they are available only to
those fitting the Securities and Exchange Commission
definition of “accredited investors”—individuals with a
net worth exceeding $1 million or with income greater
than $200,000 ($300,000 for couples) in each of the two
years prior to the investment and with a reasonable
expectation of sustainability.
• Institutional investors, such as pension plans and limited
partnerships, have higher minimum requirements. The
SEC reasons that these investors have financial advisers
or are savvy enough to evaluate sophisticated
investments for themselves.
 Hedge Funds
• Some investors use hedge funds to reduce risk in their
portfolio by diversifying into uncommon or alternative
investments like commodities or foreign currencies.
Others use hedge funds as the primary means of
implementing their long-term investment strategy.
 Why Have Derivatives?
• Derivatives are risk-shifting devices. Initially, they were
used to reduce exposure to changes in such factors as
weather, foreign exchange rates, interest rates, or stock
indexes.
• For example, if an American company expects payment
for a shipment of goods in British Pound Sterling, it may
enter into a derivative contract with another party to
reduce the risk that the exchange rate with the U.S.
Dollar will be more unfavorable at the time the bill is due
and paid. Under the derivative instrument, the other
party is obligated to pay the company the amount due at
the exchange rate in effect when the derivative contract
was executed. By using a derivative product, the
company has shifted the risk of exchange rate movement
to another party.
 Why Have Derivatives?
• More recently, derivatives have been used to segregate
categories of investment risk that may appeal to
different investment strategies used by mutual fund
managers, corporate treasurers or pension fund
administrators. These investment managers may decide
that it is more beneficial to assume a specific "risk"
characteristic of a security.
 The Risks

• Since derivatives are risk-shifting devices, it is important

to identify and understand the risks being assumed,
evaluate them, and continuously monitor and manage
them. Each party to a derivative contract should be able
to identify all the risks that are being assumed before
entering into a derivative contract.
• Part of the risk identification process is a determination
of the monetary exposure of the parties under the terms
of the derivative instrument. As money usually is not due
until the specified date of performance of the parties'
obligations, lack of up-front commitment of cash may
obscure the eventual monetary significance of the
parties' obligations.
 The Risks
• Investors and markets traditionally have looked to
commercial rating services for evaluation of the credit
and investment risk of issuers of debt securities.
• Some firms have begun issuing ratings on a company's
securities which reflect an evaluation of the exposure to
derivative financial instruments to which it is a party.
• The creditworthiness of each party to a derivative
instrument must be evaluated independently by each
counterparty. In a financial derivative, performance of
the other party's obligations is highly dependent on the
strength of its balance sheet. Therefore, a complete
financial investigation of a proposed counterparty to a
derivative instrument is imperative.
 The Risks
• An often overlooked, but very important aspect in the
use of derivatives is the need for constant monitoring
and managing of the risks represented by the derivative
instruments.
• For instance, the degree of risk which one party was
willing to assume initially could change greatly due to
intervening and unexpected events. Each party to the
derivative contract should monitor continuously the
commitments represented by the derivative product.
• Financial derivative instruments that have leveraging
features demand closer, even daily or hourly monitoring
and management.
 Leveraging

• Some derivative products may include leveraging

features. These features act to multiply the impact of
some agreed-upon benchmark in the derivative
instrument. Negative movement of a benchmark in a
leveraged instrument can act to increase greatly a party's
total repayment obligation. Remembering that each
derivative instrument generally is the product of
negotiation between the parties for risk-shifting
purposes, the leveraging component, if any, may be
unique to that instrument.
 Leveraging

• For example, assume a party to a derivative instrument

stands to be affected negatively if the prime interest rate
rises before it is obliged to perform on the instrument.
This leveraged derivative may call for the party to be
liable for ten times the amount represented by the
intervening rise in the prime rate. Because of this
leveraging feature, a small rise in the prime interest rate
dramatically would affect the obligation of the party. A
significant rise in the prime interest rate, when
multiplied by the leveraging feature, could be
catastrophic.
 Trading of Derivatives
• Some financial derivatives are traded on national
exchanges. Those in the U.S. are regulated by the
Commodities Futures Trading Commission.
• Financial derivatives on national securities exchanges are
regulated by the U.S. Securities and Exchange
Commission (SEC).
• Certain financial derivative products have been
standardized and are issued by a separate clearing
corporation to sophisticated investors pursuant to an
explanatory offering circular. Performance of the parties
under these standardized options is guaranteed by the
issuing clearing corporation. Both the exchange and the
clearing corporation are subject to SEC oversight.
 Trading of Derivatives
• Some derivative products are traded over-the-counter
(OTC) and represent agreements that are individually
negotiated between parties. Anyone considering
becoming a party to an OTC derivative should investigate
first the creditworthiness of the parties obligated under
the instrument so as to have sufficient assurance that
the parties are financially responsible.
INTRODUCTION TO FINANCIAL
FUTURES MARKETS
• Our purpose in this topic is to provide an
introduction to financial futures contracts,
how they are priced, and how they can be
used for hedging.
 What a futures contract is?

• A futures contract is an agreement that requires a party to the

agreement either to buy or sell something at a designated future
date at a predetermined price.
• Futures contracts are categorized as either commodity futures or
financial futures. Commodity futures involve traditional agricultural
commodities (such as grain and livestock), imported foodstuffs
(such as coffee, cocoa, and sugar), and industrial commodities.
Futures contracts based on a financial instrument or a financial
index are known as financial futures. Financial futures can be
classified as
• (1) stock index futures
• (2) interest rate futures
• (3) currency futures.
 Users of futures contracts markets

Users of futures contracts markets

1. Hedgers
2. Speculators
3. Brokers
 MECHANICS OF FUTURES TRADING

• A futures contract is a firm legal agreement between a buyer

and an established exchange or its clearinghouse in which the
buyer agrees to take delivery of something at a specified price
at the end of a designated period of time. The price at which
the parties agree to transact in the future is called the futures
price. The designated date at which the parties must transact
is called the settlement date.
 LIQUIDATING A POSITION

• Most financial futures contracts have settlement dates in the

months of March, June, September, or December.
• The contract with the closest settlement date is called the
nearby futures contract.
• The contract farthest away in time from the settlement is
called the most distant futures contract.
• A party to a futures contract has two choices on liquidation of
the position.
First, the position can be liquidated prior to the
settlement date.
The alternative is to wait until the settlement date.
 Clearinghouse

• A clearinghouse is agency associated with an exchange, which

settles trades and regulates delivery.
 THE ROLE OF THE CLEARINGHOUSE

• Associated with every futures exchange is a clearinghouse,

which performs several functions, one of these functions is
• guaranteeing that the two parties to the transaction will
perform.
• Besides its guarantee function, the clearinghouse makes it
simple for parties to a futures contract to unwind their
positions prior to the settlement date.
 MARGIN REQUIREMENTS

• When a position is first taken in a futures contract, the

investor must deposit a minimum dollar amount per contract
as specified by the exchange.
• Three kinds of margins specified by the exchange:
1) initial margin (may be an interest-bearing security
such as a Treasury bill, cash, or line of credit)
2) maintenance margin (specified by the exchange)
3) variation margin (additional margin to bring it back to
the initial margin if the equity falls below the maintenance
margin, must be in cash).
 MARKET STRUCTURE

• On the exchange floor, each futures contract is traded at a

designated location in a polygonal or circular platform called a
pit. The price of a futures contract is determined by open
outcry of bids and offers in an auction market.
• Floor traders include two types: locals and floor brokers.
 Daily Price Limits

• The exchange has the right to impose a limit on the daily price
movement of a futures contract from the previous session's
closing price.
 FUTURES VERSUS FORWARD CONTRACTS

• A forward contract, just like a futures contract, is an

agreement for the future delivery of something at a specified
price at the end of a designated period of time.
 Futures contracts Forward contracts

Standardized contract yes no

(delivery date,
quality, quantity)

Where to be traded organized exchanges over-the-counter instrument

(primary market)

Credit risk (default risk) no yes

Clearinghouse yes no

Settlement marked-to-market (daily) end of the contract

Margin requirement yes no

Transaction cost low high

Regulations yes no
 RISK AND RETURN CHARACTERISTICS OF
FUTURES CONTRACTS
• Long futures: An investor whose opening position is the
purchase of a futures contract
• Short futures: An investor whose opening position is the sale
of a futures contract.
• The long will realize a profit if the futures price increases.
• The short will realize a profit if the futures price decreases.
 Pricing of futures contracts

• To understand what determines the futures price, consider once again the
futures contract where the underlying instrument is Asset XYZ. The
following assumptions will be made:
1. In the cash market Asset XYZ is selling for $100.
2. Asset XYZ pays the holder (with certainty) $12 per year in four
quarterly payments of $3, and the next quarterly payment is exactly 3
months from now.
3. The futures contract requires delivery 3 months from now.
4. The current 3-month interest rate at which funds can be loaned or
borrowed is 8% per year.
What should the price of this futures contract be? That is, what should
the futures price be? Suppose the price of the futures contract is $107.
Consider this strategy:
• Sell the futures contract at $107.
• Purchase Asset XYZ in the cash market for $100.
• Borrow $100 for 3 months at 8% per year.
 1. From Settlement of the Futures Contract
• Proceeds from sale of Asset XYZ to settle the
futures contract = $107
• Payment received from investing in Asset XYZ
for 3 months = $3
• Total proceeds = $110

2. From the Loan

• Repayment of principal of loan = $ 100
• Interest on loan (2% for 3 months) = 2
• Total outlay = $102

• Profit = $8
 Theoretical Futures Price Based On Arbitrage
Model
We see that the theoretical futures price can be determined based on the
following information:
1. The price of the asset in the cash market.($ 100)
2. The cash yield earned on the asset until the settlement date. In our
example, the cash yield on Asset XYZ is $3 on a $100 investment or 3%
quarterly (12% annual cash yield).
3. The interest rate for borrowing and lending until the settlement date. The
borrowing and lending rate is referred to as the financing cost. In our
example, the financing cost is 2% for the 3 months.
We will assign the following:

r = financing cost
y = cash yield
P = cash market price ($)
F = futures price ($)
• The theoretical futures price ;

F =P+P(r-y)
Our previous example to determine the theoretical futures
price ;
r= 00.2
y= 00.3
P= $ 100
Then , the theoretical futures prises is:

F= $ 100 + $ 100 ( 0.02 – 0.03 )

F= $ 100 - $ 1
F= $ 99
Difference Between Lending and Borrowing Rate

• The borrowing rate is greater than the lending rate.

• Letting; rB = borrowing rate
rL = lending rate

F = P + p(rB-y)
F = P + p(rL-y)
• For example, assume that the borrowing rate is 8% per year,
or 2% for 3 months, while the lending rate is 6% per year, or
1.5% for 3 months. The upper boundary and lower boundary
for the theoretical futures price is:
• F(upper boundary) = $100 + $100(0.02 - 0.03)
= $ 99
• F(lower boudary) = $100 + $100(0.015 - 0.03)
= $ 98.50
 General Principles of Hedging With Futures

• The major function of futures markets is to transfer price risk

from hedgers to speculators. That is, risk is transferred from
those willing to pay to avoid risk to those wanting to assume
the risk in the hope of gain. Hedging in this case is the
employment of a futures transaction as a temporary
substitute for a transaction to be made in the cash market.
The hedge position locks in a value for the cash position. As
long as cash and futures prices move together, any loss
realized on one position (whether cash or futures) will be
offset by a profit on the other position. When the profit and
loss are equal, the hedge is called a perfect hedge.
 Risk Associated with Hedging

• The term r - y, which reflects the difference between the cost

of financing and the asset's cash yield, is called the net
financing cost. The net financing cost is more commonly
called the cost of carry or, simply, carry.
 The amount of the loss or profit on a hedge will be determined
by the relationship between the cash price and the futures
price when a hedge is placed and when it is lifted. The
difference between the cash price and the futures price is
called the basis.
That is, basis = cash price - futures price
• if a futures contract is priced according to its theoretical value,
the difference between the cash price and the futures price
should be equal to the cost of carry. The risk that the hedger
takes is that the basis will change, called basis risk.
 Cross-hedging

• Cross-hedging is common in asset/liability and portfolio

management because no futures contracts are available on specific
common stock shares and bonds. Cross-hedging introduces another
risk—the risk that the price movement of the underlying
instrument of the futures contract may not accurately track the
price movement of the portfolio or financial instrument to be
hedged. It is called cross-hedging risk.
• Therefore, the effectiveness of a cross-hedge will be determined by:
1. The relationship between the cash price of the underlying
instrument and its futures price when a hedge is placed and when it
is lifted.
2. The relationship between the market (cash) value of the
portfolio and the cash price of the instrument underlying the
futures contract when the hedge is placed and when it is lifted.
 Long Hedge Versus Short Hedge

• A short (or sell) hedge is used to protect against a decline in

the future cash price of a financial instrument or portfolio.
• To execute a short hedge, the hedger sells a futures contract
(agrees to make delivery).
• A long (or buy) hedge is undertaken to protect against an
increase in the price of a financial instrument or portfolio to
be purchased in the cash market at some future time.
• Thank you for listening,