FINANCIAL DERIVATIVES

A Presentation on Financial Derivatives. this covers it's definition, features, types, benefits, challenges and applications.
Derivative is defined as the future contract between two parties. It means there must be a contract-binding on the underlying parties and the same to be fulfilled in future.
Normally, the derivative instruments have the value which is derived from the values of other underlying assets, such as agricultural commodities, metals, financial assets, intangible assets.

1. Prepared by Chidinma Igwe January 2019 DERIVATIVES

2. Our v ision and mission Our vision is to simplify wealth creation Our mission is to positively unlock the opportunities in society

3. Objectives Definition Features Participant in derivative market Types of Derivatives - Forward - Futures - Options Type of options Distinctions Between forward and future contracts Benefits of Derivatives Challenges Applications of Financial derivatives Questions Content

4. Objectives U nderstand the meaning of derivatives D escribe the features and types of financial derivatives U nderstand uses of derivative securities D istinguish between futures and forward contracts

5. Derivatives are financial instruments which derives it value from another financial instrument. It turns promises to values. The value is derived from the prices of other assets. The term ‘derivative’ indicates that it has no independent value, i.e., its value is the underlying asset. The underlying asset can be securities, commodities , currency, livestock or anything else . Derivative is one of the three(3) categories of financial instrument. The other two(2) being stocks (i.e. equities or shares)and debt (i.e. bonds and mortgages ) Derivatives are widely used as hedging instruments due to their flexibility Definition

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7. It is a contract Derivative is defined as the future contract between two parties. It means there must be a contract-binding on the underlying parties and the same to be fulfilled in future Derives value from underlying asset: Normally, the derivative instruments have the value which is derived from the values of other underlying assets, such as agricultural commodities, metals, financial assets, intangible assets Specified obligation In general, the parties have specified obligation under the derivative contract. Obviously, the nature of the obligation would be different as per the type of the instrument of a derivative. For example, the obligation of the parties, under the different derivatives, such as forward contract, future contract, option contract and swap contract would be different Features of Derivatives

8. Direct or exchange traded The derivatives contracts can be undertaken directly between the two parties or through the particular exchange like financial futures contracts. Delivery of underlying asset not involved Usually , in derivatives trading , the taking or making of delivery of underlying assets is not involved, rather underlying transactions are mostly settled by taking offsetting positions in the derivatives themselves. Features of Derivatives

9. Hedgers The use derivatives market to reduce or eliminate the risk associated with price of assets. Majority of the participates in the derivative market belong to this category Speculators The transact future and option contracts to get extra leverage in betting on the future movement in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture . Arbitrageurs Their behavior is guided be the desire to take advantages of a discrepancy between prices of more or less the same assets or competing assets in different market e.g the see the future price of an asset getting out of line with cash price , they will take an offsetting position in the two markets to lock in profit Participants in Derivatives Market

10. There are two types of derivatives. Commodity derivatives Financial derivatives Commodity derivatives- the underlying asset is a commodity. It can be agricultural commodity like wheat, soybeans, cotton , precious metals like gold, silver etc Financial derivative denotes a variety of financial instruments including stocks, bonds, treasury bills, interest rate, foreign currencies and other securities . Financial derivatives include futures, forwards, options, swaps, etc. Types of Derivatives

11. A forward contract is a customised contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price . Forward contracts are ‘buy now, pay later’ products, which enable you to essentially ‘fix’ an exchange rate at a set date in the future (often 12 – 24 months ahead ) Features forward contracts are privately traded Forward contracts, on the other hand, are customized as per the requirements of the counterparties There is no margin requirement in a forward contract forward market is not regulated by the Government FORWARDS

12. Example of forward contract

13. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardised exchange-traded contracts. For example, if someone buys a July crude oil futures contract (CL), they are saying they will buy 1,000 barrels of oil from the seller at the price they pay for the futures contract, come the July expiry. The seller is agreeing to sell the buyer the 1,000 barrels of oil at the agreed upon price Features Futures contracts are traded on an exchange Since they are traded on exchange, futures contracts are highly standardized single clearinghouse acts as the counterparty for all futures contracts. This means that the clearinghouse is the buyer for every seller and seller for every buyer. This eliminates the risk of default Futures contracts require a margin to be posted at the contract initiation The government regulates futures market Futures

14. Example of futures contract

15. Distinction

16. In finance, an option is a contract which gives the buyer the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price prior to or on a specified date, depending on the form of the option. Types of Options Call Option -Call option - gives the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Put Option -Put option -Put option give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date Options

17. Types of Options

18. Swaps - Derivative contracts that allow the exchange of cash flows between two parties. The swaps usually involve the exchange of a fixed cash flow for a floating cash flow. The most popular types of swaps are interest rate swaps, commodity swaps, and currency swaps. swaps are not traded on exchanges but are traded over-the-counter. In addition, counterparties in swaps are usually companies and financial organizations and not individuals, because there is always a high risk of counterparty default in swap contracts. Example - Party A agrees to pay Party B a predetermined, fixed rate of interest on a principal on specific dates for a specified period of time. Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other interval determined by the parties SWAP

19. Types of Swaps Interest rate swaps- entail swapping only the interest related cash flows between the parties in the same currency These Currency Swaps- These entail swapping both principal and interest on different currency than those in the opposite direction. Commodity swaps -A commodity swap is a type of swap agreement whereby a floating (or market or spot) price based on an underlying commodity is traded for a fixed price over a specified period. The vast majority of commodity swaps involve oil

20. D erivatives exert a significant impact on modern finance, because they provide numerous advantages to the financial markets which include :- Hedging risk exposure Since the value of the derivatives is linked to the value of the underlying asset, the contracts are primarily used for hedging risks. For example, an investor may purchase a derivative contract whose value moves in the opposite direction to the value of the asset. In addition, it can be utilized to reallocate risk from risk-averse players to risk-seeking players. Like most time deposits, funds cannot be withdrawn before maturity without paying a penalty. Underlying asset price determination Derivatives are frequently used to determine the price of the underlying asset. For example, the spot prices of the futures can serve as an approximation of a commodity price . Benefits of Derivatives

21. Access to unavailable assets or markets Derivatives can help organizations get access to unavailable assets or markets. By employing interest rate swaps, a company may obtain a more favorable interest rate relative to interest rates available from direct borrowing . Market efficiency It is considered that derivatives increase the efficiency of financial markets. By using derivative contracts, one can replicate the payoff of the assets. Therefore, the prices of the underlying asset and the associated derivative tend to be in equilibrium to avoid arbitrage opportunities

22. D espite the benefits that derivatives bring to the financial markets, the financial instruments come with some significant drawbacks. The drawbacks resulted in disastrous consequences during the financial crisis of 2007-2008. The rapid devaluation of mortgage-backed securities and credit-default swaps lead to the collapse of financial institutions and stock markets around the world . 1 . High risk While the high volatility of the derivatives exposes them to potentially huge losses, the sophisticated design of the contracts makes the valuation extremely complicated or even impossible. Thus, they bear the high inherent risk which include regulatory risk , operational risk , liquidity risk etc Speculative features Derivatives are widely regarded as a tool of speculation. Due to the extremely risky nature of the financial instrument and their unpredictable behavior, the unreasonable speculation may lead to huge losses . Challenges of Derivatives

23. 3. Counter-party risk Although derivatives traded on the exchanges generally go through a thorough due diligence process, some of the contracts traded over-the-counter do not include a benchmark for due diligence. Thus, there is a high probability of counter-party default.

24. Some of the application of financial derivatives are as follows M anagement of risk This is the most important function of derivatives . Financial derivatives provide a powerful tool for limiting risks that individuals and organization face in the ordinary conduct of their business . Effective use of derivatives can save cost and it can increase returns of the organization Efficiency in trading Financial derivatives allow for free trading of risk component and that leads to improving market efficiency. Traders find financial derivatives to be a more attractive instrument than the underlying security. This is because of the greater amount of liquidity in the market offered by derivatives . Speculations Financial derivatives are considered to be risky , if not used properly , these can lead to financial destruction in the organization . However, these instruments act as powerful instruments for knowledgeable traders to expose themselves to calculate and understand risk in search of rewards that is prifot Applications of Financial Derivatives

25. Reference 7, CFA Level 1 Volume 6 Derivatives and Alternative Investments, 7th Edition CFI’s Finance Courses Bhalla , V.K.Financial Derivatives- Risk Management, Sultan Chand and Company Ltd., New Delhi, 2001.

26. Questions