Financial derivatives

Calicut University

1. Financial derivatives Introduction To financial derivatives - 1

2. Introduction Risk/ uncertainty in life  accident, calamity, theft, unexpected change in demand, government policy, labour rates,interest rates, economic conditions, foreign exchange rates etc. Insurance  accidents, life, theft etc. Derivatives  change in value due to change in market conditions

3. Derivatives A derivative is a contract between two parties which derives its value/price from an underlying asset. The most common types of derivatives are futures, options, forwards and swaps. Principle: Risk-averse and risk taking individual

4. Meaning It derives its value from “something else” aka underlying asset/ underlying’s /bases From verb ‘To Derive’  No independent value Ex: Curd (Price depends upon milk) Right to buy or sell is traded It gives a right to a person to buy/sell of an asset after or during a specified period Deferred delivery instruments/ deferred payment instruments

5. Characteristics Underlying asset No independent value Predefined period Contract fulfillment Instruments for hedging risk Minimal initial investments Off-balance sheet instrument Secondary market instruments

6. Types / classification of derivatives

7. Forwards A forward contract is a customizable derivative contract between two parties to buy or sell an asset at a specified price on a future date. Forward contracts can be tailored to a specific commodity, amount and delivery date. Forward contracts do not trade on a centralized exchange and are considered over-the-counter (OTC) instruments.

8. futures Futures contracts are financial derivatives that oblige the buyer to purchase some underlying asset (or the seller to sell that asset) at a predetermined future price and date. A futures contract allows an investor to speculate on the direction of a security, commodity, or a financial instrument, either long or short, using leverage. Futures are also often used to hedge the price movement of the underlying asset to help prevent losses from unfavorable price change.

9. options Options are contracts giving the buyer  the right, but not the obligation,  to buy or sell a particular asset on or before a specified date. An option is a contract giving the buyer the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put) the underlying asset at a specific price on or before a certain date. People use options for income, to speculate, and to hedge risk. Options are known as derivatives because they derive their value from an underlying asset. A stock option contract typically represents 100 shares of the underlying stock, but options may be written on any sort of underlying asset from bonds to currencies to commodities.

10. swaps Two parties agree to exchange cash flows at future dates according to a prearranged formula Most swaps involve cash flows based on a  notional principal amount  such as a loan or bond, although the instrument can be almost anything. Usually, the principal does not change hands.

11. Over the counter derivatives An over the counter (OTC) derivative is a financial contract that is arranged between two counterparties but with minimal intermediation or regulation. OTC derivatives do not have standardized terms and they are not listed on an asset exchange. As an example, a forward and a futures contract both can represent the same underlying, but the former is OTC while the latter is exchange-traded. Over the counter  derivatives are instead private contracts that are negotiated between counterparties without going through an exchange or other type of formal intermediaries, although a broker may help arrange the trade. Therefore, over the counter derivatives could be negotiated and customized to suit the exact risk and return needed by each party. Although this type of derivative offers flexibility, it poses credit risk because there is no clearing corporation.

12. Exchange traded derivatives An exchange-traded derivative is a standardized financial contract, traded on an exchange, that settles through a clearinghouse, and is guaranteed. A key feature of exchange-traded derivatives that attract investors is that they are guaranteed by clearinghouses, such as the Options Clearing Corporation (OCC) or the CFTC, reducing the product's risk. Intermediary  Exchange  Takes initial margin from both sides to act as a guarantee, Specify the terms of trade, Standardise the contracts, Less counterparty risk Ex: Futures, Stock options…

13. Commodity & financial derivatives

14. Financial derivatives (common derivatives) Derives its value from an underlying asset Underlying asset  stocks/ bonds/ interest rates/ currencies Features:- Financial contract  2 parties  Directly between the parties OR exchange Off-balance sheet in nature Settlement(mostly)  Taking offsetting positions

15. Types

16. Difference Between commodity and financial derivatives Commodity Derivatives Financial Derivatives Underlying asset  Commodity *U.A  Financial instruments Wheat, Corn, Pepper, Crude oil etc. Stocks, Bonds, Currencies etc. Quality of U.A matters No quality issues *U.A  Bulky Not bulky Physical settlement Cash-settlement Need warehouses for storage No need of storage facility *U.A  Underlying Asset

17. Uses Risk management Income generation Trading efficiency Achievement of investment goals Reduced transaction cost Financial engineering

18. Economic Functions Risk management Price Discovery Liquidity Efficiency Portfolio management Economic development

19. Limitations Increased volatility Increased bankruptcies Increased regulatory burden Enhancement of risk Speculative and gambling motives Instability of the financial system Contract life

20. Risk Involved Counter party risk Market Basis risk Inter connection risk Operations risk Liquidity risk