Chapter 8

DERIVATIVE INSTRUMENTS
Meaning and concept of Derivatives
Financial derivatives –Future, option, pull and call option ,
interest
swaps, contract swaps Contract swaps, Forward rate
agreements,
Credit derivatives , Securitization, credit default swaps, Risk
associated with derivatives product.
Meaning and concept of 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. It is a financial
instrument which derives its value/price from the underlying assets.
• When the price of the underlying change , the value of the derivatives also
change. A derivatives is not a product, it is a contract that derives its value
from change in the price of the underlying assets .( E.g. the value of a gold
future contract is derive from the value of the underlying assets i.e. gold).
• Derivatives are financial instruments which derive it value from another
financial instrument. It turns promises to values. The value is derived from
prices of other.
• Derivatives are widely used as hedging instruments due to their flexibility.
Features of Derivatives
• Traded on exchanges
• All transaction in derivatives take place in future specific date.
• Hedging device reduces risk.
• Derivatives are often leveraged , such that a small movement in the
underlying value can cause a large difference in the value of
derivatives.
Derivative Market
• A derivative market is a financial market where various derivative
instruments are traded. Derivative instruments are financial contracts that
derive their value from an underlying asset or reference rate. The underlying
asset can be anything, such as stocks, bonds, commodities, currencies, or
interest rates.
• In a derivative market, traders can buy and sell derivatives contracts, such as
options, futures, forwards, and swaps, which allow them to speculate on the
movement of the underlying asset or to manage financial risk.
• Derivative markets are typically highly liquid and traded on exchanges or
over-the-counter (OTC) markets, which allow traders to easily buy and sell
derivative contracts. These markets can be volatile and complex, and require
a thorough understanding of the underlying assets and financial instruments.
Traders in derivatives
• Hedger – A hedger is someone who faces risk associated with price
movement of an assets and who uses derivatives as means of reducing
risk.
• Speculator – A trader who enters the future market for pursuit of
profit accepting risk in the endeavor. A speculator is an investor or
trader who seeks to profit from price movements in an asset or market,
without necessarily owning the underlying asset. Speculators take on
higher risk and may make higher returns compared to traditional
investors who aim to buy and hold assets for the long term.
Traders in derivatives cont…
• Arbitrageur - An arbitrageur is an investor or trader who seeks to
profit from price discrepancies in the market by simultaneously
buying and selling the same or similar assets in different markets or at
different prices.
• For example, an arbitrageur may notice that the same stock is trading
at different prices on two different stock exchanges. They may buy the
stock at the lower price on one exchange and simultaneously sell it at
the higher price on the other exchange, earning a profit from the
price difference.
OTC and Exchange Traded Derivatives
• OTC – Over the counter of off exchange trading is to trade financial
instruments such as stock, bonds, commodities or derivatives directly
between two parties without going through an exchange or other
intermediary. The contract between two parties are privately
negotiated. The contract can be tailor- made to the two parties liking.
Over- the - counter markets are uncontrolled, unregulated and have
very few laws. Its more like a free fall.
Exchange-Traded Derivatives
• Exchange Traded Derivatives (ETD) contract are those derivatives
instruments that are traded via specialized derivatives exchange or
other exchanges. A derivatives exchange is a market where individuals
trade standardized contracts That have been defined by the exchange.
The worlds largest derivatives exchange (by number of transaction )
are the korea exchange.
• There is a very visible and transparent market price for the derivatives.
Financial Derivatives
• Financial derivatives are financial instruments that are linked to a
specific financial instrument or indicator or commodity, and through
which specific financial risks can be traded in financial markets in
their own right.
• Derivatives include swaps, futures contracts, options, and forward
contracts. Derivatives refers to financial contracts drawn between two
or more parties on an underlying asset. Typically, underlying assets in
derivatives are securities, currencies, indexes, and commodities.
Types of derivatives
• There are two types of derivatives
1. Commodity Derivatives – the underlying assets is a commodity. It
can be agricultural commodity like wheat, cotton, metals , gold, silver
etc.
2. Financial Derivatives – denotes a variety of financial instruments
like bonds, treasury bills, interest rate, foreign currencies and other
securities. Financial derivatives includes future, forwards, options ,
swaps etc.
Forward contract
• It is a customized contract between two parties to buy or sell an asset
or any product or commodity at a predetermined price at a future date.
It is to be noted that forwards are not traded on any central exchanges,
but over-the-counter and that they are not standardized to be regulated.
Therefore, it is mostly useful for hedging and to minimize risk even
though it doesn't guarantee any kind of profits.
• Over-the-counter Forwards are exposed to counterparty risk as well.
Counterparty risk is a kind of credit risk that the buyer or seller might
not be able to keep his part of the obligation. If the buyer or seller
becomes insolvent and is not able to deliver on his part of the bargain,
the other party may not have any recourse to save his position.
• Forward contracts are ‘buy now, pay later’ products, which enables
you to essentially ‘fix’ an exchange rate at a set date in the future.
• Features-forward contracts are privately traded
• Forward contract, customers as per the requirements of the
counterparties
• There is no margin requirement in forward contract.
• Forward market is not regulated by government.
• E.g.= Farmer agree to sell 100 kg wheat at 40/kg after 3 month.
Later after three month farmer take Rs.4000 and sell 100 kg.
Buyer and seller gave guaranteed price. They are now protected
from price swings in market.
Futures contract
• A future contract is an agreement between two parties to buy or sell an
assets at a certain time in the future at a certain price. Future contract are
special types of forward contract in the sense that the former are
standardized exchange traded contracts.
• E.g.= if someone buys a July crude oil future contract(CL), they are
saying they will buy 1000 barrels of oil from the seller at the price they
pay for the future contract, come the July expiry. The seller is agreeing to
sell the buyer the 1000 barrels of oil at the agreed upon price.
• Features – Traded on a exchange, highly standardized.
• Government regulates future market.
• Single clearinghouse acts as the counterparty for all future. This means
that the clearinghouse is the buyer for every seller and seller for every
buyer. This eliminates the risk of default.
Option
• A derivatives option is a type of financial instrument that gives the
holder the right, but not the obligation, to buy or sell an underlying asset
at a predetermined price (strike price) on or before a specified date
(expiration date).
• An option is a contract which gives the buyer the right, but not
obligation, to buy or sell an underlying assets or instruments at specified
strike price to or on a specified depending on the form of the option.
• Options can be traded on exchanges or over-the-counter (OTC). They
can be complex financial instruments and should be used with caution,
as they can involve significant risk. It's important to have a thorough
understanding of options and their underlying assets before trading them.
Two types of option
• Call option = Gives the buyer the right but not the obligation to buy a given
quantity of the underlying assets, at a given price on or before a given future
date.
• Put option = Gives the buyer the right, but not the obligation to sell a given
quantity of the underlying assets, at a given price on or before a given date.
Other option
I .American
II. European
An American option can be exercised at any time before or on the expiration date,
whereas a European option can only be exercised on the expiration date itself.
This means that an American option provides greater flexibility to the holder as
they can choose to exercise the option when it's most advantageous to them. On
the other hand, European options are generally less expensive than American
options because of their more limited exercise date.
Swaps
• Swaps derivatives are customizable derivative contracts between two
parties to exchange of cash flows. Swaps are based on underlying's
such as commodities, equities, interest rates, currencies etc. Exchange
between fixed cash flow for flotation cash flow.
• They are traded over-the-counter (OTC) primarily between financial
institutions or businesses. The terms of the swaps are negotiated and
customized to the needs of both parties as they are traded over the
counter. They are risky in nature as one party can default on the
payment thus leading to default risk.
Example of swap
• Party A agree 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 payment may be annually,
quarterly, monthly or at any other interval determined by the parties.
Types of swap
• Interest rate swaps
Interest rate swaps are customizable derivative contracts between two
parties to exchange cash flows. The cash flows are dependent on a notional
principal amount agreed by both parties. It basically involves the swapping
of a fixed interest rate with a floating interest rate. Interest rate swaps are
used as a hedge against interest rate risks or to speculate and profit.
• Commodity Swaps
Commodity swaps are customizable derivative contracts between two
parties to exchange floating cash flows that are based on a
commodity’s spot price for fixed cash flows i.e. the predetermined price of
a commodity. It does not involve the exchange of the actual commodity. It
is used as a hedge against commodity price fluctuations.
• Currency Swap
Currency swaps refer to a customizable derivatives contract with
currency quotes as an underlying asset, wherein two parties exchange
liabilities or cash flows. Here the parties involved swap the principal
amount and interest payments denominated in different currencies.
Currency Swaps are used to protect against currency exchange rate
fluctuations
• Debt-Equity Swaps
A debt-equity swap is a customizable derivative contract between two parties
that involves the swapping of equity for debt and vice versa. Debt-equity
swaps are used by a company not only to refinance its debt but also to relocate
its capital structure. For instance, a publicly-traded company
exchanging bonds for stocks.
• Credit Default Swap (CDS)
Credit Default Swap is a customizable derivative contract between two parties
for swapping the risk of debt default. The buyer of a CDS pays a premium for
effectively insuring against a debt default. He receives a lump sum payment if
the debt instrument is defaulted whereas the seller on the other hand receives
monthly payments from the buyer. If the debt instrument defaults they have to
pay the agreed amount to the buyer of the credit default swap. Credit default
swaps were famously used on mortgage backed securities that resulted in the
2008 financial crisis.
Credit derivatives
• Credit derivatives are financial instruments that allow investors to manage
and transfer credit risk. They are contracts between two parties that derive
their value from the creditworthiness of an underlying entity, such as a
company or a sovereign nation. The most common types of credit
derivatives are credit default swaps (CDS), which provide protection against
default by the underlying entity.
• They are used to hedge against potential losses due to the default of a
borrower, such as a company or a sovereign nation.
• For example, a credit default swap (CDS) is a type of credit derivative
where one party pays another party a premium to protect against the risk of
default of a particular borrower, such as a company or a government. If the
borrower defaults, the party that bought the CDS will receive a payout from
the party that sold the CDS.
• A credit derivatives is an instruments designed to separate risk from
credit risk and allows the separate trading of the latter. It is a
instrument with a payoff determined by whether a third party makes a
promised payment on a debt obligation.
• Parties who wish to rid themselves of credit risk can engage in credit
derivatives transaction to pass the credit risk on to another party who
is willing to accept it.
CREDIT SECURITIZATION
Credit Securitization refer to the transformation of liquid, credit
securitization market started in the united state with the Securitization of
mortgage loans in early 1970s.
In the recent years, the market for asset-backed securities (ABS) has
grown explosively.
There are mainly two incentive of ABS transaction by bank.
1) Banks use credit securitization as an alternative funding model to
emitting deposits.
2) 2) For the application of asset-backed securities is that they enable
banks to transfer both market risk and credit risk out of the bank.
• Credit securitization is a financial process in which loans or other
types of debt are pooled together and sold to investors as securities.
The underlying loans are typically mortgages, auto loans, credit card
receivables, or other forms of consumer or business debt.
• The securitization process involves creating a special purpose vehicle
(SPV), which is a separate legal entity that holds the pool of loans or
debt securities. The SPV then issues bonds or other types of securities
backed by the cash flows generated by the underlying debt. These
securities are typically rated by credit rating agencies and sold to
institutional investors such as pension funds, insurance companies,
and hedge funds.
Securitization is the process of pooling and repacking of homogenous
illiquid financial assets into liquid marketable securities that can be sold
in financial market to investor for the blocked capital.

Asset-backed securities (ABS) and mortgage-backed securities(MBS)

are two of the most important types of asset classes within the fixed-
income sector. MBS are created from the pooling of mortgages that are
sold to interested investors, whereas ABS is created from the pooling of
non-mortgage assets. These securities are usually backed by credit card
receivables, home equity loans, student loans, and auto loans. The ABS
market was developed in the 1980s and has become increasingly
important to the U.S. debt market
Benefits of Securitization
• Provide good return
• Less risky
• Low lock in period
• Quick and easy redeem
CREDIT DEFAULT SWAPS
• A swap in which the buyer of the swap makes payment to the swap’s
seller up until the maturity date of a contract.
• A credit default swap is the most common from of credit derivatives
and may involve municipal bonds, emerging market bond, mortgage –
backed securities or corporate bonds.
• A credit default swap is also often referred to as a credit derivatives
contract.
Risk Associated With Derivatives Product
• Derivative products are financial instruments whose value is derived from the value of an
underlying asset, such as a stock, bond, or commodity. While derivatives can be used to manage
risk, they can also be associated with various types of risk themselves, including:
• Market Risk: Derivatives are often used to speculate on the future price movements of
underlying assets. This exposes investors to market risk, which is the risk of loss due to changes
in market conditions, such as interest rates, foreign exchange rates, and commodity prices.
• Counterparty Risk: Derivatives are typically traded over-the-counter (OTC) between two
parties, and there is always a risk that one party may not fulfill its obligations under the
contract. This is known as counterparty risk, and it can lead to losses if the counterparty defaults
or becomes insolvent.
• Liquidity Risk: Some derivatives can be illiquid, meaning that they cannot be easily bought or
sold on the open market. This can create liquidity risk, which is the risk that an investor may not
be able to sell the derivative when they need to, or may have to sell it at a discount to its true
value.
• Operational Risk: Derivative transactions involve complex documentation
and settlement procedures, which can create operational risk, such as errors,
delays, or fraud.
• Legal Risk: Derivatives are subject to complex legal and regulatory
frameworks, and legal disputes can arise over the interpretation of contract
terms or the rights and obligations of the parties involved.
• Basis Risk: Basis risk arises when the price movements of the derivative do
not perfectly match the price movements of the underlying asset, leading to
potential mismatches in hedging positions.
• It is important for investors to understand these risks before investing in
derivatives and to have a clear risk management strategy in place.
Additionally, derivative products should only be used by sophisticated
investors who have a deep understanding of the risks involved and are able
to bear the potential losses.
Forward Rate Agreement (FRA)
• A Forward Rate Agreement (FRA) is a financial contract between two
parties, where one party agrees to pay the other party a fixed interest rate
on a notional amount of money for a specified period of time in the future.
• The FRA is used to hedge against interest rate risks, allowing the parties
to lock in a fixed interest rate for a future date. It is commonly used by
banks, financial institutions, and corporations to manage their interest rate
exposure.
• The notional amount is the amount of money on which the interest rate is
based, and the fixed rate is agreed upon at the time the contract is entered
into. The settlement date is the date on which the payment is made, and
the payment amount is calculated based on the difference between the
fixed rate and the prevailing market rate on that date.