Derivatives-brief summary

Derivatives are the financial instruments whose value is determined by the value and characteristics of one or more underlying assets.

E.G.> stock index futures and options are known as derivative products because they derive their existence from actual market indices, but have no intrinsic characteristics of their own.

Now let’s discuss what financial instruments are:

• Financial instruments are basically cash, evidence of an ownership interest in an entity, or a contractual right to receive, or deliver, cash or another financial instrument.

They are of two types:

a) Cash instruments: are basically those whose value can be directly determined by markets, such as securities, loans and deposits.

b) Derivative instruments: are those whose values are derived by the value of its underlying assets.

Uses of Derivatives:

1) Transfers the risk by taking opposite position or reduces the risk of one party. E.g. >a wheat farmer and a wheat miller could enter into a futures contract to exchange cash for wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the wheat miller, the availability of wheat.

· Future/Forward contract gives the holder the right and obligation to buy or sell certain commodities at a certain period in future for a specified price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price.

Only difference b/w future and forward contract is that future contracts are traded through exchange derivatives and forward contracts through OTC.

· Option contract gives the holder the right but not the obligation.

i. Call option: The right to buy a certain security at a strike price at some time in future.

ii. Put option: The right to sell.

2) They lead to greater market volatility as huge amounts of securities can be controlled by relatively small amounts of margin or option premiums.

3) Also derivatives can be transacted off-balance sheet.

Types of derivatives:

• OTC (Over the Counter) Derivatives: Are contract which are traded directly between two parties. E.g.>Forwards
• Exchange traded Derivatives: Are contracts that are traded via intermediaries or specialized derivatives and they take initial margin from both the sides. E.g.>Futures

Common Derivative contracts:

• Forward/Future contracts.
• Options: Call and Put
• Swaps: an agreement between two parties to exchange future cash flow streams or returns called legs using prearranged formulae. Various types of swaps are: interest rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps.
1. Interest Rate Swaps: It is exchange of fixed rate on loan for floating rate to gain the comparative advantages. Can range for 2 to 15 yrs.
2. Currency Swaps: involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency.

Credit Derivatives: are derivatives whose value is derived from the credit risk of the underlying asset, bond or securities. Or in other words it’s a bilateral contract b/w buyer and seller under which the seller sells protection against the credit risk of the reference entity.

Types:

• Funded Credit Derivatives: wherein initial payment is done by the protection seller which is used to settle credit events. The advantage of this to the protection buyer is that it is not exposed to the credit risk of the protection seller.

• Unfunded Credit Derivatives: bilateral contract wherein both the parties are responsible for making its payments under the contract (i.e. payments of premiums and any cash or physical settlement amount) itself without recourse to other assets

1. Credit Default Swaps (CDS) is a contract between buyer or fixed rate payer to pay periodic amounts to the seller or floating rate payer in exchange for the right to settle the payoff in case of any default or credit events to the third party or reference entity. In case a credit event occurs the contracts settle usually by physical settlement i.e. by delivery by the buyer to the seller of the debt obligation or by cash settlement i.e. by paying the difference of market and par value of debt obligation to the seller by the buyer.
2. Total Return Swaps (TRS) is a financial contract which transfers both the credit as well as market risk of the underlying assets. It allows one party to derive the benefit of owning an asset without showing off in balance sheet and other party to gain protection for loss on asset.

o Credit risk is the risk due to debtor’s non payment of loan amounts.

oMarket risk is due to up and downs of rate of investments in market.

LIBOR (London Inter bank Offered Rate): is a reference rate based on interest rates on which banks offer to lend unsecured fund to other banks in London wholesale money market.

Money Market is a financial market which deals in short term borrowings and lending.

LIBID (London Inter Bank Bid Rate): is a rate at which banks are prepared to accept deposit.