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DERIVATIVES AND RISK MANAGEMENT

What are derivatives? Give examples.
Derivatives are a kind of risk management instrument. A derivative is a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Security contract (regulation) act 1956 [SC(R)A] defines derivative to include 1. A security derived from a debt instrument, share, loan (secured/unsecured), risk instrument or contract for differences or any other form of security 2. A contract which derives its value from prices, or index of prices, of underlying securities Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Derivatives are contracts and can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region. Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes. For example, a European investor purchasing shares of an American company off of an American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros. Many forms of financial derivatives instruments exist in the financial markets. Among them, the three most fundamental financial derivatives instruments are: forward contracts, futures, and options.

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EXCHANGE RATE DERIVATIVES:

Distinguish between futures, forward and options.....

Forward Contract Future agreement that obliges the buyer and seller Depending on the transaction and the requirements of the contracting parties. Depending on the transaction Futures Future agreement that obliges the buyer and seller Standardized Options Future agreement where the seller is obliged, but the buyer has an "option" but not an obligation Standardized

Contract Size

Expiry Date

Standardized

Standardized. American style options can be exercised at any time. European style options can only be exercised at expiry. Quoted and traded on the Exchange The buyer pays a premium to the seller. The seller deposits an initial guarantee (margin) with subsequent deposits made depending on the market. The underlying asset can be used as guarantee. Options Exchange. Operation can be quit prior to expiry. Profit or loss can be realized at any time. Clearing House When a long position is exercised it may be settled by delivery or cash settled. A long position which is out-of-the-money is usually cancelled prior to expiry.

Transaction method Guarantees

Negotiated directly by the Quoted and traded on the Exchange buyer and seller None. It is very difficult to undo the operation; profits and losses are cash settled at expiry. Both parties must deposit an initial guarantee (margin). The value of the operation is marked to market rates with daily settlement of profits and losses.

Secondary Market Institutional Guarantee Settlement

None. It is difficult to quit Futures Exchange. Operation can be the operation; profit or quit prior to expiry. Profit or loss can loss at expiry. be realized at any time. The contracting parties Cash settled. Clearing House Contracts are usually closed prior to expiry by taking a compensating position. At expiry contracts can be cash settled or settled by delivery of the underlying.

Distinguish between forward contract and futures contract: Fundamentally, forward and futures contracts have the same function: both types of contracts allow people to buy or sell a specific type of asset at a specific time at a given price. However, it is in the specific details that these contracts differ. First of all, futures contracts are exchange-traded and, therefore, are standardized contracts. Forward contracts, on the other hand, are private agreements between two parties and are not as rigid in their stated terms and conditions. Because forward contracts are private agreements, there is always a chance that a party may default on its side of the agreement. Futures contracts have clearing houses that guarantee the transactions, which drastically lowers the probability of default to almost never. Secondly, the specific details concerning settlement and delivery are quite distinct. For forward contracts, settlement of the contract occurs at the end of the contract. Futures contracts are marked-to-market daily, which means that daily changes are settled day by day until the end of the contract. Furthermore, settlement for futures contracts can occur over a range of dates. Forward contracts, on the other hand, only possess one settlement date.

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Lastly, because futures contracts are quite frequently employed by speculators, who bet on the direction in which an asset's price will move, they are usually closed out prior to maturity and delivery usually never happens. On the other hand, forward contracts are mostly used by hedgers that want to eliminate the volatility of an asset's price, and delivery of the asset or cash settlement will usually take place.

Distinguish between options and futures: The main fundamental difference between options and futures lies in the obligations they put on their buyers and sellers. An option gives the buyer the right, but not the obligation to buy (or sell) a certain asset at a specific price at any time during the life of the contract. A futures contract gives the buyer the obligation to purchase a specific asset, and the seller to sell and deliver that asset at a specific future date, unless the holder's position is closed prior to expiration. Aside from commissions, an investor can enter into a futures contract with no upfront cost whereas buying an options position does require the payment of a premium. Compared to the absence of upfont costs of futures, the option premium can be seen as the fee paid for the privilege of not being obligated to buy the underlying in the event of an adverse shift in prices. The premium is the maximum that a purchaser of an option can lose. Another key difference between options and futures is the size of the underlying position. Generally, the underlying position is much larger for futures contracts, and the obligation to buy or sell this certain amount at a given price makes futures more risky for the inexperienced investor. The final major difference between these two financial instruments is the way the gains are received by the parties. The gain on a option can be realized in the following three ways: exercising the option when it is deep in the money, going to the market and taking the opposite position, or waiting until expiry and collecting the difference between the asset price and the strike price. In contrast, gains on futures positions are automatically 'marked to market' daily, meaning the change in the value of the positions is attributed to the futures accounts of the parties at the end of every trading day - but a futures contract holder can realize gains also by going to the market and taking the opposite position.

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