M A H Sazzad

S Shikder*

Derivative Markets
A Generalist’s Approach to Deerivative Contract

A derivative contract is a delayed ed delivery agreement whose value depends on or o is derived from
the value of a another, underlyin ing transaction. The underlying transaction may y be
b from a market
for immediate delivery (spot orr ccash market) or from another derivative market ket. A key point of
the definition is that delivery off tthe underlying is delayed until sometime in thee future.
f Economic
conditions will not remain static ic over time; changing economic conditions can make m the delayed
delivery contract more or less vavaluable to the initial contract counterparties. Bec
ecause the contract
obligations do not become real al until a future date, derivative contract positio
tions are unfunded
today, are carried off the balance ce sheet, and the financial requirements for initia
tiating a derivative
contract are just sufficient for a fu
future performance guarantee of counterparty obligations.
ob

Derivatives markets

Perhaps the major developmentt in financial markets over the past thirty-five years ye has been the
establishment and growth of fi financial derivatives markets. Derivatives contr ntracts promise to
deliver underlying products at so some time in the future or give the right to buy or sell them in the
future. For example, a contractt m may promise the delivery of a specified quantit tity of US dollars.
The derivative contract can thenn bbe traded in a different market from that in whic
hich the underlying
product is itself traded (in thee ccase of a derivative contract in US dollars, this th would be the
foreign exchange market). Mark rkets in which underlying products are traded (such(s as the forex
market) are often referred to as cash markets to distinguish them from deri rivatives markets.
Although cash and derivatives m markets are separate, the derivatives markets are ar linked to cash
markets through the possibility ty that a delivery of the underlying product mightmi be required.
Consider the following example. le. A has some form of derivative contract that req equires him to take
delivery of a specified quantity oof US dollars, say $18,000, in one month’s timee at a fixed rate of
exchange -he is currently long in US dollars. A hopes that the value of the dolla llar will rise so that
as soon as he receives the dollar ars, he can sell them on the spot market at a prof
rofit. With the spot
exchange rate at £1 = $1.80, thee ccontract is worth £10,000. If the dollar does star
tart rising in value,
in line with A’s expectations, clelearly the value of A’s contract rises above £10,00
,000 (it would now
cost more than £10,000 to buyy $$18,000 on the spot market). In fact, the pricin cing of derivatives
contracts is very complex and w we shall have little to say about it here.* Noneth
etheless, it is clear
that there is a close relationshipp between the prices of derivatives contracts and d the prices of the
underlying assets they represent,
nt, and that the value of a derivative, and hence its it price, varies as
the price in the cash market flucuctuates. We should also add that, in practice, derivatives
de seldom
lead to the exchange of the unde derlying product. Instead, contracts are closed out o or allowed to
lapse before the delivery date arrrrives. Derivatives, then, are instruments that allo
llow market agents
to gamble on movements in thee pprices of other instruments without being requir ired to trade in the
instruments themselves. There aare three major types of financial derivatives – futures, options
and swaps – and myriad variation ions upon them. Exchange-traded derivatives (futu utures and options,
which are traded through financ ncial futures exchanges) are dealt with here. They
Th are not OTC
business. Contracts differ from th those in forward foreign exchange in the form of operation of the
market, the terms of the contract,
ct, and the likelihood of their leading to deliveryy of
o the underlying

*
Lecturer in Finan
ance; DBA; IIUC; Web: www.mahiiuc.weebly.co
com
 M A H Sazzad
S Shikder*

product. A crucial difference is that a derivatives contract is a tradable instrum

rument and can be
sold on to a third party. Swaps,, w
which are quite different in nature and operation
ion, are considered
in Chapter 10. Although derivat atives trading based upon commodities (agricult ultural products or
minerals) has existed for well ov
over a century, the need for financial derivatives markets was not
recognized until the early 1970s.
0s. Their development resulted from the globalizaization of business,
the increased volatility of forereign exchange rates, and increasing and fluc uctuating rates of
inflation.

Financial futures
Legally binding agreements to de deliver, or take delivery of, a commodity or a fina
inancial instrument
at some specified future date.. The most common products underlying futur tures contracts are
foreign currencies (exchange ra rates), interest rates on notional amounts of capital,
ca and stock
exchange indices. The futures cocontracts are themselves tradable – that is, they can
ca be bought and
sold in futures markets. To incre
crease their tradability, futures contracts are stand
ndardized in terms
of both time period and amount. t. They specify the quantity and quality of the und
nderlying product,
the agreed price and the date off ddelivery.

Options
Options that give the right to bu
buy a given amount of a financial instrument orr commodity
c at an
agreed price within a specifiedd ttime but, like all options, do not oblige investo
stors to do so. An
option gives the right to buy orr ssell a given amount of a financial instrument orr commodity at an
agreed price (known as the exercercise price or strike price) within a specified time,
tim but does not
oblige investors to do so. Justst as with futures, options contracts are drawn n up between two
counterparties, the purchaser and the writer (seller) of the option, and are reg egistered with and
traded through a financial futures
res exchange. Options contracts are offered both on o cash securities
(short- and long-term interest rat
rates, exchange rates, equities of individual comp
mpanies, and stock
exchange indices) and on futu tures contracts. For options on cash securities es (premium paid
options), the buyer pays the ful ull price or premium of the option at the time of purchase. For
options on futures contracts (preremium margined options), buyers and sellers are a margined and
marked to market in the same waay as with futures themselves.

Exchange-traded versus OTC

Exchange-traded derivatives have

ave three principal advantages over OTC derivativtives:
• The existence of the clea
learing house guarantees all contracts and virtualally eliminates the
default risk present in OOTC trades; thus, exchange-based derivatives are ar lower in price
than OTC derivatives sin ince there will almost always be some residuall risk
r for a bank in
writing an OTC contract ct even though it will attempt to minimize its risks
ris by arranging
offsetting contracts withh other customers/banks and/or by taking a posit
sition in exchange-
traded derivatives.
• Markets for exchange-ba based derivatives are more liquid than bilaterall OTC
O trades since
there are many traders dea
dealing in each futures contract.
• Exchange-based futuress and options are highly tradable because they y are standardized
whereas OTC options, be being non-standard and redeemable only at thee bankb where they
were bought, have a low ow resale value. Against these, we must set the th fact that OTC

*
Lecturer in Finan
ance; DBA; IIUC; Web: www.mahiiuc.weebly.co
com
 M A H Sazzad
S Shikder*

options are designed to mmeet the specific requirements of each customer

er in terms of size,
strike price and expiry.

Forward versus futures contra

racts

We have seen that forward forexex contracts are OTC contracts and so are not trada
adable in organised
markets. On the other hand, they
ey benefit from the additional flexibility of OTC contracts
c in terms
of both the period and the amou ount of the contract. Forward contracts are avai ailable on a much
wider range of currencies than aare exchangetraded futures and options since futures
fu exchanges
are only willing to offer derivati
atives contracts that are likely to be popular with
th both buyers and
sellers. As with OTC derivatives,
es, specially arranged forward forex contracts invo
volving unpopular
currencies are bound to be relati
atively expensive because of the extra risk thatt the
th market-maker
(the bank) has to accept. This iss m
made greater by the fact that the spot markets in
n these currencies
are likely to be thin and hence the
their exchange rates more volatile a small number er of large deals in
the same direction might shift th the exchange rate by a considerable amount. There
Th may also be
important cash-flow differences es between forward forex contracts and futures. s. Net profits on a
futures hedge are accrued on a dadaily basis whereas the net profits on a forward hedge
h are realised
only on the date of delivery of the currency.

Forward and futures contracts

ts versus options

Forward and futures contracts lo lock in an investor to a given exchange rate. Thus,
T the contract
provides a hedge if the exchange ge rate moves in the direction that would have produced
pr a loss in
the underlying cash market, butt aalso reduces the profit that would have resulted d in
i the underlying
market from a movement of th the spot exchange rate in the opposite directio tion. Consider the
following example. A British fi firm importing goods from the US in June 200 006 has to make a
payment of $1 million before th the end of September and faces the risk that the dollar will rise
against sterling, increasing the st
sterling cost of the transaction to the firm. The spot
sp exchange rate
is £1 = $1.85, but if that were to fall to £1 = $1.80 the goods would cost thee firm f a little more
than £20,000 extra. This couldd oobviously seriously affect the company’s profit fit margin when it
sold the goods in Britain. Conse sequently, it chooses to buy a September sterlinging future with the
Chicago Metal Exchange at a pr price of £1 = $1.8680. If sterling falls to £1 = $1.80,
$1 the value of
the futures contract will rise. Thu
hus the company loses on its payment for the im mported goods but
is able to offset this by reversin
ing its futures contract and making a profit. How owever, if sterling
strengthens, rising say to £1 = $1
$1.90, the firm gains on its import of goods (they
ey now cost less in
sterling) but loses on the futureres contract because it loses value as sterling rises.
ri That is, the
hedge removes both the risk off loss and the possibility of profit. On the other er hand, an option
allows most of any potential pro rofit to be taken. If the US dollar rose, the optio
ion would become
out-of-the-money but would simp mply be abandoned by the firm with the loss only ly of the premium.
Whether a trader chooses futures es or options depends on what she thinks is likelyly to happen to the
price of the underlying productt anand on her attitude towards risk.

• A trader who has a longg pposition in the underlying market and who is convinced
co that the
price of the instrument in question is not going to fall may choose not to hedge at all and
remain in an open positio
ion. That is, she will accept the risk of an exchang
nge rate change.

*
Lecturer in Finan
ance; DBA; IIUC; Web: www.mahiiuc.weebly.co
com
 M A H Sazzad
S Shikder*

• A trader who is confidentent that the price will fall may (a) sell the product
ct before the price
falls; (b) take an offsetti
etting short position by selling futures contracts cts; or (c) sell the
currency forwards. Thiss eeliminates entirely her exposure to the price fall.
ll.
• A trader who is uncertai tain in which direction the price will move may ay choose options.
Even then, if she thinkss tthat the price is more likely to fall than to rise,
e, financial futures
are preferable to optionss because they are likely to offer her cheaper protection.
pro Options
are preferable if the trade
der has no view or thinks that the price is more likely
li to rise than
fall.

The use and abuse of derivative ives

Derivatives, then, allow firms to hedge against erratic price and interest rate movements
m while
also attracting speculators becauause of their high gearing. These two aspects of the market have
led to conflicting attitudes regard
rding their overall contribution to financial marke
kets. Supporters of
derivatives markets argue that the
they perform a number of important roles. They are ar said to:
• facilitate the hedging of risk through sophisticated risk management, t, and
a by so doing
reduce the cost of protecti
ction against risk;
• be quicker to respond too nnew information than the cash markets, allowin ing people who do
not participate in derivativ
tives trading to forecast more accurately future cash
ca market prices
and thus to make better co consumption, pricing and investment decisions – this is the ‘price
discovery’ role of derivatatives;
• assist in the standardisatiation of commodity or financial instrument cont ntracts in the cash
markets because derivativtives contracts are highly standardised themselveses;
• contribute to the integra gration of global capital markets, hence impro roving the global
allocation of savings andd fostering higher investment levels;
• help to combat the adve verse effects of volatile commodity prices on the th economies of
developing countries bec ecause forward prices tend to be less volatilee thant spot prices,
giving commodity produ ducers an opportunity to reduce the volatility of theprice of their
output through hedging;
• facilitate speculation, pproviding liquid markets and enabling hed edgers to protect
themselves from risk in th the most efficient way possible.

Doubts have been expressed ab about the price discovery role since it assume mes that financial
markets are efficient – that is, th
that prices in these markets change immediately to reflect all new
information coming to the mark arket and that market agents are able to interp rpret correctly the
implications of this informationn for future developments. However, the main doubts d expressed
about the benefits of derivativeses have centred on the role of speculation and the difficulties that
the increasing complexity of de derivatives products have caused for regulators. rs. Support for the
attack on derivatives trading hasas come from problems in markets as a whole and an from examples
of spectacular losses by individu
idual companies and banks. For example, derivat atives trading was
widely held to be partly to blame
me for a major stock market crash in 1987. The argument
ar was that
stock market traders were pess ssimistic and expected a fall in the price off stocks
s when the
exchanges opened after a weeke ekend. Large orders to sell arrived at brokerage ge houses prior to
opening and, as the market starterted falling, many traders automatically sold futu tures in the shares
of the major corporations. This ddestabilised stock markets and contributed to thehe
panic selling of stocks and sha hares. This view of the crash led to a generall concern that the
derivatives markets might contrib
tribute to the volatility of the cash market. The derivatives
der markets

*
Lecturer in Finan
ance; DBA; IIUC; Web: www.mahiiuc.weebly.co
com
 M A H Sazzad
S Shikder*

strenuously deny this, but worrie

ries have been expressed at a high level. Towards ds the end of April
1994 finance ministers from thehe Group of 10 (G10) lea ding industrial countri tries agreed on the
need to strengthen co-operationon in gathering statistics and assessing the imp plications for the
world financial system of the inn
nnovative segments of financial markets. There was w also a call for
improved disclosure requiremen ents and sufficient capital adequacy standardss among financial
institutions to underpin their ris
risky activities. Capital adequacy requirements ts under the Basel
were modified to try to take the rrisks of derivatives trading into account. They became
be part of the
Capital Adequacy Directive, whi hich came into force in the European Union from m the beginning of
1996. Certainly there is some eevidence that Wall Street equity prices have been b affected by
heavy activity in stock index cocontracts, especially around expiry dates, and thereth is a possible
theoretical argument to supportrt the view that derivatives trading makes the cash cas markets more
volatile and nervy. The argument
ent is that in the past, when people thought pricess in a market were
becoming too high, they wouldd eexpress their bearish feelings by leaving the maarket. This would
exert downward pressure on pric rices and help to stabilise them. Now, however, er, they stay in the
market but protect themselves ag against risk by using the derivatives markets. No sale is made in
the cash markets and bearish op opinion loses its restraining influence on prices es. Thus, although
spreading risks through derivativ
tives reduces risks for the individual, it increasess risk
r
for the system as a whole (system
emic risk). This provides big profit opportunitiess for
f the uninsured
speculators but increases risks oof bankruptcies. Individual company losses thr hrough derivatives
have become almost routine in re recent years. The most spectacular was the collap lapse of the British
merchant bank Barings in 1995. 5. This was a case where it became clear that the management of
the bank did not know whatt w was being done in their name and almost certainly c did not
understand the complexities of dederivatives trading and the extent of the associateted risks.

Uses and functions of derivativives

Generally derivatives are used as risk management tools. Here is the brief descrip
ription of their
uses and functions.

Uses of derivatives
Derivatives are supposed to prov
ovide the following services:

Risk aversion tools: One of thee m most important services provided by the derivat atives is to
control, avoid, shift and managee eefficiently different types of risks through vario
ious strategies like
hedging, arbitraging, spreading,, eetc. Derivatives assist the holders to shift or mod
odify suitably the
risk characteristics of their portfo
tfolios. These are specifically useful in highly vola
olatile financial
market conditions like erratic trad
rading, highly flexible interest rates, volatile excha
change rates and
monetary chaos.

Prediction of future prices: Dererivatives serve as barometers of the future trendsds in prices which
result in the discovery of new pri
rices both on the spot and futures markets. Furtheher, they help in
disseminating different informati
ation regarding the futures markets trading of vari rious commodities
and securities to the society whic
ich enable to discover or form suitable or correctct or true
equilibrium prices in the markets
ts. As a result, they assist in appropriate and supe
perior allocation of
resources in the society.

*
Lecturer in Finan
ance; DBA; IIUC; Web: www.mahiiuc.weebly.co
com
 M A H Sazzad
S Shikder*

Enhance liquidity: As we see th that in derivatives trading no immediate full amou

ount of the
transaction is required since most
ost of them are based on margin trading. As a resusult, large number
of traders, speculators arbitrageur
eurs operate in such markets. So, derivatives tradin
ding enhance
liquidity and reduce transactionn ccosts in the markets for underlying assets.
Assist investors: The derivativeses assist the investors, traders and managers of large
lar pools of
funds to devise such strategies so that they may make proper asset allocation incr
ncrease their yields
and achieve other investment goa oals.

Integration of price structure:: It has been observed from the derivatives tradin ing in the market
that the derivatives have smoothe
then out price fluctuations, squeeze the price sprea
ead, integrate
price structure at different points
ts of time and remove gluts and shortages in the markets.
m

Catalyse growth of financial m markets: The derivatives trading encourage the competitive
co
trading in the markets, differentt rrisk taking preference of the market operators like
lik speculators,
hedgers, traders, arbitrageurs, etc
tc. resulting in increase in trading volume in thee country.
c They
also attract young investors, profe
ofessionals and other experts who will act as cataltalysts to the
growth of financial markets.

Brings perfection in market: La Lastly, it is observed that derivatives trading deve velop the market
towards ‘complete markets’. Com omplete market concept refers to that situation wh here no particular
investors can be better off than ot
others, or patterns of returns of all additional secu
curities are
spanned by the already existingg ssecurities in it, or there is no further scope of add
dditional
security.

Functions of derivatives markekets

The following functions are perfo
rformed by derivative markets:

Discovery of price: Prices in ann organised derivatives market reflect the percept ption of market
participants about the future andd lead the prices of underlying assets to the percei
ceived future level.
The prices of derivatives convergrge with the prices of the underlying at the expira
iration of the
derivative contract. Thus derivati
atives help in discovery of future as well as curren
ent prices.

Risk transfer: The derivatives mmarket helps to transfer risks from those who hav
ave them but may
not like them to those who havee aan appetite for them.

Linked to cash markets: Deriva vatives, due to their inherent nature, are linked to the underlying
cash markets. With the introducti
ction of derivatives, the underlying market witnes esses higher
trading volumes because of partic
rticipation by more players who would not otherw rwise participate
for lack of an arrangement to tran
ransfer risk.

Check on speculation: Speculat lation traders shift to a more controlled environmeent of the
derivatives market. In the absenc
nce of an organized derivatives market, speculator
tors trade in the
underlying cash markets. Managi ging, monitoring and surveillance of the activities
ies of various
participants become extremely didifficult in these kind of mixed markets.

*
Lecturer in Finan
ance; DBA; IIUC; Web: www.mahiiuc.weebly.co
com
 M A H Sazzad
S Shikder*

Encourages entrepreneurship: p: An important incidental benefit that flows fromm derivatives

trading is that it acts as a catalyst
st for new entrepreneurial activity. Derivatives have
ha a history of
attracting many bright, creative,, w well-educated people with an entrepreneurial attitude.
att They
often energize others to create ne new businesses, new products and new employmeent opportunities,
the benefit of which are immense se.

Increases savings and investmeents: Derivatives markets help increase savingss and a investment
in the long run. The transfer of ri
risk enables market participants to expand their volume
v of
activity.

*
Lecturer in Finan
ance; DBA; IIUC; Web: www.mahiiuc.weebly.co
com
 M A H Sazzad
S Shikder*

*
Lecturer in Finan
ance; DBA; IIUC; Web: www.mahiiuc.weebly.co
com
 M A H Sazzad
S Shikder*

*
Lecturer in Finan
ance; DBA; IIUC; Web: www.mahiiuc.weebly.co
com
 M A H Sazzad
S Shikder*

*
Lecturer in Finan
ance; DBA; IIUC; Web: www.mahiiuc.weebly.co
com
 M A H Sazzad
S Shikder*

*
Lecturer in Finan
ance; DBA; IIUC; Web: www.mahiiuc.weebly.co
com
 M A H Sazzad
S Shikder*

*
Lecturer in Finan
ance; DBA; IIUC; Web: www.mahiiuc.weebly.co
com