Introduction

Existence of Derivatives

A. Introduction
1. Derivative instruments are relatively new instruments. 2. Interest rate futures, is hardly 30 years old. 3. But derivatives turned out to be very popular. 4. The volume of trading in several derivative contracts outpaced the trading volume of the underlying assets.

5. Derivative instruments have been blamed for having precipitated several financial scandals as resulting in spectacular losses. 6. Derivatives reducing risks and flexible but improperly used will cause serious problems. 7. Some take huge speculative positions, almost all of which were irrational.

B. What are Derivative Instruments?

1. A derivative instrument has little value in and of itself. Its value is entirely dependent on the value of its underlying asset. 2. Derivative market transactions allow for future transactions at prices determined today.

3. The analysis and pricing of derivative instruments can be complicated and highly quantitative. 4. There is a broad spectrum of derivative instruments, many names and highly specialized purposed.

C. Common Derivative Instruments

1. Forwards, Futures, Options and Swaps are probably derivative instruments. 2. Forward Contract: A contract between two parties agreeing to carrying out a transaction at a future date but at a price determined today.

3. Futures Contract: a. A futures contract can be simply defined as a standardized and exchange traded form of forward contract. b. A futures contract represents a formal agreement between two parties. c. The futures are standardized and exchange traded.

4. Option Contract: a. A option contract provides the holder, the right but not the obligation to buy or sell the underlying asset at a predetermined price. b. While a Call option provides the right to buy, a Put oprion would provide the right to sell.

5. Swap Contract: a. A swap can be defined as a transaction in which two parties simultaneously exchange cash-flows based on a notional amount of the underlying asset. b. The rate at which the amount or an amounts are exchanged is predetermined based on either a fixed amount or an amount to be based on a reference measure.

D. Evoluation of Derivative Instruments

1. Derivative instruments evolved as a result of product innovation. Innovation which was in response to increase complex needs. 2. New and better financial products were needed to manage changed needs. 3. The requirement that every newly evolved product must provide increased benefits over existing products.

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4. Forward Contracts: a. Forwards were the simplest and traditional derivatives. b. Two parties undertake to complete a transaction at a future date but a price determined today. c. The two parties could be a producer who promise to supply and a consumer who needs the product at a future date.

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d. Both parties here are faced with risk, essentially price risk. e. The parties have eliminated price risk by locking their price or cost. f. Problems of Forward contract: i. Multiple Coincidence ii. Price Setting iii. Counterparty Risk

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5. Needs of Futures Contracts a. A futures contract is standardized forward contract standardized in contract size, maturity, product quality, place of delivery. b. With standardization, it was possible to trade them on an exchange to increases liquidity and reduces transaction costs.

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c. The problem of multiple coincidence of wants is overcome. d. Unfair price may exist in Forward contract but not exist in Futures. e. The exchange mininizes the potential default risk by means of the margining process and by daily marking to market.

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3. Needs of Options a. Inadequacies that stimulated searching for further product innovation: i. Being locked-in means that one could not benefit from subsequent favourable price movements. ii. Option protests you from unfavourable price movements while take advantage of favourable price movements.

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b. Options advantages: i. provide the best of both worlds: downward protection and upside protection. ii. Options are extremely flexible and can combined in various ways to achieve different objectives or cash flows. iii. complicated business risk situations that cannot be handled with forwards or futures but easily handled with options. c. Following the adventure of options, Financial Engineering revolves around thee designing of risk management solutions to complex risks.
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E. Main Players in Derivative Markets

1. Hedgers a. Hedgers would obviously be major players. b. Hedgers use derivative markets to manage or reduce risk. c. They are typically businesses that use derivatives to offset exposures resulting from their business activities.

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2. Arbitrageurs a. Arbitrage is the process of trying to take advantage of price differentials between markets. b. Arbitrageurs closely follow quoted prices of the same asset or instruments in different markets looking for pricing divergences. c. Should the divergence in prices be enough to make profits, they would buy in the market with the lower price and sell in the market where the quoted price is higher.
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3. Speculators a. They take positions in assets or market without taking offsetting positions. If they expect a certain asset to fall in value, they would short (sell) the asset. b. Should the price increase instead, they would make losses on their short position. Speculators therefore expose themselves to risk and hope to profit from taking on risk.

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F. Commodity vs. Financial Derivatives

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G. Types of Risks
1. Market & Price Risk 2. Inflation Risk 3. Interest Rate Risk 4. Default & Credit Risk 5. Liquidity Risk 6. Currency & Exchange Rate Risk 7. Political Risk

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