DERIVATIVE MARKET
WHAT IS DERIVATIVE MARKET ???
A DERIVATIVE IS A CONTRACT BETWEEN TWO OR MORE PARTIES WHOSE VALUE IS BASED ON AN AGREED-UPON UNDERLYING FINANCIAL ASSET (LIKE A
SECURITY) OR SET OF ASSETS (LIKE AN INDEX).
DERIVATIVES ARE FINANCIAL CONTRACTS WHOSE VALUES ARE DERIVED FROM THE VALUES OF UNDERLYING ASSETS. THEY ARE WIDELY USED TO SPECULATE ON FUTURE EXPECTATIONS OR TO REDUCE A SECURITY PORTFOLIO’S RISK.
DERIVATIVE MARKET
Introduction to Derivative Forward and Futures
Various aspects of forwards
Pricing of forward contracts
Financial Derivatives
Options Options SWAPSWAP
INTEREST RATE FUTURES CONTRACTS
AN INTEREST RATE FUTURES CONTRACT LOCKS IN THE PRICE TO BE PAID FOR A SPECIFIED DEBT INSTRUMENT. SPECULATORS WHO EXPECT INTEREST RATES TO DECLINE CAN PURCHASE INTEREST RATE FUTURES CONTRACTS, BECAUSE THE MARKET VALUE OF THE UNDERLYING DEBT INSTRUMENT SHOULD RISE.
SPECULATORS WHO EXPECT INTEREST RATES TO RISE CAN SELL INTEREST RATE FUTURES CONTRACTS, BECAUSE THE MARKET VALUE OF THE UNDERLYING DEBT INSTRUMENT SHOULD DECREASE.
• VALUING INTEREST RATE FUTURES.
• SPECULATING IN INTEREST RATE FUTURES.
• HEDGING WITH INTEREST RATE FUTURES.
RISK OF TRADING FUTURES CONTRACTS
• MARKET RISK
• BASIS RISK
• LIQUIDITY RISK
• CREDIT RISK
• PREPAYMENT RISK
• OPERATIONAL RISK
FORWARD CONTRACT
• A FORWARD CONTRACT IS A CUSTOMIZABLE DERIVATIVE CONTRACT
BETWEEN TWO PARTIES TO BUY OR SELL AN ASSET AT A SPECIFIED PRICE ON A FUTURE DATE.
• FORWARD CONTRACTS CAN BE TAILORED TO A SPECIFIC COMMODITY, AMOUNT AND DELIVERY DATE.
EXAMPLE:
• SUPPOSE, AN AGRICULTURAL PRODUCER HAS TWO MILLION BUSHELS OF CORN TO SELL SIX MONTHS FROM NOW AND IS CONCERNED ABOUT A POTENTIAL DECLINE IN THE PRICE OF CORN. IT THUS ENTERS INTO A FORWARD CONTRACT WITH ITS FINANCIAL INSTITUTION TO SELL TWO MILLION BUSHELS OF CORN AT A PRICE OF $4.30 PER BUSHEL IN SIX MONTHS, WITH SETTLEMENT ON A CASH BASIS.
SPOT VS. FORWARD FOREIGN EXCHANGE TRADING
A FORWARD EXCHANGE CONTRACT IS AN AGREEMENT UNDER WHICH A BUSINESS AGREES TO BUY A CERTAIN AMOUNT OF FOREIGN CURRENCY ON A SPECIFIC FUTURE DATE. THE
PURCHASE IS MADE AT A PREDETERMINED EXCHANGE RATE.
SPOT FOREIGN EXCHANGE
THE SPOT RATE REPRESENTS THE PRICE THAT A BUYER EXPECTS TO PAY FOR FOREIGN CURRENCY IN ANOTHER CURRENCY. THESE CONTRACTS ARE TYPICALLY USED FOR
IMMEDIATE REQUIREMENTS, SUCH AS PROPERTY PURCHASES AND DEPOSITS, DEPOSITS ON CARDS, ETC.
FORWARD FOREIGN EXCHANGE
A FORWARD FOREIGN EXCHANGE IS A CONTRACT TO PURCHASE OR SELL A SET AMOUNT OF A FOREIGN CURRENCY AT A SPECIFIED PRICE FOR SETTLEMENT AT A PREDETERMINED
FUTURE DATE (CLOSED FORWARD) OR WITHIN A RANGE OF DATES IN THE FUTURE (OPEN FORWARD). CONTRACTS CAN BE USED TO LOCK IN A CURRENCY RATE IN ANTICIPATION OF ITS INCREASE AT SOME POINT IN THE FUTURE. THE CONTRACT IS BINDING FOR BOTH
PARTIES.
CURRENCY SWAP CONTRACT
1. Company A is a US-based company that is planning to expand its operations in Europe.
Company A requires €850,000 to finance its European expansion.
2. Company B is a German company that operates in the United States. Company B wants to acquire a company in the United States to diversify its business. The acquisition deal requires US$1 million in financing.
3. borrowing in foreign currencies is costly due to high interest rates, Company A and Company B will prefer to borrow in their domestic currencies (that can be borrowed at a lower interest rate) and enter into the currency swap agreement with each other.
4. The currency swap between Company A and Company B can be designed in the following manner. Company A obtains a credit line of $1 million from Bank A with a fixed interest rate of 3.5%. At the same time, Company B borrows
€850,000 from Bank B with the floating interest rate of 6-month LIBOR. Then, the companies create a swap agreement with each other.
5. Company A must pay Company B the floating interest payments denominated in euros while Company B will pay Company A the fixed interest payments in US dollars. On the maturity date,
OPTIONS
• CALL OPTIONS ARE SECURITIES THAT ALLOW A PERSON TO BUY A STOCK AT A SPECIFIED PRICE, KNOWN AS THE EXERCISE (OR STRIKE) PRICE, ON OR
BEFORE A CERTAIN DATE, KNOWN AS THE EXPIRATION DATE.
• PUT OPTIONS ARE SIMILAR TO CALL OPTIONS EXCEPT THAT THEY GIVE THE
BUYER THE RIGHT TO SELL STOCK AT A SPECIFIC PRICE INSTEAD OF BUYING
IT.
Hedging
A hedge is an investment to reduce the risk of adverse price movements in an asset.
Normally, a hedge consists of taking an offsetting position in a related security.
Examples of hedging strategies:
1. Diversification :
The adage that goes “don’t put all your eggs in one basket” never gets old, and it actually makes sense even in finance. Diversification is when an investor puts his finances into investments that don’t move in a uniform direction. Simply put, it is investing in a variety of assets that are not related to each other so that if one of these declines, the others may rise.
For example, a businessman buys stocks from a hotel, a private hospital, and a chain of malls. If the tourism industry where the hotel operates is impacted by a negative event, the other investments won’t be affected because they are not related.
2. Arbitrage :
The arbitrage strategy is very simple yet very clever. It involves buying a product and selling it immediately in another market for a higher price; thus, making small but steady profits. The strategy is most commonly used in the stock market.
Let’s take a very simple example of a junior high school student buying a pair of Asics shoes from the outlet store that is near his home for only $45 and selling it to his schoolmate for $70. The schoolmate is happy to find a much cheaper price compared to the department store which sells it for $110.
