Module 4

Derivatives
Meaning and Types of Derivatives
Derivative is a financial instrument that derives its value from some other financial price
(Underlying Assets). This ‘other financial price’ is called the underlying.
User & Purpose: Derivative serve as a method to hedge and reduce risks.
Users Purpose
 Corporation To hedge currency risk and inventory risk
 Individual Investors For speculation, hedging and yield enhancement.
 Institutional Investor For hedging asset allocation, yield enhancement and to
avail arbitrage opportunities.
 Dealers For hedging position taking, exploiting inefficiencies
and earning dealer spreads.

Example: The most important derivatives are Futures, Options, Forward, Swaps
Forward
A forward contract is an agreement between a buyer and a seller obligating the seller to
deliver a specified asset of specified quality and quantity to the buyer on a specified date
at a specified place and the buyer, in turn, is obligated to pay to the seller a pre-negotiated
price in exchange of the delivery.

Future Contract
A futures contract is an agreement between two parties that commits one party to buy an
underlying financial instrument (bond, stock or currency) or commodity (gold, soybean or
natural gas) and one party to sell a financial instrument or commodity at a specific price at a
future date. The agreement is completed at a specified expiration date by physical delivery or
cash settlement or offset prior to the expiration date. In order to initiate a trade in futures
contracts, the buyer and seller must put up "good faith money" in a margin account.

Option
An option is a contractual agreement that gives the option buyer the right, but not the
obligation, to purchase (in the case of a call option) or to sell (in the case of a put
option) a specified instrument at a specified price(PREMIUM) at any time of the option
buyer’s choosing by or before a fixed date in the future. Upon exercise of the right by
the option holder, an option seller is obliged to deliver the specified instrument at the
specified price.

Currency options
A currency option may be defined as a contract between two parties — a buyer and a
seller — whereby the buyer of the option has the right but not the obligation, to buy or
sell a specified currency at a specified exchange rate, at or before a specified date, from
the seller of the option. While the buyer of an option enjoys a right but not an
obligation, the seller of the option, nevertheless, has an obligation in the event the buyer
 exercises the given right.

There are two types of options:

Call option — gives the buyer the right to buy a specified currency at a specified
exchange rate, at or before a specified date.
Put option — gives the buyer the right to sell a specified currency at a specified
exchange rate, at or before a specified date

Kinds of Financial Derivative

On the Basis of Underlying Asset
1. Equity Derivatives – Derived from stocks or stock indices.
o Examples: Stock futures, stock options, index futures, index options.
o Used to hedge or speculate on stock price movements.
2. Currency Derivatives – Derived from foreign currencies.
o Examples: Currency forwards, currency futures, currency options.
o Used to hedge foreign exchange risk or speculate on exchange rate
movements.
3. Interest Rate Derivatives – Derived from interest-bearing assets.
o Examples: Interest rate swaps, interest rate futures, interest rate options.
o Used to hedge interest rate risk.
4. Commodity Derivatives – Derived from physical commodities.
o Examples: Gold, silver, oil, agricultural commodity futures and options.
o Used by producers, traders, and investors to hedge price volatility in
commodities.
5. Credit Derivatives – Derived from credit risk of a borrower.
o Example: Credit Default Swaps (CDS).
o Used to transfer credit risk without transferring the underlying asset.

Major players in derivatives markets

Hedgers
A hedger holds a position in the cash market and is worried about fall in the value of
his portfolio. He would take an opposite position in the futures market to protect against
fall in value of his portfolio. Against his view if the market rises, his portfolio value
increases to compensate for fall in futures value.
Speculators
Speculators as such make guess about the movement of stock prices. They undertake
buy or sell transactions in the cash/future markets accordingly. Speculators accept the
risk passed on by a hedger, in anticipation of making a profit. Speculators provide
depth and liquidity to the futures market and in their absence the price protection
sought by the hedger would be very costly.
Arbitrageurs
Arbitrageurs try to identify deviations in futures prices from their fair (theoretical)
values in order to obtain a risk-free rate of return. Though deviations persist, arbitrage
is not free, nor is it perfectly risks less. Arbitrage involves transaction costs, brokerage
costs, bid-ask spreads between the purchase and sales price and most importantly,
impact cost.

Three Categories of International Bonds

There are three general categories for international bonds: domestic, euro, and foreign. The
categories are based on the country (domicile) of the issuer, the country of the investor, and
the currencies used.

 Domestic bonds: Issued, underwritten and then traded with the currency and
regulations of the borrower’s country.
 Eurobonds: Underwritten by an international company using domestic currency and
then traded outside of the country’s domestic market.
 Foreign bonds: Issued in a domestic country by a foreign company, using the
regulations and currency of the domestic country.

For example:

 Domestic bonds: A British company issues debt in the United Kingdom with the
principal and interest payments based or denominated in British pounds.
 Eurobonds: A British company issues debt in the United States with the principal and
interest payments denominated in pounds.
 Foreign bonds: A British company issues debt in the United States with the principal
and interest payments denominated in dollars.
Dollar-denominated Bonds

Dollar-denominated bonds are issued in US dollars and offer investors more choices to
increase diversity. The two types of dollar-denominated bonds are Eurodollar bonds and
Yankee Bond. The difference between the two bonds is that Eurodollar bonds are traded
outside of the domestic market while Yankee bonds are issued and traded in the U.S.

1. Eurodollar bonds

Eurodollar bonds are the largest component of the Eurobond market. A Eurodollar bond must
be denominated in U.S. dollars and written by an international company. Since Eurodollar
bonds are not registered with the SEC, they can not be sold to the U.S. public. However, they
can be traded on the secondary market.

Even though many portfolios do include Eurodollar bonds in U.S. portfolios, U.S. investors
do not participate in the primary market for such bonds. Therefore, the primary market is
dominated by foreign investors.
2. Yankee bonds

Yankee bonds are another type of dollar-denominated bonds. However, unlike the Eurodollar
bonds, the Yankee bonds’ target market is within the U.S. These bonds are issued by a
foreign company or country that has registered with the Securities and Exchange Commission
(SEC). Since Yankee bonds are meant to be purchased by U.S. citizens in the primary
market, they must follow regulations set by the SEC. For example, the company issuing the
bond needs to be financially stable and capable of making payments throughout the period of
the bond.

Non-dollar-denominated Bonds

Non-dollar-denominated international bonds are all the issues denominated in currencies

other than the dollar. Since there is currency volatility, U.S. investors face the question of
whether to hedge their currency exposure.

The different types of non-dollar-denominated bonds depend on the domicile of the issuer
and the location of the primary trading market. The three major types are the domestic
market, the foreign market, and the Euro market.

1. Domestic market

The domestic market includes bonds that are issued by a borrower in their home country
using that country’s currency. Domestic markets have seen significant growth for several
reasons. First of all, for companies, issuing debt in the domestic currency allows them to
better match liabilities with assets. By doing so, they also don’t need to worry about the
currency exchange risk.

Also, by issuing debt in dollar-denominated markets and the domestic market, companies
gain access to more investors. It allows them to obtain a better borrowing rate.

2. Foreign market

The foreign bond market includes the bonds that are sold in a country, using that country’s
currency, but issued by a non-domestic borrower. For example, the Yankee bond market is
the U.S. dollar version of this market. This is because they are sold in the U.S. using the
dollar, but issued by a syndicate outside of the U.S.

Other examples include the Samurai market and the Bulldog market. The Samurai market is
Yen-denominated bonds issued in Japan but by non-Japanese borrowers. The Bulldog market
is pound-denominated bonds issued in the U.K. by non-Brtish groups.
3. Euro market

Securities that are issued into the international market are called Eurobonds. This market
encompasses all the bonds that are not issued in a domestic market and can be issued in any
currency. Eurodollar bonds are an example of a U.S. dollar-denominated version of a
Eurobond as they are sold in the international markets.

Most of the time, the bonds are written by an international syndicate and sold in several
different national markets simultaneously. Issuers of Eurobonds include international
corporations, supranational companies, and countries.

1. In finance, it is the market for eurocurrencies: these are all currencies that are held
as deposits by companies or individuals outside of their country of issue.
2. In commerce, it refers to the single market of the European Union (EU) in which
goods and services are freely traded between member countries, and which have a
common trade policy with non-EU countries.

Euromarkets
A euromarket can be used to describe the financial market for eurocurrencies. A
eurocurrency is any currency held or traded outside its country of issue. For example,
a eurodollar is a dollar deposit held or traded outside the U.S. A key incentive for the
development, and continued existence of such a market is that it is free from the regulatory
environment (and sometimes political or other country-specific risks) of the "home" country.

The "euro-" prefix in the term arose because originally such currencies were held in Europe,
but that is no longer solely the case, and a eurocurrency can now be held anywhere in the
world that local banking regulations permit. The eurocurrency market is a major source of
finance for international trade because of ease of convertibility and the absence of domestic
restrictions on trading.

FDI Flow:

Foreign Direct Investment (FDI) flows record the value of cross-border transactions related to
direct investment during a given period of time, usually a quarter or a year. Financial flows
consist of equity transactions, reinvestment of earnings, and intercompany debt transactions.