Lecture 13 & 14 – Financing Risk: Using Derivates

1. What Are Derivatives?

• A derivative is a financial instrument that depends on the value of an underlying real or

financial asset.

• Key ideas:

✓ It’s not about owning the asset itself.

✓ It’s about owning the right, the obligation, or the bet based on the asset's future value.

• Examples of Underlying Assets:

✓ Stocks: Tesla, Apple

✓ Bonds: Malaysian Government Securities (MGS)
✓ Commodities: Crude oil, palm oil
✓ Currencies: USD/MYR exchange rate
✓ Interest Rates: Federal Reserve base rates
✓ Indices: S&P 500, FTSE Bursa Malaysia

• Scenario example: Imagine you are a bank that gives home loans (mortgages) to customers.

Problem:
Interest rate swap

✓ You lend money today at a fixed interest rate (say 5% per year).
✓ But if interest rates go up in the future, you are stuck earning only 5%, while the cost of
getting money (your funding cost) could rise to 6% or 7%.
✓ This would hurt the bank’s profits.

Solution:

✓ You buy an interest rate swap (a type of derivative).

✓ In the swap:
o You agree to pay a floating interest rate (which moves with the market, like
KLIBOR – Kuala Lumpur Interbank Offer Rate).
o You receive a fixed interest rate (say 5%).

✅ Now, if interest rates rise, the floating payments you make increase, but you also receive
higher payments from your swap partner.

✅ This helps to offset your losses from the original mortgage contracts.

➡️ The interest rate swap is a derivative — its value depends on market interest rates!
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2. Purpose of Derivatives

Purpose Description Example

Protect against price risks.

For example, if you're worried that the

price of oil might go up, you could
Airlines hedge fuel prices using oil
Hedging "hedge" by locking in a fixed price for oil
futures.
now, even though you'll pay for it later.
This way, if the price goes up, you're
protected because you’ve already secured
a lower price.
Speculation is when you make an
investment or take a financial risk hoping
to make a profit from changes in price,
but without any guarantee. It's like
Trader bets gold price will rise
Speculation betting that something (like a stock,
using futures
commodity, or currency) will go up or
down in value, and if you're right, you
make money. If you're wrong, you lose
money. Bet on price movement to profit
Arbitrage is when you take advantage of
price differences for the same thing in
different markets. You buy something at
Buy currency cheap in London, sell
Arbitrage a lower price in one place and sell it at a
it high in NY
higher price in another, making a profit
from the difference. Exploit price
differences between markets
Portfolio management is the process of
choosing and managing a collection of
EPF, Khazanah, PNB
investments (like stocks, bonds, and
Portfolio Pension fund uses swaps to
other assets) to achieve specific financial
Management manage bond risks
goals. It involves deciding where to put
your money and how to balance risk and
reward. Adjust risk-return profile

Real Life Example (Speculation vs Hedging):

• A wheat farmer uses forward contracts to lock in a sale price for wheat = Hedging.
• A trader buys oil futures hoping oil prices will go up = Speculation.
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3. Major Types of Derivatives

3.1. Forward Contracts

• Customized, private contract.

• Agreement to buy or sell an asset at a specific price on a future date.

• No standardization, no exchange — greater counterparty risk.

• A simple example of a forward contract is:

Let’s say a farmer grows wheat, and a bakery needs wheat in 3 months. The farmer and
the bakery agree today that in 3 months, the farmer will sell the bakery 1000 bushels of
wheat for $10 per bushel, regardless of what the market price of wheat is in 3 months.

✓ Why? The farmer locks in the price today, ensuring they know how much they'll get
for their wheat.
✓ Why? The bakery locks in the price to avoid paying more if wheat prices rise in 3
months.

In 3 months, if the market price of wheat has gone up to $12 per bushel, the bakery still
buys it at the agreed-upon price of $10 per bushel. If the price goes down to $8 per bushel,
the farmer still gets $10 per bushel.

3.2. Futures Contracts

• Standardized versions of forward contracts. OTC - Over the counter - Transacted in a proper
medium like Bursa Malaysia
• Traded on an organized exchange like CME, NYMEX.

• Daily settlement (called mark-to-market) to manage risks.

• Key Features:
✓ Margin requirements (initial and maintenance).
✓ Highly liquid.
✓ Lower default risk.

• Example:

Imagine you're an investor who believes the price of gold will go up in 3 months. You buy
a futures contract that agrees to buy 100 ounces of gold at $1,800 per ounce in 3 months,
no matter what the market price is at that time.

✓ Why? You hope that in 3 months, gold will be worth more than $1,800 per ounce, and
you'll make a profit by buying it at the lower price.
✓ Why? The seller of the futures contract hopes the price of gold will go down, so they
can sell it to you at the agreed-upon price and make a profit.

In 3 months:

✓ If the price of gold goes up to $2,000 per ounce, you can still buy it at $1,800 per ounce
and make a profit.
 ✓ If the price drops to $1,600 per ounce, you're stuck buying it at $1,800 per ounce, and
you lose money.

3.3. Option Contracts

• Right but NOT obligation to buy (call) or sell (put) an asset at a specified price before
expiry.

• Buyer pays a premium for this privilege.

• Types of Options:
✓ Call Option: Right to buy
✓ Put Option: Right to sell

• Example:
Imagine you're thinking about buying a stock, but you're not sure if the price will go up or
down. So, you buy a call option for a stock that gives you the right (but not the obligation)
to buy 100 shares of that stock at $50 per share within the next month, for a price of $5 per
share.

✓ Why? You think the stock price might go up, and you want the option to buy it at $50
per share if it does.
✓ Why? You only pay the $5 per share for the option itself, not for the stock. If the stock
price doesn't go up, you can just let the option expire and lose only the $5 per share
you paid for the option.

In 3 weeks, if the stock price goes up to $60 per share, you can buy it for $50 per share
(because of your option) and sell it at $60 per share, making a profit.

But if the stock price drops to $40 per share, you won't use your option to buy at $50,
because it's cheaper in the market. You'll just let the option expire and lose the $5 per share
you paid.

• Advantages: Limited risk (loss is only the premium).

• Disadvantages: Time decay (value falls closer to expiry if price does not move).

3.4. Swaps

• Agreements to exchange cash flows based on different financial variables.

• Most common swaps:

✓ Interest Rate Swaps: Exchange fixed vs floating rate payments.
✓ Currency Swaps: Exchange principal and interest payments in different currencies.
✓ Credit Default Swaps: Insurance-like protection against borrower default.

• Example:
Imagine two companies, Company A and Company B, that want to exchange financial
benefits to reduce their costs.

✓ Company A has a loan with a fixed interest rate of 5%, and they think interest rates
will drop.
 ✓ Company B has a loan with a variable interest rate that changes based on the market,
and they think interest rates will rise.

They agree to swap their interest payments:

✓ Company A agrees to pay Company B a variable interest rate based on the market
(let’s say 3%).
✓ Company B agrees to pay Company A a fixed interest rate of 5%.

Now, if interest rates go up, Company A benefits because they’re paying a lower rate (the 3%
variable) compared to their original 5% fixed rate. If interest rates go down, Company B
benefits, as they are paying a fixed 5% rate instead of the lower variable rate.

3.5. Differences: Minimising the losses - financial risk

Spesific
Forward Futures
Feature Swap Option
Contract Contract
Right (but not
Standardized Agreement to
Agreement to obligation) to
agreement to exchange cash
buy/sell an asset buy/sell an
Definition buy/sell an asset flows or
at a set price in asset at a set
at a set price in financial
the future. price in the
the future. benefits.
future.
Directly KLSM / KLSE Traded directly Traded on
between parties Traded on between parties exchanges or
Traded On
(not on an exchanges. (not on an over-the-
exchange). OTC exchange). counter.
Standardized
or
Highly Standardized Highly
Customization customizable,
customizable. terms. customizable.
depending on
the type.
Both parties are The buyer has
Both parties are Both parties are
obligated to the right, but
Obligation to obligated to obligated to
exchange the not the
Execute fulfill the fulfill the
agreed cash obligation, to
contract. contract.
flows. execute.
Exercised
Settled at the Settled daily Cash flows
anytime before
Settlement contract’s (marked to exchanged at
or on
expiration date. market). agreed intervals.
expiration date.

A farmer agrees An investor Two companies A person buys

to sell wheat to a agrees to buy swap interest the right to
Example bakery at a fixed gold at $1,800 payments (fixed purchase stock
price in 3 per ounce in 3 vs. variable at $50 per share
months. months. rates). within a month.

Limited risk
Counterparty Market risk Counterparty
(only the
Risk risk (if the other (prices can risk (if the other
premium paid
party defaults). change daily). party defaults).
for the option).
Risk from failures of Inlfation risk

others
 Typically used
Typically used Used for
Typically used to manage
to hedge against speculation or
Purpose for speculation financial risk
price hedging price
or hedging. (e.g., interest
fluctuations. movements.
rate risk).

Bursa Malaysia

4. Derivatives Markets
Financial institutions, Maybank, Public Bank, Hong Leong

Type Features Examples

Exchange-Traded Transparent, standardized, regulated Futures, Options
OTC (Over-the-Counter) Customized, flexible, riskier Swaps, Forwards

Important:
During the 2008 financial crisis, most toxic derivatives (Credit Default Swaps) were traded OTC,
where there was no transparency or regulation.

Example: 2008 Financial Crisis

Step-by-step:
1. Banks offered subprime mortgages to risky borrowers (low income, poor credit).
2. They packaged these loans into Mortgage-Backed Securities (MBS).
3. Investors trusted these MBS (rated AAA by rating agencies).
4. Banks and insurers like AIG sold Credit Default Swaps (CDS) to "insure" these MBS.
5. When homeowners defaulted, MBS lost value rapidly.
6. CDS sellers (like AIG) couldn’t pay the insurance claims.
7. Banks collapsed, government bailouts followed.

You do not want to earn any profit or loss in a transaction - BE you inflow and outflow

5. Hedging Strategies Using Derivatives

Small, spesific Big, general

Feature Microhedging Macrohedging

Targets specific, individual Targets overall portfolio or large
Scope
transactions or assets. exposures.
Hedging small, precise risks, Hedging broad, systemic risks that
Focus often related to a single asset or affect multiple assets or the entire
transaction. portfolio.
Hedging a specific purchase of Hedging the risk of currency
Example 1,000 barrels of oil in the next fluctuations affecting an entire set of
month. international contracts.
To protect against risks tied to To protect against large-scale market
Purpose
specific, small transactions. risks or price movements.
Futures, options, or forwards for Futures, options, swaps, or other
Instruments Used
specific transactions. instruments for large, aggregated risks.
Risk
Focused on hedging individual, Focused on hedging broad, long-term
Management
short-term exposures. market risks.
Approach
Typically simpler as it deals with More complex as it involves broader,
Complexity
single exposures. systemic risk management.
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6. Functions and Benefits of Derivatives

Function Benefit Example

Risk Transfer unwanted risks to willing
Airline hedges oil price risk
Management parties
Reveal future expectations of Futures prices hint at future crude oil
Price Discovery
prices prices
Lower Costs Cheaper to hedge than spot trading Hedging interest rate risk via swaps
Easy entry/exit even in huge Institutions buying/selling bond
Liquidity
amounts futures
Banks create bespoke interest rate
Flexibility Create custom risk profiles
swaps

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7. Risks and Misuse of Derivatives
Speculative group

i. Leverage Risk: Small movements in the underlying asset can lead to massive gains or
devastating losses.

ii. Complexity Risk: Some derivatives (like exotic options, multi-legged swaps) are extremely
complicated, even for experienced managers.

iii. Moral Hazard: If companies think they are insured against losses via derivatives, they might
behave recklessly.

iv. Market Risk: Unexpected events (e.g., COVID-19 pandemic) can make hedging strategies fail
miserably. War, human rights

Extra Reading - Home Purchase Derivative

Suppose:
• You buy a condo in Kuala Lumpur for RM500,000 today.
• You're worried that Malaysia’s property market might crash within 2 years.
• You buy a real estate derivative contract (similar to a Put Option).

Contract details:
• Strike price: RM500,000
• Expiry: 2 years
• Premium paid: RM10,000

Outcomes:
• If house price falls to RM450,000, you exercise the option and get paid RM50,000 (your loss
is fully covered).
• If house price rises to RM550,000, you let the option expire and happily enjoy your property
gains (loss = RM10,000 premium only).

Lesson:
• Derivatives let you secure the future value of your property.
• Protects against downward market risks.