Unit 8: Derivative Instruments

By: Pitambar Shrestha

Meaning and Concept of Derivatives Product

A derivative is an instrument whose value depends on the

values of other more basic underlying assets (variables).

The underlying variables could be stock prices, exchange

rate, and interest rate.

A derivative is a security with a price that is dependent

upon or derived from one or more underlying assets.

The derivative itself is a contract between two or more

parties based upon the asset or assets. Its value is
determined by fluctuations in the underlying asset.
Meaning and Concept of Derivatives Product

Derivative instruments are a tool whose price is derived from underlying

exposure such as currency, commodities, shares bonds, or any of the
indices and use to reduce or neutralized risk in exposure on the
underlying contracts. Derivatives help to hedge against the uncertain
movements in the prices of underlying contracts.

A derivative is a contract between two parties which derives its

value/price from an underlying asset.

The most common types of derivatives are futures, options, forwards and
swaps. It is a financial instrument which derives its value/price from the
underlying assets.

The value of the underlying asset is bound to change as the value of the
underlying assets keep changing continuously. Generally stocks, bonds,
currency, commodities and interest rates form the underlying asset.
Features of Derivatives

 Two parties
 Traded on exchange
 Expiration date
 Exercise price
 Right and obligation
 No compulsory physical trading of underlying assets
 All transactions in derivatives take place in future specific date
 Hedging Device-Reduces risk
 Derivatives has low transaction cost
 Derivatives are often leveraged, such that a small movement in
the underlying value can cause a large difference in the value of
the derivative.
Most Common Type of Derivatives

1) Option: An option is a contract which gives the buyer (the

owner or holder of the option) the right, but not the obligation,
to buy or sell an underlying asset or instrument at a
specific strike price on a specified date, depending on the form
of the option.

The strike price may be set by reference to the spot

price (market price) of the underlying security or commodity on
the day an option is taken out, or it may be fixed at
a discount in a premium.

The seller has the corresponding obligation to fulfill the

transaction to sell or buy, if the buyer (owner) "exercises" the
option. An option can be categorized in to call and put option.
Most Common Type of Derivatives

Types of Option

Call option: A call option is an option which provides the right to buy a
specified number of assets at a pre-determined exercise price within or
at the specified time period.

If price of share is expected to increase in future then it is beneficial to

purchase call option because call option provides the right to buy the
stock at pre determined exercise price whatever be the price of asset in
future.

If price of stock decreases then the buyer of the option will lose only the
premium paid for it, which is maximum profit for the seller or writer of
the option.
Most Common Type of Derivatives

Types of Option

Call option: A call option is an option which provides the right to buy a
specified number of assets at a pre-determined exercise price within or
at the specified time period.

If price of share is expected to increase in future then it is beneficial to

purchase call option because call option provides the right to buy the
stock at pre determined exercise price whatever be the price of asset in
future.

If price of stock decreases then the buyer of the option will lose only the
premium paid for it, which is maximum profit for the seller or writer of
the option.
Most Common Type of Derivatives

Put option: A put option is an option which provides the right to sell a specified
number of assets at a pre-determined exercise of price within or at the specified
time period.

If price of share is expected to decrease in future then it is beneficial to purchase the

put option because put option provides the right to sell the stock at pre determined
exercise price whatever be the price of stock in future.

The purchase price of the option is called the premium. If price of stock goes above
the exercise price then the buyer of the option will lose only the premium paid for it,
which is maximum profit for the seller or writer of the option because buyer of option
will sell the share in market price i.e. they ignore the put to exercise.

Put or call option can also be categorized in to American and European option. European
option can be exercised only at expiration date but American option can be exercised
within the expiration date.
Most Common Type of Derivatives

The Value of Options

The worth of a particular options contract to a buyer or seller is measured by its
likelihood to meet their expectations. In the language of options, that's
determined by whether or not the option is, or is likely to be, in-the-
money or out-of-the-money at expiration.

A call option is in-the-money if the current market value of the underlying stock is
above the exercise price of the option. The call option is out-of-the-money if the
stock is below the exercise price.

A put option is in-the-money if the current market value of the underlying stock is
below the exercise price. A put option is out-of-the-money if its underlying price
is above the exercise price. If an option is not in-the-money at expiration, the
option is assumed worthless.

If the strike price equal to the current market price, the option is said to be at-
the-money option.
Most Common Type of Derivatives

An option's premium can have two parts: an intrinsic value and a time value. Intrinsic
value is the amount that the option is in-the-money. Time value is the difference
between the intrinsic value and the premium. In general, the longer time that market
conditions work to your benefit, the greater the time value.

Equity Call Option
In-the-money = strike price less than stock price
At-the-money = strike price same as stock price
Out-of-the-money = strike price greater than stock price
Equity Put Option
In-the-money = strike price greater than stock price
At-the-money = strike price same as stock price
Out-of-the-money = strike price less than stock price
Option Premium
Intrinsic Value + Time Value
Most Common Type of Derivatives

2) Forward Contract: A forward contract is a customized contract between two parties to

buy or sell an asset at a specified price on a future date.

A forward contract can be used for hedging or speculation, although its non-
standardized nature makes it particularly for hedging. Unlike standard futures contracts,
a forward contract can be customized to any commodity, amount and delivery date.

A forward contract settlement can occur on a cash or delivery basis. Forward contracts do
not trade on a centralized exchange and are therefore regarded as over-the-counter
(OTC) instruments.

While their OTC nature makes it easier to customize terms, the lack of a centralized
clearinghouse also gives rise to a higher degree of default risk. As a result, forward
contracts are not as easily available to the retail investor as futures contracts.
Most Common Type of Derivatives

3) Future Contract: A futures contract is a legal agreement, generally made on

the trading floor of a futures exchange, to buy or sell a
particular commodity or financial instrument at a predetermined price at a
specified time in the future.

Futures contracts are standardized to facilitate trading on a futures

exchange and, depending on the underlying asset being traded, detail the
quality and quantity of the commodity.

Some futures contracts may call for physical delivery of the asset, while others
are settled in cash. The terms "futures contract" and "futures" refer to essentially
the same thing
Most Common Type of Derivatives

4) Swaps: A swap is a derivative contract through which two parties exchange

financial instruments. These instruments can be almost anything, but most swaps
involve cash flows based on a notional principal amount that both parties agree
to.

Swap refers to an exchange of one financial instrument for another between the
parties concerned. This exchange takes place at a predetermined time, as
specified in the contract.

Swaps are not exchange oriented and are traded over the counter, usually the
dealing are oriented through banks. Swaps can be used to hedge risk of various
kinds which includes interest rate risk and currency risk. Currency swaps and
interest rates swaps are the two most common kinds of swaps traded in the
market.
Most Common Type of Derivatives

Interest Rate Swap: An interest rate swap is a contractual agreement between

two counterparties to exchange cash flows on particular dates in the future.
There are two types of legs (or series of cash flows).

A fixed rate payer makes a series of fixed payments and at the outset of the
swap, these cash flows are known.

A floating rate payer makes a series of payments that depend on the future
level of interest and at the outset of the swap; most or all of these cash flows are
not known.

An interest rate swap can either be fixed for floating (the most common), or
floating for floating (often referred to as a basis swap).
Most Common Type of Derivatives

Foreign-Exchange (FX) Swaps/Currency swap: An FX

swap is where one leg's cash flows are paid in one
currency, while the other leg's cash flows are paid in
another currency. An FX swap can be either fixed for
floating, floating for floating, or fixed for fixed. In order
to price an FX swap, first each leg is present valued in its
currency (using the appropriate curve for the currency).
Credit Derivative

A credit derivative consists of privately held negotiable bilateral contracts that allow users to
manage their exposure to credit risk.

Credit derivatives are financial assets such as forward contracts, swaps and options for which the
price is driven by the credit risk of economic agents, such as private investors or governments.

For example, a bank concerned that one of its customers may not be able to repay a loan can
protect itself against loss by transferring the credit risk to another party while keeping the loan on its
books.

Credit derivatives are fundamentally divided into two categories: funded credit derivatives and
unfunded credit derivatives.
An unfunded credit derivative is a bilateral contract between two counterparties, where each party
is responsible for making its payments under the contract (i.e., payments of premiums and any cash or
physical settlement amount) itself without recourse to other assets.

A funded credit derivative involves the protection seller (the party that assumes the credit risk)
making an initial payment that is used to settle any potential credit events. (The protection buyer,
however, still may be exposed to the credit risk of the protection seller itself. This is known as
counterparty risk.)
Securitization
Securitization is the process of taking an illiquid asset, or group of assets, and through financial
engineering, transforming them into a security. A typical example of securitization is a mortgage-
backed security (MBS), which is a type of asset-backed security that is secured by a collection of
mortgages.

Securitization is the process through which an issuer creates a financial instrument by combining other
financial assets and then marketing different tiers of the repackaged instruments to investors, and this
process can encompass any type of financial asset and promotes liquidity in the marketplace.

Mortgage-backed securities are a perfect example of securitization. By combining mortgages into

one large pool, the issuer can divide the large pool into smaller pieces based on each individual
mortgage's inherent risk of default and then sell those smaller pieces to investors.

In securitization, the company holding the loans, also known as the originator, gathers the data on the
assets it would like to remove from its associated balance sheets. These assets are then grouped
together by factors such as time remaining on the loan, the level of risk, the amount of remaining
principle, and others.
Risk Associated with Derivative Product
The primary risks associated with trading derivatives are market, counterparty, liquidity
and interconnection risks. Derivatives are investment instruments that consist of a contract
between parties whose value derive from and depend on the value of an
underlying financial asset.

Market Risk: Market risk refers to the general risk in any investment. Investors make
decisions and take positions based on assumptions, technical analysis or other factors that
lead them to certain conclusions about how an investment is likely to perform. An
important part of investment analysis is determining the probability of an investment
being profitable and assessing the risk/reward ratio of potential losses against potential
gains.

Counterparty Risk: Counterparty risk, or counterparty credit risk, arises if one of the
parties involved in a derivatives trade, such as the buyer, seller or dealer, defaults on the
contract. This risk is higher in over-the-counter, or OTC, markets, which are much less
regulated than ordinary trading exchanges.
Risk Associated with Derivative Product
Liquidity Risk: Liquidity risk applies to investors who plan to close
out a derivative trade prior to maturity. Such investors need to
consider if it is difficult to close out the trade or if existing bid-ask
spreads are so large as to represent a significant cost.

Interconnection Risk: Interconnection risk refers to how the

interconnections between various derivative instruments and dealers
might affect an investor's particular derivative trade.

Some analysts express concern over the possibility that problems

with just one party in the derivatives market, such as a major bank
that acts as a dealer, might lead to a chain reaction or snowball
effect that threatens the stability of financial markets overall.
The End