“Uses of Financial derivatives in financial markets with the better man of financial institutions and other’s” 1

Abstract

--------“To day is fine but what will be in t-o-m-o-r-r-

o-w?”
Risk is always staying beside business. Business will not be stop due to
risk. Some business has more or some has low risk. Business people either
can averse the risk or can take the risk. Some risks are unavoidable;
which will obligate the businessman to let the business. Again, some
business has opportunities to enjoy profit through elimination of risk. S/he
is successful businessman who can conquer the risk.

It is widely recommended that “Prevention is better than cure”. It is true

that, there has different mechanism or tools and techniques for analysis of
risk such as sensitivity analysis, duration, standard deviation or beta
calculation. But for the prevention of risk or reducing risk, few tools and
techniques are necessary for business people or corporation or
institutions. And, yes, derivatives are a mechanism for prevention of risk
and enjoy profit from assumption.

Commodities are homogeneous raw materials traded in large volumes

everyday. To protect themselves against the risk of adverse price
fluctuations in these commodities, business people have developed
financial instruments called commodity future contracts. Then the use of
commodity future contracts has turned into financial market as financial
future contract or financial derivatives through the utilization of interest
rate, stock index and currency.

The aim of this paper is to explain the overall knowledge about financial
derivatives. It has tried to focus the process trading future contracts
through different examples and illustrations; those have collected from
various secondary sources. Moreover, it also covers the purposes of
futures contracts. Finally, the discussion will clarify the uses derivatives
security for the better man of financial institutions, firms and individuals in
perspective of developing and developed countries.

Keywords: Forward Contracts, Future Contracts, Call options, Put options,

Speculation, and Hedging.

Md. Jahangir Alam, Lecturer in Finance, Asian University of Bangladesh,

Uttar, Dhaka.
Monir Ahammad, Lecturer in Finance, Asian University of Bangladesh,
Uttar, Dhaka.
“Uses of Financial derivatives in financial markets with the better man of financial institutions and other’s” 2

1. Introduction:
----------------------------------------------“The future is not what it used to
be” ---- Paul Valery1. Business peoples or financial institutions are
not certain for next day’s situation. They are uncertain regarding
their loss or risk. This uncertainty move forward a business man to
protect his/her losses and for reducing risk occurring in every day
transaction.

“I dipt into the future far as human eye could see, saw the vision of
the world all the wonder that would be”------- Alfred Lord Jennyson
(1842)2.

The Term Derivatives evolved from such feelings or risk of local and
international businessmen. This word often conjures up vision of
speculative dealings, a big boom and a big crash. Bad news spread
fast and brings collapse of business. But this notion is not true. Used
carefully, Derivative transaction helps cover risks which would arise
on the trading of securities on which the derivatives is based.

Literally, Derivatives means to get a thing (product or financial

instruments) from other things. Such as, Sugar is derived from
sugarcane through few processes. Financial Derivatives
(Derivatives Security) are financial contracts that derive their value
from some underlying asset (bank, stock or currency). For example –
Bank “X” agrees to purchase of $1million Treasury bill (T- bill) at $95
each from Bank “Y” maturity 3 months. If the spot rate after 90 days
is $95.50, Bank X will derive the value of $ 500,000 (0.50 x
1,000,000) from contract.

Most common financial derivatives are debt securities such as;

Treasury bills, Treasury notes, Treasury bonds and corporate bond
which are referred as “Interest rate futures”. There are also financial
futures contracts on stock index such as Dow Jones Industrial
Average (DJIA), S &P 500 index, Mini S&P 500 index which are
referred as “Stock index futures” and currency future markets.3

The purposes of derivative securities are Speculation (i.e. with

the objectives of earnings profit through assumption or prediction
from future situation) and Hedging (i.e. minimizing risk from
business transactions through long or short position).

2. Features of different Financial Derivatives:

Transaction in derivative market takes place either through a
currency futures (forward contracts and future contracts) or
currency option. For example – A farmer may wish to enter a

1
Sources: International Finance, Chapter – Forward exchange, Maurice D. Levi (3rd Edition)
2
Multinational Financial Management, Currency Futures and Option Markets, Alan C. Shapiro, 6th Edition.
3
Financial Institutions and Markets, Chapter- Financial future market, Jeff, Madura (6th edition)
“Uses of Financial derivatives in financial markets with the better man of financial institutions and other’s” 3

contract to sell his harvested crops sometime in future to eliminate

the ever prevailing risk of price fluctuations. They can enter into
either a forward contract or a future contract. The prices on the
derivative market are driven by the spot market price of underlying
assets (in the case of spot price of future in the commodity market).

In the above example, if investors in stock market enter into a

contract to sell their stock sometime in future to eliminate the ever
prevailing risk of price fluctuation will be treated as financial future
market.

2.1 Forward Contract versus Future Contract:

2.1.1. Forward Contract: A forward contract is an agreement
between a corporation and a commercial bank to exchange a
specified amount of asset (viz-currency, stock and others) at a
specified price on a specified date in the future.
When Financial Institution or Multinational Corporations (MNCs)
anticipate future need or future receipt of a foreign currency, they
can set up forward contracts to lock in the exchange rate.
Forward contracts are often valued at $1 million or more, and are
not normally used by consumers or small firms. As with the case of
spot rates, there is a bid (buying price of bank) and ask (selling
price of bank) spread on forward rates.
4
Illustration – A bank may set up a contract with one firm agreeing
to sell the firm Singapore dollar 90 days from now at
$.510/Singapore dollar. This represent the ask rate. At the same
time, the firm may agree to purchase (bid) Singapore dollars 90
days from now form some other firm at $.505 per Singapore dollar.
So the spread of forward contract is $.005 ($.510 - $.505).
Forward rates may also contain a premium or discount. If the
forward rate exceeds the existing spot rate, it contains a premium.
If the forward rate is less than the existing spot rate, it contains a
discount.

2.1.2. Forward hedge: MNCs use forward contracts to hedge their

imports and export. They can lock in the rate at which they can
purchase and sell foreign currencies respectively.
5
Illustration: Truz, Inc. is an Multinational company based in
Chicago that will need 1,000,000 Singapore dollars (S$) in 90 days
to purchase Singapore imports. The spot rate of Singapore dollars is
$.50/S$. At this spot rate the firm would need$500,000 (computed
S$1,000,000 x $.50/S$). However, it does not have the funds right
now to exchange for Singapore dollars. It could wait 90 days and
then exchange dollars for S$ at the spot rate existing at that time.

4
Source – International financial Management, Currency derivatives, Jeff Madura 7th edition.
5
Same
“Uses of Financial derivatives in financial markets with the better man of financial institutions and other’s” 4

But, Turz does not know what the spot rate will be at that time. If the
rate rises to $.60 by then Turz will need $600,000 (computed as
S$1,000,000 x $.60/S$), an additional outlay of $100,000 due to the
appreciation of the S$.
To avoid exposure to exchange rate risk, Turz can lock in the rate it
will pay for Singapore dollars 90 days from now without having to
exchange dollars for Singapore dollar immediately. Specifically, Turz
can negotiate a forward contract with a bank to purchase S$
1,000,000 90 days forward.
The specified price in a forward contract is referred to as the
delivery price. At the time the contract is entered into, the value of
the forward contract to both parties is zero. This means that it cost
nothing to take either a long or short position6.

A forward contract is settled at maturity. The most common forward

contracts are for 30, 60, 90, 180, and 360 days although other
periods (including longer periods) are available. The holder of a
short position delivers the asset to the holder of the long position in
return for cash amount to the delivery price. On the settlement date
the forward contract can have a positive or negative value
depending upon the movement of the price of the underlying asset.
It is pertinent to note that the forward price and the delivery price of
the underlying asset are both equal at the time the contract is
entered into. Over a period of time (duration of the forward
contract), the forward price tends to fluctuate but the delivery
priced remains constant.
Forward markets however, have their share of drawbacks. A forward
contract is not dealt with on an exchange. Thus, Illiquidity and
counter- party risks are the main problem.

2.2. Future Contract: The drawbacks of forward contract are

eliminated in a future. While, a futures contract is also a contract to
specifying a standard volume of a particular currency to be
exchanged on a specific settlement date, such contracts are
normally traded on a stock exchange. This leads to standardization,
imparts liquidity and creates a set of rules and regulations which
have to be adhered to by the parties to the transaction.
Currency futures contracts are available for several widely traded
currencies at the Chicago Mercantile Exchange (CME), and the
contract for each currency specifies a standardized number of units.
Such as – Australian dollar 100,000 Brazilian real 100,000, British
pound 62,500, Canadian dollar 100,000, Euro 125,000, Japanese
yen 12,500,000, Mexican peso 500,000, New Zealand dollar
100,000, Russian ruble 500,000, South African rand 500,000 and
Swiss franc 125,0007.

6
Options, Futures and Other Derivative Securities, By John C. Hull
7
Source – www.cme.com
“Uses of Financial derivatives in financial markets with the better man of financial institutions and other’s” 5

Currency futures contracts typically specify the third Wednesday in

March, June, September and December as the settlement date.
There is also an over-the- counter (OTC) currency futures contracts
with specific settlement date.

When participants in the currency futures market take a position,

they need to establish an initial margin. The initial margin shows
how much money must be in the account balance when the contract
entered into. A margin call is issued if – because of losses on the
futures contract – the balance in the account falls below the
maintenance margin.
For example- if contract start with initial margin of $ 1,418 in your
account on a pound futures contract and the loses, say, $700 in
value, the margin call will $ 332 [computed as $1050 + ($1418-
$700)], where maintenance margin is $1,050.

To ensure that every customer stands behind the financial

obligations of his contracts the exchange clearing house values
each contract in every account at the end of each trading day and
readjusts the cash balance of each trader’s margin account
accordingly using a computerized risk-management program call
SPAN (Standard portfolio Analysis of Risk). This is called marking to
market, since the trader is credited with any gains and debited any
losses in his account.
8
Illustration: On Tuesday morning, an investor takes a long position
in a Swill franc futures contract that matures on Thursday afternoon.
The agreed-on price$0.75 for SFr 125,000. To begin, the investor
must put $1,620 into his initial margin.
Time Action Cash Flow
Tuesday Investors buys SFr futures contract
morning that matures in two days. Price is none
$0.75
Tuesday Futures price rises to $0.755. Investor receives
close Position is marked to market. 125,000 x (0.755 -0.75) =
$625
Wednesday Futures price drops to $0.743 Investor pays
close 125,000 x (0.755 – 0.743) =
$1,500.
Thursday Futures price drops to $0.74. a) Investor pays
close a) Contract is marked to 125,000 x (0.743 – 0.74) = $
market 375
b) Investor takes delivery of b) Investors pays
SFr 125,000. 125,000 x 0.74 = $92,500.
Net loss on futures contract
= $1,250
Sellers on the goods or commodity are also subject to minimum
capital requirement and other regulation.

8
Source - Multinational Financial Management, Currency Futures and Option Markets, Alan C. Shapiro, 6th
Edition.
“Uses of Financial derivatives in financial markets with the better man of financial institutions and other’s” 6

9
Illustration: The oldest future markets in the USA are in
agricultural commodities, such as sugar, corn, hogs and cattle.
Today, the largest volume of trading is in financial futures, stocks
and bonds. These commodity exchanges bring together producers
and buyers of commodities looking to lock in future prices and
speculators who are willing to take on the risk which the former wish
to avoid.
Futures commodity markets make it easy to profit from price
changes or guard against them. Although commodity futures
contracts provides for the actual delivery of the commodity as on
the closing date, very few purchasers have any intention of actually
receiving the delivery of such goods, on the delivery date specified
in the contract.

2.2.1 Speculation with future contract: Currency futures contracts

are sometime purchased by speculators who are simply
attempting to capitalize on their expectation of a currency’s
future movement (appreciates). Also sold by speculators who
expect that the spot rate of a currency will be less
(depreciates) that the rate at which they would be obligated
to sell it.
10
Illustration: Assume that as of April 4, a futures contract
specifying 500,000 Mexican pesos and a June settlement date is
priced at $0.90. On April 4 speculators who expect the peso will
decline sell futures contracts on pesos. Assume that on June 17 (the
settlement date), the spot rate of the peso is $.08. So, the gain from
selling currency futures shown below –
April 4 June 17
1. Contract to sell 500,000 2. Buy 500,000 pesos @ $.08/peso
pesos @ $.09/peso ($45,000) ($40,000) from the spot market.
on June 17. 3. Sell the pesos for $45,000 to fulfill
contract and gain $5,000.
This future contract is also applicable for bond referred as interest
rate future and stocks index future through long and short position.
The following example shows how speculators use interest rat
future.
11
Illustration: In February, Jim sanders forecast that interest rate
will decrease over the next month. If his expectation is correct, the
market value of T-bills should increase. Sanders call a broker and
purchase a T-bill futures contract. Assume that the price of the
contract was 94.00 (a 6% discount) and that the price of T – bills as
of the March settlement date is 94.90 (a 5.1% discount). Sanders
can accept delivery of the T-bills and sell them for more than he
paid for them. Because T-bill futures represent $1 million of par
value the nominal profit from this speculative strategy is $ 9,000.
(Based on long position).
9
Source - Strategic Management Issues – Derivatives for decision makers by George Crawford & Bidyut Sen.
10
International financial Management – Jeff Madura (7th edition), chapter – Currency derivatives
11
Financial Institutions and Markets, Chapter- Financial future market, Jeff, Madura, 6th edition.
“Uses of Financial derivatives in financial markets with the better man of financial institutions and other’s” 7

Selling price = $949,000 (94.90% of $1,000,000)

Purchase price = - $940,000 (94.00% of $1,000,000)
Profit = $9,000
2.2.2 Hedging with Future contract:
Financial institutions can classify their assets and liabilities by
sensitivity of their market value to interest rate movement. The
difference between a financial institution’s volume of rate-sensitive
assets and rate –sensitive liabilities represents its exposure to
interest risk. Most commonly use interest rate futures are short
hedge and long hedge.

Consider a commercial bank that currently holds a large amount of

corporate bonds and long term fixed – rate commercial loans. Its
primary sources of funds have been short-term deposits. The bank
will be adversely affected if interest rates rise. In the near future
because its liabilities are more rate-sensitive than its assets. One
possible strategy is to sell Treasury bond futures because the price
movements of T-bonds are highly correlated with movements in
corporate bond prices.
If interest rates rise as expected the market value of existing
corporate bonds held by bank will decline. Yet, this decline could be
offset by the favorable impact of the future position.

2.2.3 Closing out the Futures Position:

If a firm holding a futures contract decides before the settlement
date that it no longer wants to maintain its position, it can close out
the position by selling an identical futures contract. Sellers may also
close out their positions by purchasing similar contracts. The gain or
loss to the firm from its previous futures position is dependent on
the price of purchasing futures versus selling futures. Such as a
speculator contract to purchase A$100,000 at $.53/A$ expecting
appreciates the US dollar in January 10 maturity at 19 march. But
February he wishes to close out the contract that why he made
another counter sell contract of same amount A$100,000 for
$.50/A$ matured at 19 march. Therefore in March 19 the position of
speculator is net loss $ 300012.

January-10 February-15 March -19

1. Contract to 2. Contract to sell 3. Incurs $3000
buy A$100,000 @ A$100,000 @ $.50/A$ loss from offsetting
$.53/A$ ($53,000) ($50,000) on March 19. positions in futures
on March 19. contracts.

2.2.4 Distinction between Forward and Future Contract:

The discussion of the distinction will make clear the concept and
confusion regarding futures market for readers is depicted below:
1. Size of Contract:
12
Source – International financial Management – Jeff Madura (7th edition), chapter – Currency derivatives
“Uses of Financial derivatives in financial markets with the better man of financial institutions and other’s” 8

Forward contracts are individually tailored and tend to be much larger

than the standardized contracts on the future market.
Futures contracts are standardized in terms of currency amount.
2. Trading :
Forward contracts are traded by telephone or telex. So, risk is relatively
high
Future contracts are traded in stock exchange such as CME. So risk is low.
3. Delivery date:
Bank offer forward contracts for delivery on any date
Futures contracts are available for delivery on only few specified dates a
year (such as; March, June, September and December.)

4. Settlement:
Forward contract settlement occurs on the agreed on between the bank
and the customer.

Futures contract settlements are made daily via the Exchange clearing
house; gains on position values may be withdrawn and losses are
collected daily.

5. Quotes:
Forward prices generally are quoted in European term (Units of local
currency per U.S$)
Futures contracts are quoted in American terms (dollar per one foreign
currency unit).
6. Transaction cost:
Cost of forward contracts are based on bid-ask spread
Future contracts entail brokerage fees for buy and sell orders.
7. Margin:
Margin are not required in the forward market
Margins are required of all participants in the futures market
8.Credit Risk:
The credit risk is borne by each party to a forward contract, credit limits
must be therefore be set for each customer.
The Exchange’s Clearing House becomes the opposite side to each
futures contract, thereby reducing credit risk substantially.

3. Option Market:
Having distinguished between a forward and future contract, it is
now essential to know how option work. An option is simply the
right (but the obligation) to buy or sell something at the stated
dated at a stated price.
Options are traded on many different exchanges through the world.
The underlying assets include stocks, stock index, foreign
currencies, debt instruments, and commodities. The standard
options that are traded on an exchange through brokers are
guaranteed, but require margin maintenance

Unlike the currency future contract traded on an exchange, currency

options are tailored to the specified needs of the firm. Since the
“Uses of Financial derivatives in financial markets with the better man of financial institutions and other’s” 9

options are not standardized, all the terms must be specified in the
contracts. The number of units, desired strike price and expiration
date can be tailored to the specific needs of the client.
There are basically two types of options viz: Call option and Put
option. However, as either type can be bought or sold. It can be said
there exists four distinctly different types of option instruments.

3.1. Call options:

A currency call option grants the holder the right to buy a specific
currency at a specific price (called the Exchange rate / exercise or
strike price) within a specific period of time. Call option are desirable
when one wishes to lock in a maximum price to be paid for a
currency in the future. A call option is in the money, if (spot rate >
strike price), at the money, if (spot rate = strike price), out of the
money, if (spot rate < strike price).
Option owners can sell or exercise (i.e. buy) their options. They
can also choose to let their options expire. At most, they will lose
the premiums they paid for their options. So, owner of the call
option is not obligated to exercise the contract (that’s why give
premium)

3.1.1. Speculation with call option: As mentioned earlier, in buying a

call an investor acquires the right, but not the obligation to buy
underlying assets for a specified price during a specified period
time.
13
Illustration: the investor who pays $3,000 to buy a ‘December
102 call option’ on a $100,000 US Treasury bond has the right, until
December to buy that bond at an exercise price of 102 ($102,000).
If the market price of US Treasury bonds is now, 101, the call option
has no intrinsic value and is said to be out of money, because no
one would like to exercise the call option to buy a treasury bond for
102 when the bond could be purchased on the open market for 101.
However, the call option would still sell for $3,000 because of the
possibility that the price of T-bonds may rise before December,
when the option expires. This $3,000 price is called its time value
(premium).

If the price of the treasury bonds falls to $93, the price of the call
option will fall; because it will take a bigger market price increases
to give the call option any intrinsic value before it rises. For the call
option to have any intrinsic value the market price must rise above
the strike price of 102.

3.1.2 Hedge with call option: Corporation or MNCs can purchase call
options on a currency to hedge future payable.

13
Source – Strategic Management Issues – Derivatives for decision makers, by George Crawford &Bidyut Sen
“Uses of Financial derivatives in financial markets with the better man of financial institutions and other’s” 10

14
Illustration: when Pike Co. of Seattle orders Australian goods, it
makes a payment in Australian dollars to the Australian exporter
upon delivery. An Australian dollar call option locks in a maximum
rate at which pike can exchange dollars for Australian dollars. This
exchange of currencies at the specified strike price on the call
option contract can be executed at any time before the expiration
date. In essence, the call option contract specifies the maximum
price that Pike pay to obtain these Australian dollars. If the
Australian dollar’s value remains below the strike price, Pike can
purchase Australian dollars at the prevailing spot rate when it needs
to pay for its imports and simply let its call option expire.

Options may be more appropriate than futures or forward contracts

for some situation. Such as; Intel corp. uses options to hedge its
order backlog in semiconductors. If an order is canceled, it has the
flexibility to let the option contract expire. With a forward contract, it
would be obligated to fulfill its obligation even though the order was
canceled.
3.2. Put option:
A currency put option grants the holder the right to sell a specific
currency at a specific price (the strike price) within a specific period
of time.
The owner of the Put option is not obligated to exercise the option.
Therefore the maximum potential loss to the owner of the put option
is the price (or premium) paid for the option market.
A put option is in the money, if (spot rate < strike price) at
the money, if (spot rate = strike price), out of the money, if (spot
rate > strike price).

3.2.1. Speculation with Put option:

Individuals may speculate with currency put options based on their
expectations of the future movements in a particular currency.
Speculators who expect the currency will depreciate can purchase a
put option. On the other hand, speculators can also attempt to profit
from selling put option if assumes that currency will appreciate.
15
Illustration – A put option contract on British pounds specifies
that premium on ₤1= $.04 unit, strike price or exercise price is ₤1=
$.40 and contract size is ₤31,250.A speculator who had purchased
this put option decided to exercise the option shortly before the
expiration date, when the spot rate of the pound was$1.30. The net
profits to the purchaser of put option are as follows:
Per unit Per contract
Selling price of ₤ $1.40 $43,750 (1.40 x 31,250
units)
- Purchase price of ₤ -$1.30 -$40,625 (1.40 x 31,250
units)
14
Source – International financial Management – Jeff Madura (7th edition), chapter – Currency derivatives
15
Source – International financial Management , Currency derivatives Jeff Madura ,7th Edition
“Uses of Financial derivatives in financial markets with the better man of financial institutions and other’s” 11

- Premium paid for option -0.04 -$1,250 (1.40 x 31,250

units)
Net profit = $.06 = 1,875 (.06 x 31.250
units)

3.2.2 Hedge with Put option: Like currency call options, currency put
options can be a valuable hedging device.
16
Illustration: Knoxville, Inc., (exporter) transport goods to New
Zealand and expects to receive NZ$600,000 in about 90 days.
Because it is concerned that the NZ$ may depreciate against the
US$, Knoxville is considering purchasing put options to cover its
receivables. The NZ$ put options considered here have an exercise
price of $.50 and a premium of $.03 per unit. Knoxville anticipates
that the spot rate in 90 days will be either $.44. $.46 or $.51. The
amounts to be received are $282,000, $282,000 and $288,000
respectively.

4. Institutional use of Financial Derivatives:

They are commonly used by MNCs used to hedge their foreign
currency position. In addition, they are traded by speculators who
hope to capitalize on their expectations of exchange rate
movements. A buyer of currency futures contract locks in the
exchange rate to be paid for a foreign currency at a future point in
time. Alternatively, a seller of a currency futures contract locks in
the exchange rate at which a foreign currency can be exchanged for
the home currency.
Some commercial bank and saving institutions use a short hedge to
protect against a possible increase in interest rates.
Some bond mutual funds, pension funds, and life insurance
companies take short position in interest rate futures to insulate
their bond portfolios from a possible increase in interest rates.
Securities firms execute futures transactions for individuals and
firms. They also take position in future contract to hedge their own
portfolios against stock market or interest rate movement.

Thus, financial institutions and other corporation or individual

generally use futures contracts to reduce risk, earning profit from
speculation, and hedge to payable or receivable position.

5. Conclusion:
Financial future contracts are still a fairly new product; new products
are still rapidly emerging, and much growth in the futures industry
lies ahead. In recent years, financial derivatives have received much
attention both because they have the potential to generate large
returns to speculators and because they entail a high degree of risk
in international financial market. Financial derivatives are also now
widely using to hedge in the currency value movement without
using any cash transaction which is an immense benefit of financial
16
International Financial Management Jeff Madura, Managing Transaction Exposure, 7th Edition
“Uses of Financial derivatives in financial markets with the better man of financial institutions and other’s” 12

institution specially which has shortage of liquidity for international

transaction.
“Uses of Financial derivatives in financial markets with the better man of financial institutions and other’s” 13

References:

Alan C. Shapiro, Multinational Financial Management (1999),

currency future and option market; 6th edition.

George Crawford and Bidyut Sen, Strategic Management Issues,

Derivatives for decision makers

Jack Clark Francis, Investments- Analysis and Management (1991),

Future contracts, 5th edition.

Jeff Madura, Financial Markets and Institutions (2003), Financial

Future Market; 6th Edition

Jeff Madura, International Financial Management (2003) Currency

derivatives, and Managing Transaction Exposure, 7th edition.

John C. Hull, Options, Futures and other Derivative Securities

Maurice D. Levi, International Finance – The markets and Financial

Management of Multinational Business (1996), Forward Exchange,
3rd edition.

www.cme.com