Unit:1

Introduction
 Concept of Financial Derivatives
 General meaning of derivative is derived from others source, not own
 A derivative is financial instrument whose value is dependent upon the value
of underlying assets i.e. Securities , commodities, currency, bullion or anything
else
 It is risk management tool because it designed to manage the financial risk i.e.
interest rate risk, currency risk and market price risk
 Derivative securities includes:
i. Options (use to manage stock price risk)
ii. Forward and futures (use to manage commodity price risk, exchange rate
risk and risk associated with precious metals)
iii. Swaps (use to manage interest rate risk and currency risk)

“A security that is neither debt nor equity but derives its value from an underlying
asset that is often another security is called derivatives”
- L. J. Gitman.
Features of Financial Derivatives
1. Financial asset:
 An asset is the economic resource owned by the individual, firm or
government or any other entity.
 A financial derivative also has economic value
 It can also be owned in a legal sense, purchased and sold like any other
assets. Hence it is considered an asset i.e. non-pure financial asset
2. Contract between two parties/ legally binding contract:
 Legally binding financial contract
 All terms and conditions are fixed today and written on contract paper
 One party is buyer of the asset(long position) and other party is writer or
seller (short position)
 Contracting party may be individual, government or institutions
 Both parties must follow the contract, if any disputes arises, the parties
can go legal remedy

3. Based on underlying asset:

 Value or price of derivatives based on the value of underlying assets such
as agriculture commodity, metals, financial assets (common stock) etc.

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4. Means of managing financial risk :
 By using derivatives individuals or institutions can transfer undesired risk
to other parties who want to assume the risk or who have risks that off-set
5. Maturity/ pre-determined life
6. Deferred payment instruments:
 Derivatives are deferred payment instrument or deferred delivery
instrument because derivative is contract which is made today but
payment and delivery will be done in near future.
7. Oppositely related pay-off (zero sum-game):
 The pay off i.e. gain or loss from derivative is calculated at the end of
contract period
 The pay-off of contracting parties are oppositely related i.e. the gain of
one party is equal to loss of other party.
8. Traded on exchanges and OTC market :
 The derivative contract can be under taken directly between two parties or
through the exchange.
 A derivative exchange is a market where individual/institution trade
standardized contract that have been defined by the exchange
 The main derivative exchange markets are Chicago Mercantile Exchange
(CME), Chicago Board of Trade (CBOT), New York mercantile exchange etc.

DERIVATIVE MARKETS $ INSTRUMENTS

 Market can be classified into spot (cash) market and derivative market.
 Spot market is the market for assets i.e. commodities or securities that
involves the immediate sale and delivery of asset
 On the other hand, in derivative markets the goods or securities are to be
delivered at a later date, other types of arrangements let the buyer or seller
choose whether or not to go through with the sale.
 Derivative markets are market whose performance is determined by how
another instrument or asset performs.
 In derivative markets there is agreement between buyer and seller in which
each party does something for other.
 In an agreement or contract there is price, and buyer tries to buy as cheap
as possible where as seller tries to sell at maximum profit

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 Derivative Instruments/ Types of Financial Derivative
1. Option:-

o Options are derivative securities that give the holder (investor) the right
to buy or sell (but not obligation) common stock at pre-determined
specified price over given period of time
o Two common types of options are available i.e. calls and puts
o Call options grant the holder the right to buy(but not obligation)
common stock at a stated exercise price and put options grants the
holder the right to sell common stock(but not obligation) at a fixed price
/exercise price
o Investors purchase options to take advantage of an anticipated change
in price of common stock

Features of option

i. Issued by option clearing corporation (OCC)/ clearing house

ii. Right to purchase/sell underlying asset i.e. common stock
iii. Option price/premium
iv. Exercise/strike price
v. Time to maturity/date of expiration
vi. Option styles
vii. No ownership right and no dividends

Types of Option

i. Call options: - call option is a contract giving the owner the right, but
not the obligation, to buy a given quantity of an asset a specified
period of time and price.

ii. Put options: - put option is a contract giving the owner/holder the
right, but not the obligation, to sell a given quantity of an asset a
specified price at some date in future.
o Exercise/ strike price

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 2. Forwards
o It is an agreement between two parties (i.e. buyer and seller) to purchase
or sale of physical assets such as agriculture commodity, metals, foreign
currency, bullion etc at certain time and specified price
o Forward contract is an agreement that obligates the holder to buy or sell
an asset at a predetermined delivery price during a specified future time
period

3. Futures
o Standardized contract, traded on futures exchange to buy and sell an
asset at some specific date and time
o It is legally binding obligations that the seller of the futures contract will
delivery and buyer of the contract will take delivery of an asset at some
specific date and at a price agreed on the time the contract is sold
o Example of futures contracts are soybeans, pork bellies, platinum and
coca contracts (commodities futures). Financial futures are Japanese
yen, U.S. treasury securities, interest rates, stock indexes
o Don M. Chance & Brooks(2013) “Futures is an agreement between two
parties a buyer and seller, to purchase an asset or currency at a later date
at a fixed price that trades on futures exchange and subject to daily
settlement procedures to guarantee to each party that claim against the
other party will be paid”

Types of Futures

i. Agricultural commodities(wheat, corn, oats, soybeans)

ii. Natural resources (gold, silver, copper, energy products
iii. Foreign currency
iv. T-bills
v. T-notes and bonds
vi. Miscellaneous commodities (fertilizer, rubber, cement, potatoes,
peanuts, sunflower seeds, kerosene)

4. Swaps
o Exchange something with someone is known as swap
o A swap is an agreement between two counter parties to exchange one
series of cash flows into another series of cash flows over a specified
period of time.

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o It is a device to obtain the desired form of financing indirectly which
otherwise might be too expensive.
o Swap bank facilitates swap between counterparties
o The first formal swap is currency swap which was occurred in 1981
between IBM and world Bank
o Swaps are probably the most complicated derivatives in the market.
o Swaps enable the participants to exchange their streams of cash flows.
For instance, at a later date, one party may switch an uncertain cash flow
for a certain one.
o The most common example is swapping a fixed interest rate for a
floating one.
o Participants may decide to swap the interest rates or the underlying
currency as well.
o Swaps enable companies to avoid foreign exchange risks amongst other
risks.
o Swap contracts are usually not traded on the exchange. These are private
contracts which are negotiated between two parties.
o Usually investment bankers act as middlemen to these contracts. Hence,
they too carry a large amount of exchange rate risks.

Types of Swap

 Interest rate swap:-

o Interest rate swap is an agreement between two parties in which
one party agrees to make a series of fixed interest payments and
other agrees to make series of floating interest paymen

 Currency swap :-
o It is an agreement to deliver one currency in exchange for
another
o Agreement in which two parties exchange principal amount of
loan (i.e. debt instruments generally bond) and interest payment
in one currency for the principal and interest in another currency.
o It can be classified into fixed to fixed currency swap, fixed to
floating and floating to floating currency swap

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  Equity swap :-

o An equity swap is a financial derivative contract between two parties to

exchange future cash flows based on the performance of a stock or equity
index. In an equity swap, one party typically pays the return on the
underlying equity, while the other party pays a fixed or floating rate of
interest.

Roles or Uses or Applications of financial derivatives

1. Risk management (shifting of risk/ hedge):-
 Derivative instruments make able to transfer or reduce the undesired risk.
 Due to the derivative no one can assume uncomfortable risk.
 For example pension fund with widely diversified holdings in the stock
market faces considerable risk from general fluctuation in stock prices.
The pension fund manager can use options on a stock to reduce the risk.
 Derivatives can be used to limit or increase risk level.
 We should not misunderstand as risk management is to reduce the risk
only.
 Investor who seek to increase their risk in derivative markets are called
speculator, where as investors who use derivatives to reduce the risk is
called hedgers
 Hence, derivatives help to modify the level of risk exposure.
 Followings are the derivative instruments that use for management of
risk:

Derivatives Management of risk

Options Stock price risk, foreign currency risk
Forward & futures Foreign currency risk, interest rate risk, commodity
price risk
Swaps Interest rate risk, currency risk

2. Trading efficiency/ operational advantage:-

 Derivatives provide the trading efficiency because of:
i. Lower transaction cost:

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  Derivative markets entails lower transaction cost i.e. commission and
other trading costs are lower for traders in this market.
 This makes derivative market is attractive to the investors
ii. Greater liquidity:
 Derivative markets, particularly option exchange and future
exchanges have greater liquidity.
 Although spot market is quite liquid but in spot market investor
requires large amount of money to invest
 On the other hand, investor can participate in derivative markets
with smaller amount of capital.
iii. Short position:
 Derivative allows short position to the investor very easily, because in
derivative contract one party of the contract is long position and
another is short.
 But stock market imposes several restrictions to discourage the short
position.
iv. Substitute of pure security:
 Derivatives are non-pure financial instruments but it serves as
pure/primary securities
 For example an interest rate future contract can serve as a substitute
for investment in a portfolio of Treasury securities; similarly stock
option is substitute of common stock investment.

3. Price discovery:
 The pricing of derivative securities is helpful to determine the actual
market price of underlying asset.
 Specially, forward and future markets are important source of
information for determining the spot price of an asset in future date
4. Market completeness:
 Derivatives are important tool of financial market and most of the
derivative securities are innovative.
 It plays the important role in the development and completeness of
financial market
 Derivative make the financial market completeness because the market
with financial derivatives will allow traders to more exact shape the risk
and return characteristics of their portfolios, thereby increasing the
welfare of traders and economy in general.

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  For example Nepalese financial market is incomplete because in Nepal
there is no practice of option market.

5. Speculation :
 Derivatives are also used for speculation purpose
 Speculator can be used futures and option markets to take advantage
from change in prices.

Criticism of Derivative Markets

 Derivatives have been criticized for having been the source of large losses
by some investors, corporations, investment funds, individuals etc.
 Derivatives are also criticized as a form of legalized gambling
 Followings are criticism of derivative.
i. Increase volatility in spot market
ii. Chances of bankruptcies due to careless in using derivatives:
Barings Bank Bankrupt:
Barings bank was a British merchant bank based in London, and
world’s second oldest merchant bank.
The bank collapsed in 1995 after suffering losses of British pound 1.6
billion, resulting from fraudulent investments, primarily in Futures
contracts(derivative instrument), conducted by its employee Nick
Leeson, working at its office in Singapore.
Nick Lesson, the bank’s 28 years-old head of derivatives in Singapore,
gambled more than $ 1 billion in un- hedged, unauthorized
speculative traders, eliminating the merchant bank’s cash reserve.
He was former derivatives broker from the UK.
iii. Increased regulatory burden to government:-

Misuse of Derivatives
 Derivatives include high degree of leverage i.e. small price changes can lead
to large gains/losses

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  Derivatives are powerful financial instruments
 If they are not use properly they can cause problems as well
 In other words without having the proper knowledge it is dangerous.
 Thus, to use the derivatives, investor must have knowledge of price trend
of underlying assets, interest rates, exchange rates, etc; otherwise it is very
risky investment
 Fortunately, derivatives are used by knowledgeable persons in situations
where they serve an appropriate purpose.

Derivatives and Ethics

 The word ethics derived from Greek word ethos, which means way of living.
 It studies what is morally right or wrong
 It is code of conduct
 Every business should operate ethically and morally.
 Before entering into any profession, one should know the norms and code
of ethics
 Derivative professionals must follow the norms and code of conduct of
his/her business
 They should not cheat the investors
 Code of conduct must be in the best interests of their users
 Ethical standards must also intend to establish a framework that protects
investors and also promotes efficiency, competition and capital formation
in the market
 Regulators must also ensure that the code of conduct would protect
investors and corporations in the derivative market.

Career in Derivative Markets

Derivatives are powerful instruments in the financial market.
To use derivatives it requires proper knowledge

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 There are various career opportunities in derivative markets such as OTC
derivatives dealer, jobs in futures exchanges, option exchanges, clearing
house, as well as we can become a hedgers, speculators and arbitrageur
etc.

Core/ Important concepts in Financial and Derivative Markets

1. Risk preference :-
 Return and risk alone is not sufficient to evaluate the investment
alternatives
 Investment alternatives must evaluate in terms of risk and return.
 According to attitude toward risk investor can be classified in to
 Risk taker/seeker
 Risk averter
 Risk neutral
2. Short selling:-
 Short selling of stock can be quite complex as compare to short position in
derivative markets
 In derivative markets short position is simply seller/writer of contract that
has right or obligates to sell an underlying asset at predetermined price at
later date.
3. Repurchase agreement :-
 A repurchase agreement(repo) is a legal contract between a seller and a
buyer; the seller agrees to sell currently a specified asset to the buyer-as
well as buy it back (usually) at a specified time in the future at an agreed
future price
 Derivative traders often need to be able to borrow and lend money in the
most cost-effective manner possible.
 Repo is often a very low-cost way of borrowing money, particularly if the
firm (BFIs) holds government securities.

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  Repo is a way to earn interest on short-term fund with minimal risk (for
buyers) as well as a way to borrow for short-term needs at a relatively low-
cost (for sellers).
 Risk free rate(repo rate) is also used to determine value/price of derivative
instruments
4. Return and risk:-
 Return is the numerical measure of investment performance
 It represents the percentage increase in the investor’s wealth that results
from making the investment.
 Return on stock investment includes capital gain yield and dividend yield.
 The main objective of investment is to increase their wealth.
 Wealth is increased by obtaining higher return but higher return is achieved
through higher risk.
 Risk is the uncertainty of future return.
 Most investors are risk averter.
 Investors either select less risky investment among the investment
alternatives providing equal expected return or select high yielding
alternative among the alternatives with same amount of risk.
 Hence, there is positive relationship between risk and return is known as
risk-return trade-off.
 Thus, the competitive nature of financial and derivative markets enables
investors to identify the investment alternatives by their degree of risk.

5. Market efficiency and theoretical fair value:-

 Efficient market states that financial/derivative markets are efficient and
that prices already reflect all known information concerning a stock or
other security and that prices rapidly adjust to any new information.
 The efficient market hypothesis (EMH) was developed by Eugene Fama in
the 1960s, and essentially says that at any given time, security price(stock,

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 derivatives etc.) reflect all available information and trade at exactly their
fair value at all times.
 If there is any difference between market price and theoretical fair value
then there is existence of arbitrage opportunity.

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