DERIVATIVE

INTRODUCTION
 Derivative instruments are relatively new instruments. Even the world’s
oldest exchange traded financial derivative; interest rate futures, is hardly 30
years old. Most of the more exotic forms of derivatives are instruments that
did not even exist a decade ago.
 Despite their newness however, derivative instruments have turned out to be
very popular. Trading volume in derivatives has shown impressive growth
in recent years.
 Despite their obvious popularity, derivative instruments have been blamed
for having precipitated several financial scandals which resulted in
spectacular losses.
INTRODUCTION
 Derivatives are ‘powerful’ financial instruments, which if
improperly used can cause serious problems.
 When used intelligently, derivatives can reduce risks and
allow for all kinds of flexibility.
An examination of the scandals involving derivatives shows
that in every case, the problem was not the use but the misuse of
derivatives that caused the problem.
 WHAT ARE DERIVATIVE INSTRUMENTS ?

 Derivative instruments are essentially financial

instruments that derive their value from the value of an
underlying asset.
 For example, when you buy a Crude Palm Oil (CPO) futures
contract. The value of this futures contract will rise and fall
as the value or price of spot CPO rises or falls.
 This happens because a derivative is in essence a “claim”
on the underlying asset at a predetermined price and at
predetermined futures period(s).
WHAT ARE DERIVATIVE INSTRUMENTS ?
 Unlike spot market transactions, where assets are bought/sold for cash at
prevailing spot prices for immediate delivery, derivative market
transactions allow for future transactions at prices determined today.
 Derivative instruments may be traded as exchange traded contracts
(ETC) or over-the-counter (OTC).
 While an exchange traded derivative is traded on a formal exchange, an
OTC derivative is a customized bilateral contract between two parties.
 For ETC derivatives prices are arrived at through market trading, prices
for OTC products are arrived at through negotiation among the parties.
 WHAT ARE DERIVATIVE INSTRUMENTS ?
 Today, there is a broad spectrum of derivative instruments, many with very
exotic names and highly specialized purposes. We focus on the four main
derivative instruments:
 forwards,
 futures,
 options
 swaps.
 As mentioned above, Forwards, Futures and Options are probably the three
most common derivative instruments. A forth and an increasingly popular
derivative is the swap contract.
 COMMON DERIVATIVE
INSTRUMENTS
 A Forward Contract: A forward contract can be defined as a contract
between two parties agreeing to carry out a transaction at a future date
but at a price determined today.
 A Futures Contract: A futures contract can be simply defined as a
standardized and exchange traded form of forward contract. As in a
forward contract, a futures contract represents a formal agreement
between two parties to carry out a transaction at a future date (contract
maturity date) but at a price determined at contract initiation.
 From an operational viewpoint, forwards and futures are essentially
the same. The difference being that futures are standardized and
exchange traded.
 COMMON DERIVATIVE INSTRUMENTS

 An Option Contract: An option contract provides the holder, the right but
not the obligation to buy or sell the underlying asset at a predetermined
price. While a Call option provides the right to buy, a Put option would
provide the right to sell.

 A Swap Contract: A Swap can be defined as a transaction in which two

parties simultaneously exchange cash-flows based on a notional amount of
the underlying asset. The rates at which the cash-flows would be
exchanged are determined based on a fixed rate for the fixed cash-flow and
on a reference measure (The reference measure could for example be an
interest rate like 3 month KLIBOR) for the floating cash-flow.
 THE EVOLUTION OF DERIVATIVE
INSTRUMENTS
 Like other products, derivative instruments evolved as a result
of product innovation. As is usually the case, the innovation
was in response to increasingly complex needs.
 Forwards contracts which are the simplest derivatives were
the first. Forwards were followed by Futures contracts which
had several advantages over forwards.
 THE EVOLUTION OF DERIVATIVE
INSTRUMENTS
 The next phase of evolution involved Options. Options provided
the flexibility that forwards and futures could not.
 Swaps and a host of other exotic derivatives/ structured products
have followed this evolution and now constitute a substantial
portion of the overall market for derivatives.
 The key utility that users could derive from derivative instruments
is help with managing their risks.
 However, given the features of these instruments, they could just
as easily be used for speculative and arbitrage purposes.
THE EVOLUTION OF DERIVATIVE
INSTRUMENTS
 Risk Management or hedging, requires that we establish a
position in a derivative instrument that will give us an exposure
opposite to that of our underlying position.
 For example, if we are long (holding) an underlying asset and
therefore exposed to falling price of that asset, we hedge by
taking a derivative position that will benefit when the asset’s price
falls. For example, by going short (sell or make delivery) a
forward or futures contract on the asset.
 FORWARD CONTRACTS
 In a forward contract two parties undertake to complete
a transaction at a future date but at a price determined
today.
 Since they both face price risk but in the opposite direction,
it would be logical for both parties to meet, negotiate and
agree on a price at which the transaction can be carried out
at the future date.
 Both parties have “locked-in” their price/cost.
FORWARD CONTRACTS
Mechanics of a Forward Contract

Price, quantity and quality

THE NEED FOR FUTURES CONTRACT

 The need for futures contracts came about given the

problems associated with forwards.
 The forward contract has a number of inadequacies, the 3 key ones being:
1) Multiple coincidence of needs.
2) Potential for unfair price (price squeeze)
3) Counterparty or default risk.
THE NEED FOR FUTURES CONTRACT
 As these shortcomings of the forward contract became apparent over time,
a new instrument was needed that would provide the risk management
benefit of forwards while simultaneously overcoming its problems. The
resulting innovation was the futures contract.
 A futures contract is essentially a standardized forward contract.
Standardized with respect to contract size, maturity, product quality,
place of delivery etc.
 With standardization, it was possible to trade them on an exchange –
which in turn increases liquidity and therefore reduces transaction costs.
In addition, since all buyers and sellers transact through the exchange, the
problem of multiple coincidence of wants is easily overcome.
THE NEED FOR FUTURES CONTRACT
 With exchange trading, the second problem with forward
contracts, that of being possibly locked into an unfair price
would not exist.
 This is because each party is a price taker with the futures
price being that which prevails in the market at the time of
contract initiation.
 As exchange quoted prices are market clearing prices
arrived at by the interaction of many buyers and sellers,
they would by definition be ‘fair’ prices.
 THE NEED FOR OPTIONS
 Though futures contracts have been able to overcome
the problems associated with forwards, they were still
inadequate in some respects to later day business needs.
 While futures enabled easy hedging by locking in the
price at which one could buy or sell, being locked-in
also means that one could not benefit from subsequent
favorable price movements.
 This is precisely what options do.
 THE NEED FOR OPTIONS
 In essence, options have at least three important advantages over
forwards and futures.
 First, options provide the best of both worlds, downside protection and
upside potential.
 Second, options are extremely flexible and can be combined in various
ways to achieve different objectives/cash flows.
 Finally, as we will see later, there may be complicated business risk
situations that cannot be handled with forwards/futures but can be easily
handled with options.
OPTIONS: KEY FEATURES AND TRADEOFFS

 All exchange traded options come in two basic forms: Calls and Puts.
 A Call Option: provides the holder the right but not the obligation to buy
the underlying asset at a predetermined price.
 A Put Option : provides the holder the right but not the obligation to sell
the underlying asset at a predetermined price.
 The predetermined price at which the transaction will be carried is known
as the Exercise price or strike price. Unlike futures/forwards, options
require the payment of a premium on purchase. That is, one pays a
premium to acquire a Call or a Put option.
OPTIONS: KEY FEATURES AND
TRADEOFFS
 While a European style option is only exercisable at
maturity, an American option can be exercised at or any
time before maturity.
 Given, this additional flexibility, an American option
would be more valuable than a European option
assuming all other features are the same.
 OPTIONS: KEY FEATURES AND
TRADEOFFS
 An option contract therefore should at the very least specify the
following five features:

a) the type of option whether call or put,

b) it must state the underlying asset,

c) the exercise price or strike price,

d) the maturity or expiration date, and

e) the exercise style, whether American or European style.

OPTIONS: KEY FEATURES AND
TRADEOFFS
Expectations and Options Premiums
OPTIONS: KEY FEATURES AND
TRADEOFFS
 The fact that options provide a right but not an obligation to the
holder gives tremendous advantage.
 A holder need only exercise if it will be profitable for him to do
so. For example, let us say you buy a 3-month American style call
option on Maybank Stock at an exercise price of RM20 per share.
 It means that you can exercise your option, i.e. “call it” at RM20 per
share at any time before or on the maturity date in 90 days.
 Thus, you would only exercise the option if Maybank stock goes
higher than RM20.
OPTIONS: KEY FEATURES AND
TRADEOFFS
 If the stock does not reach RM20 by expiration day, the option would
be unexercised, i.e., simply let to expire. For this privilege you pay
to buy the option.
 This payment is the option premium. So, if you don’t exercise
because the underlying stock did not go higher than the exercise
price, the premium paid is a loss to you but a profit/gain to the seller
of the option.
 Note that the maximum you can lose is the amount of premium,
however, the potential profit is technically unlimited.
OPTIONS: KEY FEATURES AND
TRADEOFFS

 While an unexercised option will become worthless after maturity,

prior to maturity the holder can either exercise it (if profitable to do
so) or sell it in the secondary market.
 The price at which it can be sold would of course depend on the
expectation of the underlying stock’s price at maturity.
 It is usual that an option will pass through several owners before
reaching maturity.
THE PRICING OF OPTIONS
 The appropriate price or value of an option is essentially its correct
premium.
 When options are traded, it is the premium that changes. There are several
models available to price options.
 Among these are the Binomial, Trinomial, Lattice, Finite Difference,
Monte Carlo models and so on.
 However, the most common and possibly most user friendly is the Black-
Scholes Option Pricing Model (BSOPM). Today most options traders use
the Binomial Model for pricing American style options and the BSOPM for
European style options.
 For their work on the BSOPM, its authors, Fisher Black and Myron Scholes
won the Nobel Prize for Economics in 1995.
 SWAPS
 Swaps are customized bilateral transactions in which the parties agree to
exchange cash flows at fixed periodic intervals, based on an underlying
asset.
 Being customized, swaps are over-the-counter or OTC instruments.
Depending on the kind of underlying asset, there are different kinds of
swaps.
 A Currency Swap for example, is one where parties exchange a cash flow
in one currency for cash flows in another currency, a commodity swap is
one where parties exchange cash flows based either on a commodities index
or the total return of a commodity in exchange for a return based on a
market yield.
 INTEREST RATE SWAPS (IRS)
 Equity Swaps constitute an exchange of cash flows based on different
equity indices.
 An Interest Rate Swap (IRS) on the other hand, is a transaction in which
the parties exchange cash flows based on two different interest rates.
 In its most common form a fixed-for-floating swap; one party pays an
amount based on a fixed interest rate whereas the other party pays in
exchange, an amount based on a floating interest rate.
 The size of the payment is determined by multiplying the interest rate
with the “notional principal”. The notional principal is the principal
amount on which interest payments are calculated.
 INTEREST RATE SWAPS (IRS)
 Typically, in an IRS cash flows are swapped at fixed
predetermined intervals over the tenor of the agreement. The
fixed intervals, known as reset periods may be monthly, quarterly,
semi-annually, etc, whereas the tenor or maturity of the swap may
be 5 or 10 years.
 The following figure outlines the cash flows involved in a fixed-for-
floating IRS of 5-year maturity and RM100 million notional
principal.
 If the reset frequency is 6 months, then a total of 10 cash flow swaps
will occur over the 5 years.
 INTEREST RATE SWAPS (IRS)
 The fixed rate payer, will pay an annualized 10% fixed rate while the floating rate
payer, will pay six-month KLIBOR +1%.

A fixed-for-floating Interest Rate Swap

 INTEREST RATE SWAPS (IRS)
 The cash flow payment based on the interest rates will occur once every six
months. Since the payments are to be made simultaneously, often the cash-
flows are netted such that only a single payment occurs.
 As to who pays whom, would obviously depend on which rate is higher. If
the floating rate, 6-month KLIBOR + 1% is higher than the fixed rate of 10%
the floating rate payer pays the difference.
 If the floating rate is lower than 10%, then the fixed payer pays the
difference. To see how this works, we examine two scenarios; first if the 6-
month KLIBOR is at 6% at reset period and a second scenario where the 6-
month KLIBOR is at 11.2%.
ILLUSTRATION: PAYOFFS TO IRS AT
MATURITY
ILLUSTRATION: PAYOFFS TO IRS AT
MATURITY

RM5,000,000

RM1, 100,000 (net difference)

ILLUSTRATION: PAYOFFS TO IRS AT
MATURITY
 SWAP TERMINOLOGY
Swap Terminology

Fixed Rate Payer The counterparty in a swap agreement who pays based on a
fixed interest rate.

Floating Rate Payer The counterparty who pays based on a floating interest rate.

Reset Frequency The time interval over which the floating rate is reviewed and
reset.

Reference Rate The market interest rate on which the floating rate payer's
payment will be based typically an interbank rate like KLIBOR,
LIBOR, T-bill rate, etc.

Notional Principal The principal amount on which interest payment amounts are
determined. Notional amount is never exchanged, only the
interest amounts based on it.
 THE MAIN PLAYERS IN
DERIVATIVE MARKETS
 As is the case with other financial markets there are thousands of
institutions and traders involved in derivative markets. However, they
could all be classified into three broad categories, namely:
(i) Hedgers,
(ii) Arbitrageurs and
(iii) Speculators.
 If hedging is the raison-d’etre for derivative markets, then obviously
hedgers would be major players.
 Hedgers use derivative markets to manage or reduce risk. They are typically
businesses that use derivatives to offset exposures resulting from their
business activities.
 THE MAIN PLAYERS IN
DERIVATIVE MARKETS
 The second category of players – arbitrageurs use derivatives to
engage in arbitrage.
 Arbitrage is the process of trying to take advantage of price
differentials between markets.
 Arbitrageurs closely follow quoted prices of the same
asset/instruments in different markets looking for price divergences.
 Should the prices be divergent enough to make profits, they would
buy on the market with the lower price and sell on the market where
the quoted price is higher.
 THE MAIN PLAYERS IN DERIVATIVE
MARKETS
 In addition to merely watching the prices of the same asset in
different markets, arbitrageurs can also arbitrage between different
product markets.
 For example between the spot and futures markets or between futures
and option markets or even between all three markets.
 The final category of players are the speculators. Speculators as the
name suggests merely speculate. They take positions in assets or
markets without taking offsetting positions.
 THE MAIN PLAYERS IN DERIVATIVE
MARKETS
 For example, if they expect a certain asset to fall in value,
they would short (sell) the asset.
 Should their expectation come true they would make profits
from having shorted the asset.
 On the other hand should the price increase instead, they
would make losses on their short position.
 Speculators therefore expose themselves to risk and hope to
profit from taking on the risk.
 COMMODITY VS. FINANCIAL DERIVATIVES
Category
Physicals  
• Agricultural Commodities
• Metals & Energy
Financials  
• Foreign Currencies
• Equity & Bond Futures
Asset Type
- Wheat, Soybean, Crude Palm Oil, Citrus,
Coffee Beans, Corn, Rice, etc.
- Gasoline, Gas Oil, Propane, etc.
- Gold, Silver, Copper.
- US$, ¥en, DM, Can $, Sfr, Eurodollars, Euros.
- T-bills, T-bonds.
- KLIBOR futures, T-bill futures, etc.
- Various Stock Indexes.
APPLICATIONS: USING DERIVATIVES
TO MANAGE RISK
 In this section we examine, three different types of risks and
explore how three different categories of derivative instruments
could be used in managing the risks. The three types of risks are,
 Equity risk
 Interest Rate Risk and
 Exchange Rate or Currency Risk.
 We will use an Option to manage equity risk, an Interest Rate
Swap for interest rate risk and use a forward/futures contract to
manage exchange rate risk.
 WHAT DERIVATIVE TO USE ?

 Typically, when we have an underlying exposure, we would need to

use only one of the available instruments to hedge the exposure. So,
how do we decide which is the best instrument? As with most
things, the decision involves trade-offs and a number of
considerations.
 Availability and ease of use would be a key consideration.
Transaction cost and liquidity of the instrument would be another.
 The ‘fit’ between ones’ needs and the standardized features of a
contract is another. For example, while forwards may be cheap, one
may not find a bank willing to be the counterparty if one does not have
an established credit/business track record.
 WHAT DERIVATIVE TO USE ?

 While options are highly flexible and are advantageous compared

to forwards/futures, they are certainly more expensive.
 Finally, while OTC instruments like forwards and swaps allow for
customization, one would be faced with counterparty risk and
issues of pricing when using them. So, in deciding on the
appropriate instrument to use, we need to balance cost,
convenience and other issues.
ISLAMIC DERIVATIVE
 INTRODUCTION
 Despite the huge strides made in Islamic Banking and Finance,
derivative instruments especially the use of financial derivatives
has remained a controversial issue.
 The issue is further clouded by the often-contradictory stand of
Islamic Jurists and scholars with regards to the acceptability of
derivative instruments.
 Still, a number of Islamic financial instruments/contracts exist
that have derivative like features.
 These being the Bay’ Salam, Istisna, Ju’ala and the Istijrar Contracts.

45
 INTRODUCTION
 In addition to these there are the recently developed
Islamic Profit Rate Swaps, and shariah compliant
derivative instruments that are based on wa’ad and
sukuks with embedded options.
 Thus, the market and its practitioners have moved on with
using derivative like instruments out of necessity even
though shariah scholars are yet to reach a consensus on
their acceptability.
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 NECESSARY FEATURES OF ISLAMIC
FINANCIAL INSTRUMENTS
 The Shariah has some basic conditions with regards to the sale of an
asset (in this case a real asset as opposed to financial assets).
 Since a derivative instrument is a financial asset dependent on the value
of its underlying asset (real asset in most cases), the Shariah conditions
for the validity of a sale would also be relevant.

47
 NECESSARY FEATURES OF ISLAMIC
FINANCIAL INSTRUMENTS
 Aside from the fact that the underlying asset must be halal, at least two
conditions have to be met:

(i) the underlying asset or commodity must currently exist in its physical,
sellable form and

(ii) the seller should have legal ownership of the asset in its final form.
 These conditions for the validity of a sale would obviously render
impossible the trading of derivatives. However, the Shariah provides
exceptions to these conditions to enable deferred sale where needed.

48
 ISLAMIC FINANCE INSTRUMENTS WITH
FEATURES OF DERIVATIVE INSTRUMENTS

 A number of instruments/contracts exist in Islamic finance

that could be considered a basis for derivative contracts
within an Islamic framework:
 the Bay’ Salam Contract, and
 the Istijrar Contract.

 While the Bay’ Salam contract has provisions and

precedence, the Istijrar is a recent innovation practiced in
Pakistan.

49
 BAY SALAM
 Bay’ al-Salam is essentially a transaction where two parties agree to carry
out a sale/purchase of an underlying asset at a predetermined future date but
at a price determined and fully paid for today.
 The seller agrees to deliver the asset in the agreed quantity and quality to
the buyer at the predetermined future date.
 This is similar to a conventional forward contract however, the big
difference is that in a Salam sale, the buyer pays the entire amount in full
at the time the contract is initiated.

50
 BAY SALAM
 The contract also stipulates that the payment must be in cash form. The idea
behind such a ‘prepayment’ requirement has to do with the fact that the
objective in a Bay’ Salam contract is to help needy farmers and small
businesses with working capital financing.
 As such, the predetermined price is normally lower than the prevailing spot
price.
 This price behavior is certainly different from that of conventional
futures/forward contracts where the futures price is typically higher than
the spot price by the amount of the carrying cost.
 The lower Salam price compared to spot is the “compensation” by the
seller to the buyer for the privilege given him.

51
 BAY SALAM
 Conditions of Salam contract are as follows:
1. Full payment by buyer at the time of effecting sale.
2. The underlying asset must be standardizable, easily quantifiable
and of determinate quality.
3. Salam contract cannot be based on a uniquely identified
underlying asset.
4. Quantity, Quality, Maturity date and Place of delivery must be
clearly enumerated in the Salam agreement.
5. The underlying asset or commodity must be available and traded
in the markets throughout the period of contract.

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 ISTISNA AND JUALA CONTRACTS
 In addition to Bay’ Salam, there are two other contracts where a
transaction is made on a “yet to” exist underlying asset: Istisna and
Ju’ala contracts.
 The Istisna Contract has as its underlying, a product to be
manufactured. In an Istisna, a buyer contracts with a
manufacturer to manufacture a needed product to his
specifications.
 The price for the product is agreed upon and fixed.
 While the agreement may be cancelled by either party before
production begins, it cannot be cancelled unilaterally once the
manufacturer begins production.
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 ISTISNA AND JUALA CONTRACTS
 Unlike the Salam Contract, the payment here is not made in
advance.
 The time of delivery too is not fixed but negotiated.

 Like the Bay’ Salam, a parallel contract is allowed for in

Istisna.
 Thus, the Istisna Contract may be used by Islamic banks for
product financing.

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 ISTISNA AND JUALA CONTRACTS

 The Ju’ala Contract is essentially a Istisna but applicable for

services as opposed to a manufactured product.
 The conditions described for the Istisna contract above apply in
the Ju’ala contract.

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 THE ISTIJRAR CONTRACT
 The Istijrar contract is a recently introduced Islamic financing instrument.
Introduced in Pakistan, the contract has embedded options that could be
triggered if the underlying asset’s price exceeds certain bounds.
 The contract is complex in that it constitutes a combination of options,
average prices and Murabaha or cost plus financing.
 The Istijrar involves two parties, a buyer which could be a company
seeking financing to purchase the underlying asset and a financial
institution.

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 THE ISTIJRAR CONTRACT
 A typical Istijrar transaction could be as follows;
 a company seeking short term working capital to finance the
purchase of a commodity like a needed raw material approaches a
bank.
 The bank purchases the commodity at the current price (Po), and resells it to
the company for payment to be made at a mutually agreed upon date in the
future – for example in 3 months.
 The price at which settlement occurs on maturity is contingent on the
underlying asset’s price movement from t0 to t90.Where t0 is the day the
contract was initiated and t90 is the 90th day which would be the maturity day.

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 ISLAMIC PROFIT RATE SWAP (IPRS)
 The Islamic Profit Rate Swap (IPRS) is a fairly new innovation by Islamic
Financial Institutions (IFIs) to manage their duration gap.
 Islamic banks, especially those in Malaysia have large asset-liability
duration mismatches.
 The asset side of their balance sheet, which shows the financing the have
undertaken would typically have a longer maturity (duration) than their
liability side which shows their deposits.
 Since banks typically take short term deposits and lend them out for longer
periods, the average duration of their assets (loans to customers) are
usually longer than the average duration of their liabilities.

58
 ISLAMIC PROFIT RATE SWAP (IPRS)
 Duration is a measure of interest rate risk.
 Financial instruments with longer duration would fall more in value
than those with shorter duration.
 This implies that banks with large asset-liability duration gaps will
see the value of their assets fall much more than the value of their
liabilities when interest rates rise.
 This differential fall in value will mean that the bank’s net worth
will be reduced by the amount of the difference in values.

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 ISLAMIC PROFIT RATE SWAP (IPRS)

 For example, if rate sensitive assets are higher than rate sensitive
liabilities by RM50 million, then the potential squeeze on net worth will
come from this RM50 million.
 Conventional banks handle such risk in three common ways.
 First, by using adjustable rate mortgages or loans with floating interest
rates.
 In Malaysia, conventional banks price housing loans as BLR + x percent.
 Thus, as the BLR (Base Lending Rate) changes, the interest charged on the
loan changes. The + x percent, is a constant rate reflecting the risk
premium.

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 ISLAMIC PROFIT RATE SWAP (IPRS)
 The second method is by using interest rate derivatives, like interest rate
futures contracts, to hedge against rising interest rates and lastly, using
interest rate swaps.
 The Islamic profit rate swap (IPRS) serves a similar function to IFIs. IFIs
that need to protect themselves from interest rate increases can use the IPRS
to hedge their profits and net worth.
 Furthermore, Islamic banking is not exclusive to Muslims but shares a
common customer pool with conventional banks.
 This inevitably ties in Islamic banking with the rest of the financial
system. Funds flow between Islamic and conventional banks in both
directions. As a result of this, interest rate changes in the conventional
sector translate into changes in the cost of funds with the Islamic
banking system.
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