Overview of Derivatives

Learning Outcome

• Definition
• Types of derivatives
• Usage of derivatives

What Are Derivatives?

Financial instrument where the payoff to the investor depends directly on the value of another asset

The asset may be:

• Stock Index
• Stock Price
• Commodity
• Exchange Rate
• Interest Rate
• Another derivative

CME Futures Fundamental

Types of Derivatives

• Forward
• Futures
• Options
• Warrants
• Swaps

Usage of Derivatives

• Hedging or Risk Management
• Speculation
• Exposure to untradeable underlying
• Leverage and reduction of transaction costs
• Regulatory arbitrage

Forward Contract

Learning Outcomes

• Definition
• Advantages
• Disadvantages

Most basic of all derivative products

What Exactly is a Forward Contract?

• Gives its holder both the right and the full obligation to conduct a transaction involving another security – the underlying asset – at a predetermined future date and at a predetermined price.

Forward Contract

• Agreement between 2 parties for delivery of a specific asset at a specified time in the future for a set price agreed upon today

• All terms are negotiable e.g. price, quantity, quality, settlement procedure

• Possibility of default by buyer or seller  

Advantages of Forward Contract

• Flexible
• May not require collateral

Disadvantages of Forward Contract

• Involve credit (default) risk
• Can be illiquid

Futures Contract

Learning Outcomes

• Definition
• Futures contract

What Exactly is Futures Contract?

• Agreement between trader and exchange or clearing house to buy/sell underlying asset at a price fixed now for future delivery

Futures Contract

A standardized forward contract

• Contract size
• Time for delivery. E.g. March, June
• Quality
• Exchange acts as counterparty for all trades

Futures Contract

• Trade through a centralised market, called futures exchange
• Product homogeneity
• Margin (Collateral) requirement
• Margin account held by the exchange’s clearinghouse
• Marked to market

Options

Learning Outcomes

• Definition
• Structure
• Types of Option

Option

• An Option contract gives its owner the right but not the obligation to buy or sell an underlying asset at a specified exercise or strike price, on or before a specified date

• The underlying assets include stocks, stock indices, bonds, commodities, futures contracts and foreign currencies. 

Structure

An option is a contract/agreement between two parties (buyer and seller)

• Buyer: Holder of the (right) option

• Seller (Writer): Obliged to fulfill the obligations of the contract if the option is exercised

Types of Option Contracts

Two Types of Option:

Call Option: Grants the holder the right, but not the obligation, to buy the underlying at a given strike price

Put Option: Grants the holder the right, but not the obligation, to sell the underlying at a given strike price

Swaps

Learning Outcomes

• Definition
• Types of swaps
• Uses of swaps

Definition

A swap is a contract calling for an exchange of payments, on one or more dates, determined by the difference in two prices

Types of Swaps

• Interest rates swaps
• Currency swaps
• Equity swaps
• Commodity swaps
• Credit risk swaps

Uses of Swaps

• Transforming liabilities: Convert the exposure to one market into exposure into another market
• Pricing links between two different cash flow streams