International Islamic University

Faculty Management Sciences

Assignment

Submitted to:

Ahmad Fraz

Submitted by:

Ahmad Hassaan Qazi

Reg. #

5848-FMS/MBA/F12

Subject:

Risk Management

Class:
Session:

MBA 1.5
2012-13.

Financial Derivatives
1. Derivatives Are New, Complex, High-Tech Financial Products Created by
Wall Street's Rocket Scientists
2. Derivatives Are Purely Speculative, Highly Leveraged Instruments
3. The Enormous Size of the Financial Derivatives Market Dwarfs Bank
Capital, Thereby Making Derivatives Trading an Unsafe and Unsound
Banking Practice
4. Only Large Multinational Corporations and Large Banks Have a Purpose for
Using Derivatives
5. Financial Derivatives Are Simply the Latest Risk-Management Fad
6. Derivatives Take Money Out of Productive Processes and Never Put
Anything Back
7. Only Risk-Seeking Organizations Should Use Derivatives
8. The Risks Associated with Financial Derivatives Are New and Unknown
9. Derivatives Link Market Participants More Tightly Together, Thereby
Increasing Systemic Risks
10. Because of the Risks Associated with Derivatives, Banking Regulators
Should Ban Their Use by Any Institution Covered by Federal Deposit
Insurance
11. Derivatives have been highly controversial for a number of reasons. For one,
they are very complex. Much of the criticism has stemmed from a failure to
understand derivatives. When derivatives fail to do their job, it is often the
derivatives themselves, rather than the users of derivatives, that take the blame.
12. Derivatives are also mistakenly characterized as a form of legalized gambling.
13. Many of the criticisms of derivatives stem from their complexity, which leads to
commentators misunderstanding their role, or investors purchasing derivatives
without understanding the risks involved.
14. Derivatives are often seen as legalized gambling. This is an unfair criticism since
derivatives have the benefit of making financial markets work better and provide
a means for people to manage risk, whereas it is difficult to argue that gambling
improves society as a whole.

Comparison chart
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chart
Meaning:

Forward Contract

Futures Contract

A forward contract is an agreement A futures contract is a standardized

between two parties to buy or sell an contract, traded on a futures
asset (which can be of any kind) at a exchange, to buy or sell a certain
pre-agreed future point in time.
underlying instrument at a certain
date in the future, at a specified price.

Structure & Customized to customers need.

Standardized. Initial margin payment
Purpose:
Usually no initial payment required. required. Usually used for
Usually used for Hedging
Speculation.
Transaction Negotiated directly by the buyer and Quoted and traded on the Exchange
method:
seller
Market
regulation:

Not regulated

Government regulated market

Institutional The contracting parties

guarantee:

Clearing House

Risk:

Low counterparty risk

High counterparty risk

Guarantees: No guranantee of settlement until the Both parties must deposit an initial
date of maturity only the forward
guarantee (margin). The value of the
price, based on the spot price of the operation is marked to market rates
underlying asset is paid
with daily settlement of profits and
losses.
Contract
Maturity:

Forward contract mostly mature by

delivering the commodity

Expiry date: Depending on the transaction

Future contracts may not necessarily

mature by delivery of commodity
Standardized

Method of
Opposite contract with same or
Opposite contract on the exchange.
predifferent counterparty. Counterparty
termination: risk remains while terminating with
different counterparty.
Contract
size:

Depending on the transaction and Standardized

the requirements of the contracting
parties.

Sr.
No.

Future
Contracts

Forward
contracts

Standardized contracts

Customized or tailor made

contracts

Publically traded

Traded privately

Daily settlement of profit and

The profit or loss is accumulated till
loss, which is known as mark
the expiry of contract
to market.

Trades at future exchange

Trades at over the counter

exchange

No default risk

Rare default risk exist

Clearing house takes the

responsibility of defaults and
pay to the other party.

No Clearing house is present

between the parties in forward
contract

Future contracts are open to

general public as they are
traded on future exchanges.

Financially sound and creditworthy

parties only can enter into forward
contracts.

Parties have indirect contracts

between them, as exchange
write a contract in between
both parties. The exchange
collect the payment from one
party and transfer to other
party.

Both parties have direct contract

between them, and payments are
also handled by them
independently as per there own
terms and conditions.

Forward contract are generally

Parties can anytime enter into intended to be in force till maturity,
opposite transactions before however,
expiry.
it is possible for party to enter into
opposite transaction before expiry.

10

Futures markets offer the

parties liquidity, which gives
them a means of buying and
selling the contracts.
Because of this liquidity, a
party can enter into a
Since forward markets are intended
contract and later, before the
to be in force till maturity, so they
contract expires,
dont provide liquidity.
enter into the opposite
transaction and offset the
position, much the
same way one might buy or
sell a stock or bond and then
reverse the transaction later.

Forward Contracts

Futures Contracts

(-) Unregulated market

(+) Regulated and highly controlled market

(+) Customized sizes and

maturities.
It creates a perfect hedge that
exactly
Matches underlying exposure

Standardized sizes and expiration periods.

Hedge position may not provide an exact
dollar-for dollar offset to underlying
exposure.

(-) Participants must negotiate rates

and prices.

(+) Pricing is extremely efficient. No negotiations

(-) Prices depend on credit risk and

relationship.

(+) Prices are the same for all.

(-) Custom made product may be

difficult toexit.

(+) Liquidity and flexibility. Hedge position

may be entered and exited when needed.

(+) One delivery date

(-) Delivery is realized several days after maturity.

(-) Credit risk of counterparty may

be huge
(+) There is no margin system.

(+) There is no credit risk.

(-) Margin system may be expensive