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VASVI AREN
AYUSH SINGHAL
3246, 3258
Whatareerivatives
4 A derivative is a financial instrument
4 2 re simply, an agreement between tw pe ple r
tw parties c nveying wnership f the underlying
asset [rather than the asset itself]
4 It is a financial c ntract with a value linked t the
expected future price m vements f the asset it is
linked t - such as a share r a currency.
4 There are many kinds f derivatives, with the m st
n table being
4 futures/f rwards
4 pti ns
4 swaps
erivativearkets

4 The derivatives market is the financial

market f r derivatives, financial
instruments like futures c ntracts r pti ns.
4 The market can be divided int tw , that
f r exchange-traded derivatives and that
f r ver-the-c unter derivatives. The legal
nature f these pr ducts is very different as
well as the way they are traded, th ugh many
market participants are active in b th
 eserivativearkets
4 Yver-the-c unter derivatives (YTC)
a] are c ntracts that are traded (and privately neg tiated) directly
between tw parties, with ut g ing thr ugh an exchange r ther
intermediary.
b] The YTC derivative market is the largest market f r derivatives,
and is largely unregulated with respect t discl sure f inf rmati n
between the parties, since the YTC market is made up f banks and
ther highly s phisticated parties, such as hedge funds.
c] Rep rting f YTC am unts are difficult because trades can ccur
in private, with ut activity being visible n any

4 Exchange-traded derivative c ntracts (ETD)

a] are th se derivatives instruments that are traded via
specialized derivative exchanges r ther exchanges.
b] is a market where individuals trade standardized c ntracts that
have been defined by the exchange
c] acts as an intermediary t all related transacti ns, and takes Initial
margin fr m b th sides f the trade t act as a guarantee.
 hreeajrasseserivatives:

A. Futures/F rwards
are c ntracts t buy r sell an asset n r bef re a future date at
a price specified t day.

2. Ypti ns
are c ntracts that give the wner the right, but n t the bligati n,
t buy (in the case f a call pti n) r sell (in the case f a put
pti n) an asset.

3. Swaps
are c ntracts t exchange cash (fl ws) n r bef re a specified
future date based n the underlying value f currencies/exchange
rates, b nds/interest rates, c mm dities, st cks r ther assets.
|tres
4 A futures c ntract is a type f derivative instrument, r
financial c ntract, in which tw parties agree t
transact a set f financial instruments r physical
c mm dities f r future delivery at a particular price.
4 But participating in the futures market d es n t
necessarily mean that y u will be resp nsible f r
receiving r delivering large invent ries f physical
c mm dities
4 it is an Exchange traded derivative, ETD
4 When a new c ntract is intr duced, the t tal p siti n
in the c ntract is zer . Theref re, the sum f all the
l ng p siti ns must be equal t the sum f all the
sh rt p siti ns. In ther w rds, risk is transferred fr m
ne party t an ther.
4 Trading takes place n a f rmal exchange wherein the
exchange pr vides a place t engage in these
transacti ns and sets a mechanism f r the parties t
trade these c ntracts.
4 There is n default risk because the exchange acts as
a c unterparty, guaranteeing delivery and payment by
use f a clearing h use.
4 The clearing h use pr tects itself fr m default by
requiring its c unterparties t settle gains and l sses
4 An invest r can ffset his r her future p siti n by
engaging in an pp site transacti n bef re the stated
maturity f the c ntract.
A rren|tres
4 A currency future, als FX future r f reign exchange future, is
a futures c ntract t exchange ne currency f r an ther at a
specified date in the future at a price (exchange rate) that is fixed
n the purchase date
4 2 st c ntracts have physical delivery, s f r th se held at the
end f the last trading day, actual payments are made in each
currency.
4 Uses
Hedging
Invest rs use these futures c ntracts t hedge against f reign
exchange risk. If an invest r will receive a cash fl w den minated
in a f reign currency n s me future date, that invest r can l ck
in the current exchange rate by entering int an ffsetting
currency futures p siti n that expires n the date f the cash
fl w.
Speculati n
Currency futures can als be used t speculate and, by incurring
a risk, attempt t pr fit fr m rising r falling exchange rates.

nterest
ate|tres

4 An interest rate future is a financial derivative with an interest-

bearing instrument as the underlying asset.
4 Examples include Treasury-bill futures, Treasury-b nd futures
and Eur d llar futures.
4 Uses
Interest rate futures are used t hedge against the risk f that
interest rates will m ve in an adverse directi n, causing a c st t
the c mpany.
B rr wers face the risk f interest rates rising. Futures use the
inverse relati nship between interest rates and b nd prices t
hedge against the risk f rising interest rates.
|rwars
4 The forward market is the ver-the-c unter financial
market in c ntracts f r future delivery.
4 The f rward market is a general term used t describe
the inf rmal market by which these c ntracts are
entered int
4 F rward c ntracts are pers nalized between parties
(i.e., delivery time and am unt are determined
between seller and cust mer).
4 N t frequently traded n exchanges.
4 The buyer agrees t buy an underlying asset fr m the
ther party (the seller). The delivery f the asset
ccurs at a later time, but the price is determined at
the time f purchase.
4 Features
A. Highly cust mized
2. All parties are exp sed t c unterparty default risk
3. Transacti ns take place in large, private and largely
unregulated markets c nsisting f banks,investment
banks, g vernment and c rp rati ns
4. Underlying assets can be a st cks, b nds, f reign
currencies, c mm dities r s me c mbinati n there f. The
underlying asset c uld even be interest rates
iinktw|tresanrwarsarket

A. B th are derivative securities f r future delivery/receipt. Agree

n future settlement r delivery in A week t A years.

2. B th are used t hedge currency risk, interest rate risk r

c mm dity price risk.

3. B th futures and f rwards are firm and binding agreements t

act at a later date. In m st cases this means exchanging an
asset at a specific price s metime in the future.

4. Physical settlement ccurs when the actual underlying asset is

delivered in exchange f r the agreed-up n price. In cases
where the c ntracts are entered int f r purely financial reas ns
the derivative may be cash settled with a single payment equal
t the market value f the derivative at its maturity r expirati n.
5. In principal they are very similar, used t
acc mplish the same g al f risk management.

6. They ffer a c nvenient means f hedging r

speculating.

8. B th physical settlement and cash settlement

pti ns can be keyed t a wide variety f underlying
assets including c mm dities, sh rt-term debt,
Eur d llar dep sits, g ld, f reign exchange,etc.
   
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÷all options

4 pr vides the h lder the right (but n t the bligati n) t purchase an

underlying asset at a specified price (the strike price), f r a certain peri d
f time.
4 If the st ck fails t meet the strike price bef re the expirati n date, the
pti n expires and bec mes w rthless.
4 Invest rs buy calls when they think the share price f the underlying
security will rise
4 r sell a call if they think it will fall. Selling an pti n is als referred t as
''writing'' an pti n.
âut options

4 gives the h lder the right t sell an underlying asset at a specified

price (the strike price).
4 The seller ( r writer) f the put pti n is bligated t buy the st ck at the
strike price.
4 Put pti ns can be exercised at any time bef re the pti n expires.
4 Put buyers - th se wh h ld a "l ng" - put are either speculative buyers
l king f r leverage r "insurance" buyers wh want t pr tect their l ng
p siti ns in a st ck f r the peri d f time c vered by the pti n.
4 Put sellers h ld a "sh rt" expecting the market t m ve upward ( r at least
stay stable)
A |reinrrentin

4 A c ntract that grants the h lder the right, but

n t the bligati n, t buy r sell currency at a
specified exchange rate during a specified
peri d f time. F r this right, a premium is
paid t the br ker, which will vary depending
n the number f c ntracts
purchased. Currency pti ns are ne f the
best ways f r c rp rati ns r individuals t
hedge against adverse m vements in
exchange rates.

nterestratetins

4 An investment t l wh se pay ff depends n the

future level f interest rates. Interest rate pti ns are
b th exchange traded and ver-the-c unter
instruments.
4 Interest rate pti ns fr m exchanges in the United
States are ffered n Treasury b nd futures,
Treasury n te futures and eur d llar futures. An
invest r taking a l ng p siti n in interest rate call
pti ns believes that interest rates will rise, while an
invest r taking a p siti n in interest rate put pti ns
believes that interest rates will fall.
 ierenetwrwarsantres
FYRWARDS
A. F rward c ntracts are private,
cust mized c ntracts between a
bank and its clients (2NCs,
exp rters, imp rters, etc.)
depending n the client's needs.
2. c llateral/security dep sit is n t
required,
3. Generally settled by actual
delivery
4. the market place is ver the
teleph ne , w rldwide.
5. It is self regulat ry
FUTURES
A Future c ntracts are
standardized, specific sized
c ntracts.
2. Small security dep sit with
the exchange is necessary.
3. 2 st are ffset and very few
are delivered.
4. The market place is the
central exchange fl r with
w rldwide c mmunicati n.
5.There is a regulati n called
c mm dity future trading
c mmisi n and nati nal future
ass ciati n.
itwrwarsantins

FYRWARDS YPTIYNS

4 A f rward c ntract is an 4 An pti n is an agreement

agreement between tw
parties t buy r sell an
asset at a certain future
time f r a certain price
agreed t day.
4 an pti n may r may n t
4 a f rward c ntract has t
happen
between tw parties f r the
pti n t buy r sell an
asset at a certain future
time f r a certain price
agreed t day.
happen depending n the
value f the asset
c mpared t the agreed
price
itwtresantins
A. A futures c ntract gives the buyer the Ñ
Ñ t purchase a
specific asset, and the seller t sell and deliver that asset at a
specific future date, unless the h lder's p siti n is cl sed pri r t
expirati n. Aside fr m c mmissi ns, an invest r can enter int a
futures c ntract with n upfr nt c st
2.An ther key difference between pti ns and futures is the size f
the underlying p siti n. Generally, the underlying p siti n is much
larger f r futures c ntracts, and the bligati n t buy r sell this
certain am unt at a given price makes futures m re risky f r the
inexperienced invest r.

3.An ther maj r difference between these tw financial instruments

is the way the gains are received by the parties. In c ntrast, gains
n futures p siti ns are aut matically 'marked t market' daily,
meaning the change in the value f the p siti ns is attributed t the
futures acc unts f the parties at the end f every trading day -
but a futures c ntract h lder can realize gains als by g ing t the
market and taking the pp site p siti n.
4.buying an pti ns p siti n d es require the
payment f a premium. C mpared t the absence
f upfr nt c sts f futures, the pti n premium can
be seen as the fee paid f r the privilege f n t
being bligated t buy the underlying in the event
f an adverse shift in prices. The premium is the
maximum that a purchaser f an pti n can l se

5.The gain n a pti n can be realized in the

f ll wing three ways: exercising the pti n when it
is deep in the m ney, g ing t the market and
taking the pp site p siti n, r waiting until expiry
and c llecting the difference between the asset
price and the strike price.
was
4 A swap is ne f the m st simple and successful f rms f YTC-
traded derivatives.
4 It is a cash-settled c ntract between tw parties t exchange ( r
"swap") cash fl w streams
4 As l ng as the present value f the streams is equal, swaps can
entail alm st any type f future cash fl w.
4 They are m st ften used t change the character f an asset r
liability with ut actually having t liquidate that asset r liability.
F r example, an invest r h lding c mm n st ck can exchange
the returns fr m that investment f r l wer risk fixed inc me cash
fl ws - with ut having t liquidate his equity p siti n.
A nterestrateswas
4 In general, an interest rate swap is an agreement t exchange rate cash fl ws fr m interest-bearing
instruments at specified payment dates. Each party's payment bligati n is c mputed using a different
interest rate. Alth ugh there are n truly standardized swaps, a plain vanilla swap typically refers t a
generic interest rate swap in which ne party pays a fixed rate and ne party pays a fl ating rate (usually
LIBYR).
F r each party, the value f an interest rate swap lies in the net difference between the present value f the
cash fl ws ne party expects t receive and the present value f the payments the ther party expects t
make. At the riginati n f the c ntract, the value f r b th parties is usually zer because n cash fl ws are
exchanged at that p int. Yver the life f the c ntract, it bec mes a zer -sum game. As interest rates
fluctuate, the value f the swap creates a pr fit n ne c unterparty's b ks, which results in a
c rresp nding l ss n the ther's b ks.
?

A p rtf li manager with a $A milli n fixed-rate p rtf li yielding 3.5% believes rates may increase and
wants t decrease his exp sure. He can enter int an interest rate swap and trade his fixed rate cash fl ws
f r fl ating rate cash fl ws that have less exp sure when rates are rising. He swaps his 3.5% fixed-rate
interest stream f r the three-m nth fl ating LIBYR rate (which is currently at 3%). When this happens, he
will receive a fl ating rate payment and pay a fixed rate that is equivalent t the rate the p rtf li is
receiving, making his p rtf li a fl ating-rate p rtf li instead f the fixed-rate return he was receiving.
There is n exchange f the principal am unts and the interest payments are netted against ne an ther.
F r example, if LIBYR is 3%, the manager receives .5%. The actual am unts calculated f r semiannual
payments are sh wn bel w. The fixed rate (3.5% in this example) is referred t as the swap rate.
A typical exam questi n c ncerning interest rate swaps f ll ws:
4 ƒ. Tw parties enter a three-year, plain-vanilla interest rate swap agreement t exchange the LIBYR rate
f r a A % fixed rate n $A milli n. LIBYR is AA% n w, A2% at the end f the first year, and 9% at the
end f the sec nd year. If payments are in arrears, which f the f ll wing characterizes the net cash fl w
t be received by the fixed-rate payer?
A. $A , at the end f year tw .
B. $A , at the end f year three.
C. $2 , at the end f year tw .
D. $2 , at the end f year three.
A. The c rrect answer is "C". What's imp rtant t remember is that the payments are in arrears, s the
end- f-year payments depend n the interest rate at the beginning f the year ( r pri r year end). The
payment at the end f year tw is based n the A2% interest rate at the end f year ne. If the fl ating
rate is higher than the fixed rate, the fixed rate payer receives the interest rate differential times the
principal am unt ($A , x ( .A2- .A ) = $2 , ).
÷alculate the âayments on an Interest Rate Swap
C nsider the f ll wing example:
N ti nal am unt = $A milli n, payments are made semiannually. The c rp rati n will pay a fl ating rate
f three-m nth LIBYR, which is at 3% and will receive a fixed payment f 3.5%.


Fl ating rate payment is $A milli n(. 3)(A8 /365) = $A4,79
Fixed payment is $A milli n(. 35)(A8 /365) = $A7,225
The c rp rati n will receive a net payment f $2,435

rrenswas
4 a currency swap is a c ntract t exchange cash fl w streams fr m s me fixed inc me bligati ns (f r
example, swapping payments fr m a fixed-rate l an f r payments fr m a fl ating rate l an). In an interest
rate swap, the cash fl w streams are in the same currency, while in currency swaps, the cash fl ws are
in different m netary den minati ns. Swap transacti ns are n t usually discl sed n c rp rate balance
sheets.

4
As we stated earlier, the cash fl ws fr m an interest rate swap ccur n c ncurrent dates and are netted
against ne an ther. With a currency swap, the cash fl ws are in different currencies, s they can't net.
Instead, full principal and interest payments are exchanged.
Currency swaps all w an instituti n t take leverage advantages it might enj y in specific c untries. F r
example, a highly-regarded German c rp rati n with an excellent credit rating can likely issue eur -
den minated b nds at an attractive rate. It can then swap th se b nds int , say, Japanese yen at better
terms than it c uld by g ing directly int the Japanese market where its name and credit rating may n t
be as advantage us.
At the riginati n f a swap agreement, the c unterparties exchange n ti nal principals in the tw
currencies. During the life f the swap, each party pays interest (in the currency f the principal received)
t the ther. At maturity, each makes a final exchange (at the same sp t rate) f the initial principal
am unts, thereby reversing the initial exchange. Generally, each party in the agreement has a
c mparative advantage ver the ther with respect t fixed r fl ating rates f r a certain currency
4 ? ample: Future ÷ontracts

4 Let's assume that in September the sp t r current price f r hydr p nic t mat es is $3.25 per
bushel and the futures price is $3.5 . A t mat farmer is trying t secure a selling price f r his
next cr p, while 2cD nald's is trying t secure a buying price in rder t determine h w much t
charge f r a Big 2ac next year. The farmer and the c rp rati n can enter int a futures c ntract
requiring the delivery f 5 milli n bushels f t mat es t 2cD nald's in December at a price f
$3.5 per bushel. The c ntract l cks in a price f r b th parties.
It is this c ntract - and n t the grain per se - that can then be b ught and s ld in the futures
market. In this scenari , the farmer is the h lder f the sh rt p siti n (he has agreed t sell the
underlying asset - t mat es) and 2cD nald's is the h lder f the l ng p siti n (it has agreed t
buy the asset). The price f the c ntract is 5 milli n bushels at $3.5 per bushel.
The pr fits and l sses f a futures c ntract are calculated n a daily basis. In ur example,
supp se the price n futures c ntracts f r t mat es increases t $4 per bushel the day after the
farmer and 2cD nald's enter int their futures c ntract f $3.5 per bushel. The farmer, as the
h lder f the sh rt p siti n, has l st $ .5 per bushel because the selling price just increased
fr m the future price at which he is bliged t sell his t mat es. 2cD nald's has pr fited by
$ .5 per bushel.
Yn the day the price change ccurs, the farmer's acc unt is debited $2.5 milli n ($ .5 per
bushel x 5 milli n bushels) and 2cD nald's is credited the same am unt. Because the market
m ves daily, futures p siti ns are settled daily as well. Gains and l sses fr m each day's trading
are deducted r credited t each party's acc unt. At the expirati n f a futures c ntract, the sp t
and futures prices n rmally c nverge.
2 st transacti ns in the futures market are settled in cash, and the actual physical c mm dity is
b ught r s ld in the cash market. F r example, let's supp se that at the expirati n date in
December there is a blight that decimates the t mat cr p and the sp t price rises t $5.5 a
bushel. 2cD nald's has a gain f $2 per bushel n its futures c ntract but it still has t buy
t mat es. The c mpany's $A milli n gain ($2 per bushel x 5 milli n bushels) will be ffset
against the higher c st f t mat es n the sp t market. Likewise, the farmer's l ss f $A milli n
is ffset against the higher price f r which he can n w sell his t mat es. vasvi
4 ? ample: Forward ÷ontracts
Let's assume that y u have just taken up sailing and like it s well that
y u expect y u might buy y ur wn sailb at in A2 m nths. Y ur sailing
buddy, J hn, wns a sailb at but expects t upgrade t a newer, larger
m del in A2 m nths. Y u and J hn c uld enter int a f rward c ntract
in which y u agree t buy J hn's b at f r $A5 , and he agrees t
sell it t y u in A2 m nths f r that price. In this scenari , as the buyer,
y u have entered a l ng f rward c ntract. C nversely, J hn, the seller
will have the sh rt f rward c ntract. At the end f ne year, y u find that
the current market valuati n f J hn's sailb at is $A65, . Because
J hn is bliged t sell his b at t y u f r nly $A5 , , y u will have
effectively made a pr fit f $A5, . (Y u can buy the b at fr m J hn
f r $A5 , and immediately sell it f r $A65, .) J hn, unf rtunately,
has l st $A5, in p tential pr ceeds fr m the transacti n.
Like all f rward c ntracts, in this example, n m ney exchanged hands
when the c ntract was neg tiated and the initial value f the c ntract
was zer .vasvi