Financial Derivatives

10 Key excerpts on "Financial Derivatives"

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  eBook - PDF

  Applied Conic Finance

  • Dilip Madan, Wim Schoutens(Authors)
  • 2016(Publication Date)
  • Cambridge University Press

    (Publisher)

  1 Financial Mathematics Principles 1.1 Financial Derivatives and Derivatives Markets A financial derivative is a special type of financial contract whose value and payouts depend on the performance of a more fundamental underlying asset. One finds derivatives on the basis of all kinds of underlying entities, such as equity derivatives, whose performance is linked to the behaviour of underlying stock prices or stock indices; fixed income derivatives, whose payout depends on the level of interest rates; currency derivatives, that are connected with one or more FX exchange rates; derivatives on commodities which, for example, can depend on the (joint) evolution of oil, gas, gold, orange juice or any other commodity prices. Actually, they can come in all forms and on the basis of all kinds of underliers; sometimes even a combination of several underliers from different asset classes (hybrids). Derivatives come into existence in modern economies and encourage price discovery in free markets with consequent price volatility. Often, good business planning requires some limited price stability. This can be (partially) provided by derivatives. One then shifts price risk to professionals better positioned to manage the oscillations. Derivatives can be used for many purposes. They can be used not only to mitigate price risk but also to speculate on it. Many contracts and structured products are implemented using derivatives. A sophisticated risk-management of a portfolio uses derivatives to hedge away as completely as possible all unde- sired exposure. Some capital instruments even have derivative features and can be seen essentially as cash flows being made contingent on the resolution of future uncertainties. Derivatives are traded on exchanges (like the CBOE) or over the counter (OTC). Derivatives traded on exchanges are typically standardized; OTC derivatives are tailor made.

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  Freight Derivatives and Risk Management in Shipping

  • Manolis G. Kavussanos, Dimitris A. Tsouknidis, Ilias D. Visvikis(Authors)
  • 2021(Publication Date)
  • Routledge

    (Publisher)

  underlying commodity”. For instance, the value of a derivative contract on crude oil depends on the current and expected price of crude oil.

  The aim of this chapter is to provide an introduction to financial derivative products and to their use in the practice of business risk management and investment. It classifies the types of participants in derivatives markets according to their aims, the types of derivative products available, their specifications and provides a set of practical examples of their uses. The rest of the chapter is organised as follows: Section 3.2 summarises the major economic functions and benefits of Financial Derivatives, while Section 3.3 outlines the various risks associated with them. Section 3.4 presents the types of participants in derivatives markets, which range from hedgers to speculators and arbitrageurs. Then, Sections 3.5 to 3.7 present the basic derivative instruments, including futures/forwards, swaps and options, respectively, discussing their specifications, characteristics, trading issues, pricing and their use for hedging and speculation purposes. Section 3.8 presents the accounting treatment of derivative transactions. Finally, Section 3.9 concludes the chapter.

  3.2 The economic functions and benefits of Financial Derivatives

  Originally, producers and consumers of commodities used derivative contracts to hedge (lock) commodity prices and in this way reduce their risk. The growth in derivative instruments has been attributed to their increasing use by governments, international corporations and major institutional and financial investors. They use derivatives in order to lower international funding costs, to provide better rates of exchange in international markets, to diversify their funding sources, to improve their risk management efficiency and to hedge price risks, amongst other functions. Fite and Pfleiderer (1995) show that Financial Derivatives allow traders to: (i) modify the risk profile of an investment portfolio, facilitating an efficient distribution of risks among risk bearers; (ii) enhance the expected return of a portfolio, depending on how efficiently risks can be shared among investors; (iii) reduce transactions costs associated with managing a portfolio; and (iv) circumvent regulatory obstacles.

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  Demystifying Fixed Income Analytics

  A Practical Guide

  • Kedar Nath Mukherjee(Author)
  • 2020(Publication Date)
  • Routledge India

    (Publisher)

  8 Financial derivative contracts

  Key learning outcomes

  At the end of this chapter, readers are expected to be familiar with:

  • Various concepts of derivatives markets and products: exchange traded vs. OTC market; forwards, futures, swaps, and options (call and put).
  • Present status of Financial Derivatives markets worldwide and in India.
  • Role of derivatives as a “useful financial innovation” and as a “weapon of mass destruction”.
  • Estimation of payoffs to buyer and seller.
  • Advantages/uses of derivatives contracts.
  • Risks in and risk management of different types of derivative instruments.

  Financial Derivatives: meaning & types of contracts

  A derivative may be defined as a financial instrument whose value depends on the value of another underlying asset. The International Monetary Fund (IMF) defines derivatives as:

  financial instruments that are linked to a specific financial instrument or indicator or commodity and through which specific financial risks can be traded in financial markets in their own right. The value of a financial derivative derives from the price of an underlying item such as an asset or index. Unlike debt securities, no principal is advanced to be repaid and no investment income accrues.

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  Financial Derivatives

  A Blessing or a Curse?

  • Simon Grima, Eleftherios I. Thalassinos, Rebecca E. Dalli Gonzi, Ioannis E. Thalassinos, Eleftherios I. Thalassinos(Authors)
  • 2020(Publication Date)
  • Emerald Publishing Limited

    (Publisher)

  2.2.2. Derivatives

  Derivatives, as explained in the first chapter, are financial contracts, whose ‘value depends on the values of one or more underlying assets or indexes’ (Adams & Runkle, 2000). However, Peter Hancock, head of Global Derivatives at J.P. Morgan, explains rather inaccurately, ‘derivatives … seem to have come to mean anything that lost money’ (Muehring, 1995, p. 21). Philippe Jorion in his book Big Bets Gone Bad (1995) noted that derivatives have been portrayed as ‘monster creatures’ to be feared and chained, indicating that this is no doubt due to the volume of trading in them and reflects a mystique of complexity and danger attached to them. Backstrand (1997), however, illustrated a more formal definition of a derivative depicting it as a ‘financial instrument, or contract, between two parties that derives its value from some other underlying asset or underlying reference price, interest rate, or index’.

  Philippe Jorion, in the same book noted above (1995), notes that there are well over hundred varieties of derivatives, many with difficult names. He notes some of these as caps, diffs, floors, swaptions, inverse floaters, knock-outs, step-ups and binaries. He indicates that the development in IT, modern microelectronics and software was the tools that have allowed mathematicians and even physicists create some highly sophisticated financial instruments. They are also hidden in mortgages and in debt instruments called structured notes. However, in their purest (plain vanilla) form as we shall see below, derivatives include forward contracts, futures, swaps and options.

  Derivatives allow firms and government entities ‘to identify, isolate, and manage the market risks in financial instruments and commodities, separately’. This is the reason why firms are increasingly relying on derivatives activities as ‘a direct source of revenue through market-making functions, position taking, and risk arbitrage’ (Basel Committee on Banking Supervision (BCBS), 1994). These financial instruments can be further categorised into exchange traded, with an actual physical location where all trades occur and over the counter (OTC), which are traded over a decentralised network of Banks or Financial Institutions. All futures and many options contracts have been standardised and are traded on established exchanges (Romano, 1996), whereas forwards, swaps and some options are custom-tailored contracts (Goldman, 1995).

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  Financial Derivatives and the Globalization of Risk

  • Benjamin Lee, Edward LiPuma, Dilip Parameshwar Gaonkar, Jane Kramer, Michael Warner, Dilip Parameshwar Gaonkar, Jane Kramer, Michael Warner(Authors)
  • 2004(Publication Date)
  • Duke University Press Books

    (Publisher)

  Their earliest forms were futures contracts whose underlying asset was a production-based bulk commodity; more recently, in response to global-izing markets, the underlying asset classes have included cur-rencies, stocks, bonds, performance indexes, and also other derivatives. A critical dimension of derivatives is that they do not involve the immediate exchange of principal and, ac-cordingly, are not immediately counted on financial balance sheets, so that especially when financial agents combine dif-ferent types of derivatives they allow for an extraordinary and unprecedented degree of leverage. So relatively small wagers can move much larger financial mountains, or more to the contemporary point, relatively large cumulative bets can re-value the currencies of entire countries. A defining feature of derivatives is that they exist in a kind of temporal parenthe-sis, beginning and terminating at a pre-specified moment, in most instances closing out the transaction at an agreed-upon date and time. Nonetheless, the formal economic definition of the deriva-tive—which encompasses any contract whose rate of return is determined by a continuously measurable underlying as-set or performance index (Rubinstein 1987)—conflates types of financial instruments critically different in terms of their basic design, forms of objectification of risk, temporality, and more generally the underlying world of social and semiotic relations upon which they are ultimately founded. On the surface, Financial Derivatives differ at the general (type) and individual (token) levels. They differ generally at the level of type according to the forms of arbitrage and hence the form of assets that they are designed to exploit: the relationship 108 among currencies, interest rates, indexes, and so on. There is nothing inherently commensurable between, for example, interest rates and stock indexes.

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  Financial Derivatives

  A Blessing or a Curse?

  • Simon Grima, Eleftherios I. Thalassinos, Rebecca E. Dalli Gonzi, Ioannis E. Thalassinos, Eleftherios I. Thalassinos(Authors)
  • 2020(Publication Date)
  • Emerald Publishing Limited

    (Publisher)

  They are also hidden in mort-gages and in debt instruments called structured notes. However, in their purest (plain vanilla) form as we shall see below, derivatives include forward contracts, futures, swaps and options. Derivatives allow firms and government entities ‘to identify, isolate, and manage the market risks in financial instruments and commodities, separately’. This is the reason why firms are increasingly relying on derivatives activities as ‘a direct source of revenue through market-making functions, position taking, and risk arbitrage’ (Basel Committee on Banking Supervision (BCBS), 1994). These financial instruments can be further categorised into exchange traded, with an actual physical location where all trades occur and over the counter (OTC), which are traded over a decentralised network of Banks or Financial Institutions. All futures and many options contracts have been standardised and are traded on established exchanges (Romano, 1996), whereas forwards, swaps and some options are custom-tailored contracts (Goldman, 1995). 26 Financial Derivatives: A Blessing or a Curse? Hedging is also considered as one of the uses of these instruments (Adams & Runkle, 2000), and a transaction involving this aims to reduce the risk of eco-nomic loss due to changes in the value, yield, price, cash flow or quantity of assets or liabilities (Dembeck & Lim, 1999). Hedging is an activity to mitigate economic risk through the use of a negatively correlated investment (Frederick, 1995; Thalassinos & Thalassinos, 2018). It requires an end-user to identify specific business assets subject to price fluctuations and then to purchase derivatives that counteract the effects of a change in the price of those assets, thus ensuring compensating gains for losses caused by underlying market move-ments.

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  Economic Areas Under Financial Stability

  • Indranarain Ramlall(Author)
  • 2018(Publication Date)
  • Emerald Publishing Limited

    (Publisher)

  Chapter 4

  Derivatives and Financial Stability

  4.1. Derivatives

  Derivatives constitute sophisticated financial instruments which are used by traders in the world for various purposes. The three main types of traders in derivatives are speculators, arbitrageurs and hedgers. Speculators are traders which undertake risky transactions in view of generating large profits. The risk involved is usually high, and in extreme cases, speculators can even kill the markets. Arbitrageurs represent traders who pocket riskless profits by availing themselves of short-term inefficiencies in the markets. Finally, hedgers are those traders who buy derivatives in order to reduce risk.

  There are four major types of derivatives in the world, namely futures, forwards, swaps and options. Among these four categories, options tend to be imbued with complex structures, alternatively known as asymmetric payoff profiles. Futures and forwards share similar linear payoff profiles. Swaps mainly represent the exchange of cash flows, whether in the same or different currencies, mostly in view of mitigating interest rate risk or currency risk.

  However, it is of paramount significance to note that derivatives mishaps can be very costly. As pointed out by Hull (2010), big losses in derivatives occurred for both financial and non-financial institutions in the world, as shown in the Boxes 4.1 and 4.2

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  Capitalism With Derivatives

  A Political Economy of Financial Derivatives, Capital and Class

  • D. Bryan, M. Rafferty(Authors)
  • 2005(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  At the time, however, the wider implications of this development were not immediately obvious even to its proponents. It took some time before computational tech- niques necessary for structuring and pricing more complex financial deriv- atives developed. It also took some time before a generation of managers were trained with familiarity in derivatives techniques and strategies, and so saw their wider potential as a corporate risk management tool. In part also, it awaited recognition of the wider role of derivatives. Only relatively recently has this wider role been grasped theoretically within orthodox economics, although it rapidly transformed into con- ventional wisdom. Myron Scholes, one of the originators of options pricing theory, has summarised this new convention succinctly: ‘most financial instruments are derivative contracts in one form or another’ (1998: 364). Beyond the hubris of this comment is the development of, for instance, real options theory, which poses investment opportunities (and existing assets and activities) as options that can be valued using derivative pricing theory. Out from the margins As derivatives have shifted towards financial instruments, the derivative categories identified in Box 1 have not fundamentally changed: futures, options and swaps remain the standard tools. 12 But the scale and scope 54 Capitalism with Derivatives 12 Ackland (2000) makes the point that the rise of swaps was a product specifi- cally of the globalisation of financial markets and floating exchange rates, and was thus intimately linked to the growth of Financial Derivatives. This is an important point. Here, however, we seek to emphasise their common character- istics and indeed forwards are the building blocks of swaps. of their use is remarkable. Some stylised facts and some of the key ‘rethinking’ of the new position of derivatives should be noted.

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  Barings Bankruptcy And Financial Derivatives

  • Peter Guangping Zhang(Author)
  • 1995(Publication Date)
  • World Scientific

    (Publisher)

  It is well INTRODUCTION TO Financial Derivatives 27 known that the price of a house depends on the price of the underlying property upon which the house is built, the structure of the house, and other factors. Without the land, the house could not have been built, and certainly would not have any value. The land can exist and has value without the house, yet the house cannot exist without the land. Derivatives can be well compared to the house in this example. Although there are many kinds of derivative assets currently traded in different financial centers and among banks around the world, generally speaking, derivative assets are financial contracts whose values, as their name implies, depend on or derive from other assets. These other assets are usually called the underlying securities on which the derivative assets are based. The underlying market is often called the cash market. Clearly, derivative assets cannot exist without the underlying assets, as the house cannot exist without land in the above example. In other words, derivative assets exist simultaneously with the underlying assets. The underlying assets can be stocks, bonds, currency, commodities, and other financial assets, or combinations of these. Derivatives are sometimes called contingent claims in some academic journals. As the word contingent literally means dependent, contingent claims also stand for claims whose values depend on other assets. The traditional stock and bond markets raise necessary capital for corporations and governments, and the foreign exchange market facilitates international trade and investment. Besides the real economic functions of these markets, all these markets are also essentially speculative. Besides the hedging functions of derivatives, most of the products can be used in speculation. If we consider trading in the traditional financial markets to be speculative, then trading in the derivative assets can be more speculative, as we shall see in later chapters.

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  Corporate Finance

  Theory and Practice in Emerging Economies

  • Sunil Mahajan(Author)
  • 2020(Publication Date)
  • Cambridge University Press

    (Publisher)

  All these parameters significantly impact revenues, profits, cash flows and valuation. Strategic risk management has, therefore, become an integral part of the corporate sector’s lexicon. Derivatives are the main tool that companies rely on to manage their strategic risk. A greater risk exposure means a higher demand for derivatives which has burgeoned to very high levels. The underlying parameters, including exchange rates, commodities, interest rates and equity prices, have over the years become highly volatile. Until the early 1970s when the Bretton Woods arrangement prevailed globally, exchange rates were fixed by the central banks. Their value seldom changed. Interest rates were also determined by the central banks. Now, of course, all financial parameters are market-determined, fluctuate on a continuous basis and are impacted by global events, making them highly volatile. Tools available to companies in the form of derivatives have also broadened in scope and become highly sophisticated. The cost of operating in the derivative markets has reduced drastically, trading and liquidity is substantial and contracts can be customized to suit specific organizational requirements. There is widespread expertise available to take advantage of the derivative markets. Financial Derivatives | 257 Consequently, the market size of derivatives is huge. The market size can be depicted in two ways, namely the notional value of the derivative contracts outstanding or their market value. For instance, a NIFTY 50 futures contract is purchased on 30 June 2018 at 10,800. It will have a market value of ₹15,000 [(11,000 − 10,800) * 75] if the NIFTY value increases to 11,000. The notional value continues to be ₹810,000 (10,800 * 75). In 2016, the notional value of all derivatives worldwide was US$544 trillion while the market value of the same derivative contracts was approximately US$15 trillion.

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