FINANCIAL DERIVATIVES

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Norrenberger is an integrated financial services group licensed and regulated by the Central Bank of Nigeria (CBN) and the Securities and Exchange Commission (SEC).
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Prepared by
Chidinma Igwe
January 2019
DERIVATIVES

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Objectives
Definition
Features
Participant in derivative market
Types of Derivatives
- Forward
- Futures
- Options
Type of options
Distinctions Between forward and future contracts
Benefits of Derivatives
Challenges
Applications of Financial derivatives
Questions
Content

Objectives
• Understand the meaning of derivatives
• Describe the features and types of financial derivatives
• Understand uses of derivative securities
• Distinguish between futures and forward contracts

• Derivatives are financial instruments which derives it value from another financial
instrument. It turns promises to values. The value is derived from the prices of other
assets.
• The term ‘derivative’ indicates that it has no independent value, i.e., its value is the
underlying asset. The underlying asset can be securities, commodities, currency,
livestock or anything else.
• Derivative is one of the three(3) categories of financial instrument. The other two(2) being
stocks (i.e. equities or shares)and debt(i.e. bonds and mortgages )
• Derivatives are widely used as hedging instruments due to their flexibility
Definition

VIDEO

• It is a contract
Derivative is defined as the future contract between two parties. It means there must
a contract-binding on the underlying parties and the same to be fulfilled in future
• Derives value from underlying asset:
Normally, the derivative instruments have the value which is derived from the values of
other underlying assets, such as agricultural commodities, metals, financial assets, intangible
assets
• Specified obligation
In general, the parties have specified obligation under the derivative contract.
Obviously, the nature of the obligation would be different as per the type of the
instrument of a derivative. For example, the obligation of the parties, under the different
derivatives, such as forward contract, future contract, option contract and swap contract
would be different
Features of Derivatives

• Direct or exchange traded
The derivatives contracts can be undertaken directly between the two parties or
through the particular exchange like financial futures contracts.
• Delivery of underlying asset not involved
Usually, in derivatives trading, the taking or making of delivery of underlying assets is not
involved, rather underlying transactions are mostly settled by taking offsetting
positions in the derivatives themselves.
Features of Derivatives

• Hedgers
The use derivatives market to reduce or eliminate the risk associated with price of assets.
Majority of the participates in the derivative market belong to this category
• Speculators
The transact future and option contracts to get extra leverage in betting on the future
movement in the price of an asset. They can increase both the potential gains and potential
losses by usage of derivatives in a speculative venture .
• Arbitrageurs
Their behavior is guided be the desire to take advantages of a discrepancy between prices of
more or less the same assets or competing assets in different market e.g the see the future
of an asset getting out of line with cash price , they will take an offsetting position in the two
markets to lock in profit
Participants in Derivatives Market

• There are two types of derivatives.
• Commodity derivatives
• Financial derivatives
Commodity derivatives- the underlying asset is a commodity. It can be agricultural
commodity like wheat, soybeans, cotton , precious metals like gold, silver etc
Financial derivative denotes a variety of financial instruments including stocks,
bonds, treasury bills, interest rate, foreign currencies and other securities.
Financial derivatives include futures, forwards, options, swaps, etc.
Types of Derivatives

• A forward contract is a customised contract between two entities, where
settlement takes place on a specific date in the future at today’s pre-agreed price .
• Forward contracts are ‘buy now, pay later’ products, which enable you to essentially ‘fix’
an exchange rate at a set date in the future (often 12 – 24 months ahead)
• Features
• forward contracts are privately traded
• Forward contracts, on the other hand, are customized as per the requirements of the
counterparties
• There is no margin requirement in a forward contract
• forward market is not regulated by the Government
FORWARDS

Example of forward contract

A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. Futures contracts are special types of forward
contracts in the sense that the former are standardised exchange-traded contracts. For
example, if someone buys a July crude oil futures contract (CL), they are saying they will buy
1,000 barrels of oil from the seller at the price they pay for the futures contract, come the
July expiry. The seller is agreeing to sell the buyer the 1,000 barrels of oil at the agreed
upon price
• Features
• Futures contracts are traded on an exchange
• Since they are traded on exchange, futures contracts are highly standardized
• single clearinghouse acts as the counterparty for all futures contracts. This means that
the clearinghouse is the buyer for every seller and seller for every buyer. This eliminates
the risk of default
• Futures contracts require a margin to be posted at the contract initiation
• The government regulates futures market
Futures

Example of futures contract

Distinction

In finance, an option is a contract which gives the buyer the right, but not the obligation,
to buy or sell an underlying asset or instrument at a specified strike price prior to or on a
specified date, depending on the form of the option.
Types of Options
Call Option -Call option - gives the buyer the right but not the obligation to buy a
given quantity of the underlying asset, at a given price on or before a given
future date.
Put Option -Put option -Put option give the buyer the right, but not the obligation
obligation to sell a given quantity of the underlying asset at a given price on or
before a given date
Options

Types of Options

• Swaps- Derivative contracts that allow the exchange of cash flows between two parties.
The swaps usually involve the exchange of a fixed cash flow for a floating cash flow. The
most popular types of swaps are interest rate swaps, commodity swaps, and currency
swaps.
• swaps are not traded on exchanges but are traded over-the-counter. In addition,
counterparties in swaps are usually companies and financial organizations and not
individuals, because there is always a high risk of counterparty default in swap contracts.
• Example - Party A agrees to pay Party B a predetermined, fixed rate of interest on a
principal on specific dates for a specified period of time. Because swaps are customized
contracts, interest payments may be made annually, quarterly, monthly, or at any other
interval determined by the parties
SWAP

Types of Swaps
Interest rate swaps- entail swapping only the interest related cash flows between the
parties in the same currency These
Currency Swaps- These entail swapping both principal and interest on different
currency than those in the opposite direction.
Commodity swaps -A commodity swap is a type of swap agreement whereby a floating
(or market or spot) price based on an underlying commodity is traded for a fixed price
a specified period. The vast majority of commodity swaps involve oil

Derivatives exert a significant impact on modern finance, because they provide numerous
advantages to the financial markets which include :-
• Hedging risk exposure
Since the value of the derivatives is linked to the value of the underlying asset, the contracts
are primarily used for hedging risks. For example, an investor may purchase a derivative
contract whose value moves in the opposite direction to the value of the asset. In addition,
it can be utilized to reallocate risk from risk-averse players to risk-seeking players. Like most
time deposits, funds cannot be withdrawn before maturity without paying a penalty.
• Underlying asset price determination
Derivatives are frequently used to determine the price of the underlying asset. For example,
the spot prices of the futures can serve as an approximation of a commodity price.
Benefits of Derivatives

• Access to unavailable assets or markets
Derivatives can help organizations get access to unavailable assets or markets. By employing
interest rate swaps, a company may obtain a more favorable interest rate relative to interest
rates available from direct borrowing.
• Market efficiency
It is considered that derivatives increase the efficiency of financial markets. By using derivative
contracts, one can replicate the payoff of the assets. Therefore, the prices of the underlying
and the associated derivative tend to be in equilibrium to avoid arbitrage opportunities

Despite the benefits that derivatives bring to the financial markets, the financial
instruments come with some significant drawbacks. The drawbacks resulted in disastrous
consequences during the financial crisis of 2007-2008. The rapid devaluation of
mortgage-backed securities and credit-default swaps lead to the collapse of financial
institutions and stock markets around the world.
1. High risk
While the high volatility of the derivatives exposes them to potentially huge losses, the
sophisticated design of the contracts makes the valuation extremely complicated or even
impossible. Thus, they bear the high inherent risk which include regulatory risk ,
operational risk , liquidity risk etc
• Speculative features
Derivatives are widely regarded as a tool of speculation. Due to the extremely risky nature
of the financial instrument and their unpredictable behavior, the unreasonable speculation
may lead to huge losses.
Challenges of Derivatives

• 3. Counter-party risk
Although derivatives traded on the exchanges generally go through a thorough due
diligence process, some of the contracts traded over-the-counter do not include a
benchmark for due diligence. Thus, there is a high probability of counter-party default.

• Some of the application of financial derivatives are as follows
• Management of risk
This is the most important function of derivatives . Financial derivatives provide a powerful tool
for limiting risks that individuals and organization face in the ordinary conduct of their business
. Effective use of derivatives can save cost and it can increase returns of the organization
• Efficiency in trading
Financial derivatives allow for free trading of risk component and that leads to improving
market efficiency. Traders find financial derivatives to be a more attractive instrument than the
underlying security. This is because of the greater amount of liquidity in the market offered by
derivatives .
• Speculations
Financial derivatives are considered to be risky , if not used properly , these can lead to
financial destruction in the organization . However, these instruments act as powerful
instruments for knowledgeable traders to expose themselves to calculate and understand risk
in search of rewards that is prifot
Applications of Financial Derivatives

Reference
•
• 7, CFA Level 1 Volume 6 Derivatives and Alternative Investments, 7th Edition
• CFI’s Finance Courses
• Bhalla, V.K.Financial Derivatives- Risk Management, Sultan Chand and Company Ltd.,
New Delhi, 2001.

Questions

FINANCIAL DERIVATIVES

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