Derivatives are financial contracts whose value is dependent on an underlying asset. Common types of derivatives include forwards, futures, options, and swaps. Derivatives can be used to hedge risk, speculate on asset prices, or gain leverage. While derivatives provide benefits like hedging and market efficiency, they also carry high risks like counterparty risk and can enable speculation. Corporate finance deals with capital investment, financing, and liquidity management decisions to maximize shareholder value and profits. This includes capital budgeting, sourcing debt or equity, and ensuring sufficient working capital and cash flows.

1. Derivative Securities
and Corporate Finance
Elizabeth Comisario
&
Christoper Punzalan

2. What Is a Derivative?
The term derivative refers to a type of financial contract
whose value is dependent on an underlying asset, group of
assets, or benchmark. A derivative is set between two or
more parties that can trade on an exchange or over-the-
counter (OTC). These contracts can be used to trade any
number of assets and carry their own risks. Prices for
derivatives derive from fluctuations in the underlying asset.
These financial securities are commonly used to access
certain markets and may be traded to hedge against risk.

3. KEY TAKEAWAYS
• Derivatives are financial contracts that derive their value
from an underlying asset, group of assets, or benchmark.
• A derivative is set between two or more parties that can
trade on an exchange or over-the-counter.
• Prices for derivatives derive from fluctuations in the
underlying asset.
• Derivatives are usually leveraged instruments, which
increases their potential risks and rewards.
• Common derivatives include futures contracts, forwards,
options, and swaps.

4. Understanding Derivatives
A derivative is a complex type of financial
security that is set between two or more parties.
Traders use derivatives to access specific
markets and trade different assets. The most
common underlying assets for derivatives are
stocks, bonds, commodities, currencies, interest
rates, and market indexes.

5. Derivatives can be used to hedge a position,
speculate on the directional movement of
an underlying asset, or give leverage to
holdings. These assets are commonly traded
on exchanges or OTC and are purchased
through brokerages. The Chicago Mercantile
Exchange (CME) is among the world's
largest derivatives exchanges

6. Types of Derivatives
1. Forwards and futures
These are financial contracts that obligate the contracts’
buyers to purchase an asset at a pre-agreed price on a
specified future date. Both forwards and futures are
essentially the same in their nature.
However, forwards are more flexible contracts because the parties
can customize the underlying commodity as well as the quantity of
the commodity and the date of the transaction. On the other hand,
futures are standardized contracts that are traded on the
exchanges.

7. 2. Options
Options provide the buyer of the
contracts the right, but not the
obligation, to purchase or sell the
underlying asset at a
predetermined price. Based on
the option type, the buyer can
exercise the option on the
maturity date (European options)
or on any date before the
maturity (American options).

8. 3. Swaps
Swaps are derivative
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
and currency swaps.

9. Advantages of
Derivatives
Unsurprisingly, derivatives exert a significant
impact on modern finance because they
provide numerous advantages to the
financial markets

10. 1. Hedging risk exposure
Since the value of the derivatives is linked to
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 an asset the investor owns. In this way, profits
in the derivative contract may offset losses in the
underlying asset.

11. 2. 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.

12. 3. 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 asset and the
associated derivative tend to be in equilibrium to
avoid arbitrage opportunities.

13. 4. Access to unavailable assets or markets
Derivatives can help organizations get
access to otherwise unavailable assets or
markets. By employing interest rate swaps,
company may obtain a more favorable
interest rate relative to interest rates
available from direct borrowing.

14. Disadvantages of Derivatives
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
Global Financial Crisis of 2007-2008.
The rapid devaluation of mortgage-backed securities
and credit-default swaps led to the collapse of
financial institutions and securities around the world.

15. 1. High risk
The high volatility of derivatives
exposes them to potentially huge
losses. The sophisticated design of the
contracts makes the valuation
extremely complicated or even
impossible. Thus, they bear a high
inherent risk.

16. 2. Speculative features
Derivatives are widely regarded as a
tool of speculation. Due to the
extremely risky nature of derivatives
and their unpredictable behavior,
unreasonable speculation may lead to
huge losses.

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

19. What Is Corporate Finance?
Corporate finance is the subfield of
finance that deals with how
corporations address funding sources,
capital structuring, accounting, and
investment decisions.

20. Corporate finance is often concerned
with maximizing shareholder value
through long- and short-term financial
planning and the implementation of
various strategies. Corporate finance
activities range from capital investment
to tax considerations.

21. KEY TAKEAWAYS
•Corporate finance is concerned with how businesses
fund their operations in order to maximize profits
and minimize costs.
•It deals with the day-to-day operations of a
business' cash flows as well as with long-term
financing goals (e.g., issuing bonds).
•In addition to capital investments, corporate finance
is concerned with monitoring cash flows, accounting,
preparing financial statements, and taxation.

22. Understanding Corporate Finance
Corporate finance departments are charged with
governing and overseeing their firms' financial activities
and capital investment decisions. Such decisions include
whether to pursue a proposed investment and whether to
pay for the investment with equity, debt, or both. They also
include whether shareholders should receive dividends,
and if so, at what dividend yield.
Additionally, the finance department manages current
assets, current liabilities, and inventory control.

23. Corporate Finance Tasks

24. Capital Investments
The capital investment
decision process is primarily
concerned with capital budgeting.
Through capital budgeting, a
company identifies capital
expenditures, estimates future cash
flows from proposed capital
projects, compares planned
investments with potential
proceeds, and decides which
projects to include in its capital
budget.

25. Making capital investments is perhaps the
most important corporate finance task that
can have serious business implications. Poor
capital budgeting (e.g., excessive investing
or under-funded investments) can
compromise a company's financial position,
either because of increased financing costs
or inadequate operating capacity.

26. Capital Financing
Corporate finance is also responsible for sourcing capital in the form
of debt or equity. A company may borrow from commercial banks
and other financial intermediaries or may issue debt securities in the
capital markets through investment banks.

27. Capital financing is a balancing act in terms of
deciding on the relative amounts or weights
between debt and equity. Having too much debt
may increase default risk, and relying heavily on
equity can dilute earnings and value for early
investors. In the end, capital financing must
provide the capital needed to implement capital
investments.

28. Short-Term Liquidity
Corporate finance is also tasked with short-
term financial management, where the goal
is to ensure that there is enough liquidity to
carry out continuing operations. Short-
financial management concerns current
assets and current liabilities or working
capital and operating cash flows

29. A company must be able to meet all its current liability obligations
when due. This involves having enough current liquid assets to
avoid disrupting a company's operations. Short-term financial
management may also involve getting additional credit lines or
issuing commercial papers as liquidity backups