International Business ---- Lecture 3

Financial Derivative -- What is it???? A derivative instrument is a contract between two parties that specifies conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments are to be made between the parties

Why Have Derivatives? Derivatives are risk-shifting devices. Initially, they were used to reduce exposure to changes in such factors as weather, foreign exchange rates, interest rates, or stock indexes.

WHY DERIVATIVES!?!!! For example, if an American company expects payment for a shipment of goods in British Pound Sterling, it may enter into a derivative contract with another party to reduce the risk that the exchange rate with the U.S. Dollar will be more unfavorable at the time the bill is due and paid. Under the derivative instrument, the other party is obligated to pay the company the amount due at the exchange rate in effect when the derivative contract was executed. By using a derivative product, the company has shifted the risk of exchange rate movement to another party.

Why Have Derivatives? More recently, derivatives have been used to segregate categories of investment risk that may appeal to different investment strategies used by mutual fund managers, corporate treasurers or pension fund administrators. These investment managers may decide that it is more beneficial to assume a specific "risk" characteristic of a security.

STEPPING STONES Definition of Financial Derivatives Why Have Derivatives? Common Financial Derivatives The Risks Leveraging Trading of Derivatives

Definition of Financial Derivatives A financial derivative is a contract between two (or more) parties where payment is based on (i.e., "derived" from) some agreed-upon benchmark. Since a financial derivative can be created by means of a mutual agreement, the types of derivative products are limited only by imagination and so there is no definitive list of derivative products. Some common financial derivatives, however, are described later. More generic is the concept of “hedge funds” which use financial derivatives as their most important tool for risk management.

Repayment of Financial Derivatives In creating a financial derivative, the means for, basis of, and rate of payment are specified. Payment may be in currency, securities, a physical entity such as gold or silver, an agricultural product such as wheat or pork, a transitory commodity such as communication bandwidth or energy. The amount of payment may be tied to movement of interest rates, stock indexes, or foreign currency. Financial derivatives also may involve leveraging, with significant percentages of the money involved being borrowed. Leveraging thus acts to multiply (favorably or unfavorably) impacts on total payment obligations of the parties to the derivative instrument.

Common Financial Derivatives Options Forward Contracts Futures Structured Notes Swaps Hedge Funds A Brief Guide to Financial Derivatives http://sites.state.pa.us/PA_Exec/Securities/capital/derivatives.html

Options The purchaser of an Option has rights (but not obligations) to buy or sell the asset during a given time for a specified price (the "Strike" price). An Option to buy is known as a "Call," and an Option to sell is called a "Put. " The seller of a Call Option is obligated to sell the asset to the party that purchased the Option. The seller of a Put Option is obligated to buy the asset. In a “Covered” Option, the seller of the Option already owns the asset. In a “Naked” Option, the seller does not own the asset Options are traded on organized exchanges and OTC.

Forward Contracts In a Forward Contract, both the seller and the purchaser are obligated to trade a security or other asset at a specified date in the future. The price paid for the security or asset may be agreed upon at the time the contract is entered into or may be determined at delivery. Forward Contracts generally are traded OTC.

Futures A Future is a contract to buy or sell a standard quantity and quality of an asset or security at a specified date and price. Futures are similar to Forward Contracts, but are standardized and traded on an exchange, and are valued daily. The daily value provides both parties with an accounting of their financial obligations under the terms of the Future. Unlike Forward Contracts, the counterparty to the buyer or seller in a Futures contract is the clearing corporation on the appropriate exchange. Futures often are settled in cash or cash equivalents, rather than requiring physical delivery of the underlying asset.

Structured Notes Structured Notes are debt instruments where the principal and/or the interest rate is indexed to an unrelated indicator. A bond whose interest rate is decided by interest rates in England or the price of a barrel of crude oil would be a Structured Note, Sometimes the two elements of a Structured Note are inversely related, so as the index goes up, the rate of payment (the "coupon rate") goes down. This instrument is known as an "Inverse Floater."

Swaps A Swap is a simultaneous buying and selling of the same security or obligation. Perhaps the best-known Swap occurs when two parties exchange interest payments based on an identical principal amount, called the "notional principal amount."

Swaps Interest rate swaps occur generally in three scenarios. Exchanges of a fixed rate for a floating rate, a floating rate for a fixed rate, or a floating rate for a floating rate. The "Swaps market" has grown dramatically. Today, Swaps involve exchanges other than interest rates, such as mortgages, currencies, and "cross-national" arrangements. Swaps may involve cross-currency payments (U.S. Dollars vs. Mexican Pesos) and crossmarket payments, e.g., U.S. short-term rates vs. U.K. short-term rates.

Hedge Funds A “hedge fund” is a private partnership aimed at very wealthy investors. It can use strategies to reduce risk. But it may also use leverage, which increases the level of risk and the potential rewards. Hedge funds can invest in virtually anything anywhere. They can hold stocks, bonds, and government securities in all global markets. They may purchase currencies, derivatives, commodities, and tangible assets. They may leverage their portfolios by borrowing money against their assets, or by borrowing stocks from investment brokers and selling them (shorting). They may also invest in closely held companies.

Hedge Funds Hedge funds are not registered as publicly traded securities. Institutional investors, such as pension plans and limited partnerships, have higher minimum requirements. The SEC reasons that these investors have financial advisers or are savvy enough to evaluate sophisticated investments for themselves.

Hedge Funds Some investors use hedge funds to reduce risk in their portfolio by diversifying into uncommon or alternative investments like commodities or foreign currencies. Others use hedge funds as the primary means of implementing their long-term investment strategy.

The Risks Since derivatives are risk-shifting devices, it is important to identify and understand the risks being assumed, evaluate them, and continuously monitor and manage them. Each party to a derivative contract should be able to identify all the risks that are being assumed before entering into a derivative contract. Part of the risk identification process is a determination of the monetary exposure of the parties under the terms of the derivative instrument. As money usually is not due until the specified date of performance of the parties' obligations, lack of up-front commitment of cash may obscure the eventual monetary significance of the parties' obligations.

The Risks Investors and markets traditionally have looked to commercial rating services for evaluation of the credit and investment risk of issuers of debt securities. Some firms have begun issuing ratings on a company's securities which reflect an evaluation of the exposure to derivative financial instruments to which it is a party. The creditworthiness of each party to a derivative instrument must be evaluated independently by each counterparty. In a financial derivative, performance of the other party's obligations is highly dependent on the strength of its balance sheet. Therefore, a complete financial investigation of a proposed counterparty to a derivative instrument is imperative.

The Risks An often overlooked, but very important aspect in the use of derivatives is the need for constant monitoring and managing of the risks represented by the derivative instruments. For instance, the degree of risk which one party was willing to assume initially could change greatly due to intervening and unexpected events. Each party to the derivative contract should monitor continuously the commitments represented by the derivative product.

Leveraging Some derivative products may include leveraging features. These features act to multiply the impact of some agreed-upon benchmark in the derivative instrument. Negative movement of a benchmark in a leveraged instrument can act to increase greatly a party's total repayment obligation. Remembering that each derivative instrument generally is the product of negotiation between the parties for risk-shifting purposes, the leveraging component, if any, may be unique to that instrument.

Leveraging For example, assume a party to a derivative instrument stands to be affected negatively if the prime interest rate rises before it is obliged to perform on the instrument. This leveraged derivative may call for the party to be liable for ten times the amount represented by the intervening rise in the prime rate. Because of this leveraging feature, a small rise in the prime interest rate dramatically would affect the obligation of the party. A significant rise in the prime interest rate, when multiplied by the leveraging feature, could be catastrophic.

Trading of Derivatives Some financial derivatives are traded on national exchanges. Certain financial derivative products have been standardized and are issued by a separate clearing corporation to sophisticated investors pursuant to an explanatory offering circular. Performance of the parties under these standardized options is guaranteed by the issuing clearing corporation.

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