1. PBBF 303: FIN RISK MANAGEMENT AND INSURANCE LECTURE EIGHT DERIVATIVES

2. Derivative
Sinkey (2002) defines Derivative as a contract that derives its value from an underlying asset such as interest rate, exchange rate, commodity price, or equity value. They are widely used to speculate on future expectations or to reduce a security portfolio’s risk.
Derivatives are one type of securities whose price is derived from the underlying assets. And value of these derivatives is determined by the fluctuations in the underlying assets. (a contract one holds may be considered as worthy depending on the performance of the underlying asset)
These underlying assets are most commonly stocks, bonds, currencies, interest rates, commodities and market indices. As Derivatives are merely contracts between two or more parties, anything like weather data or amount of rain can be used as underlying assets.

3. Hedging
Hedging involves taking on one risk to offset another. Some tools are specially designed for hedging.
These are forwards, futures and swaps. Together with options, they are known as derivative instruments or derivatives because their value depends on the value of another asset.

4. Derivative Instruments
Forward Contracts,
Futures Contracts
Swaps
Options,

5. Forward Contract
The forward market facilitates the trading of forward contracts.
A forward contract is an agreement between two parties (i.e. corporation and bank) to exchange a specified amount of asset (currency, commodity, interest rate) at a specified exchange rate, price or interest rate called the forward rate on a specified date in the future

6. Futures Contract
A financial futures contract is a standardized agreement to deliver or receive a specified amount of a specified financial instrument at a specified price and date.
The buyer of a financial futures contract buys the financial instrument, while the seller of a financial futures contract delivers the instrument for the specified price.

7. Features of Futures Contract
Financial futures contracts are traded on organized exchanges, which establish and enforce rules for such trading.
The operations of financial futures exchanges are regulated by the commodity futures trading commission (CFTC).
The CFTC approves futures contracts before they can be listed by futures exchanges and imposes regulations to prevent unfair trading practices.

8. Futures a simple example
Suppose a farmer plans to harvest 20,000 baskets of corn in 6months and plans to hedge 10,000. The current price is GHc2.5 per basket. The farmer sells a futures contract, which will allow him to sell corn at 2.5 per basket in 6 months.
If the price of corn falls to GHc2.0 per basket, the farmer loses GHc5,000 (0.5*10,000 baskets) on his corn sold on the market, but gains GHc5000 on his futures contract.
If the price of corn rises to GHc3 per basket, the farmer makes GHc5,000 more on his corn on the market but loses Ghc5,000 on the futures contract. The farmer has therefore hedged his risk by effectively locking in a price of GHc2.5

9. Distinction between Forward and Futures Contracts
Similarity
Fundamentally, forward and futures contracts have the same function: both types of contracts allow people to buy or sell a specific type of asset at a specific time at a given price.
Differences
However, it is in the specific details that these contracts differ. First of all, futures contracts are exchange-traded and, therefore, are standardized contracts. Forward contracts, on the other hand, are private agreements between two parties and are not as rigid in their stated terms and conditions.

10. Cont.
2. Because forward contracts are private agreements, there is always a chance that a party may default on its side of the agreement.
Futures contracts have clearing houses that guarantee the transactions, which drastically lowers the probability of default to almost never.
3. Thirdly, the specific details concerning settlement and delivery are quite distinct.

11. Cont.
For forward contracts, settlement of the contract occurs at the end of the contract.
Futures contracts are marked to market daily, which means that daily changes are settled day by day until the end of the contract.
Thus, settlement for futures contracts can occur over a range of dates. Forward contracts, on the other hand, only possess one settlement date.

12. Cont.
4. Lastly, because futures contracts are quite frequently employed by speculators, who bet on the direction in which an asset's price will move, they are usually closed out prior to maturity and delivery usually never happens.
On the other hand, forward contracts are mostly used by hedgers that want to eliminate the volatility of an asset's price, and delivery of the asset or cash settlement will usually take place. 

13. Options
Options are traded on exchanges and in the over-the counter market.
There are two basic types of options.
A call option gives the holder the right to buy the underlying asset by a certain date for a certain price.
A put option gives the holder the right to sell the underlying asset by a certain date for a certain price.

14. Cont.
The price in the contract is known as the exercise price or strike price. The date in the contract is known as the expiration date or maturity.
American options can be exercised at any time up to the expiration date. The European options can be exercised only on the expiration date.
Most of the options that are traded on exchanges are American. Investors regularly trade options on common stocks. Thus, in the exchange traded equity options market, one contract is usually an agreement to buy or sell 100 shares (round lots)

15. Cont.
The circumstances in which the put turns out to be profitable are just the opposite of those in which the call is profitable. Eg. With exercise price of $60
If the market price is $40. Value of put option at expiration = exercise price – market price of the share = $ 60 - $40 = $20
If you sell or write a call, you promise to deliver shares if asked to do so by the call buyer. In other words, the buyer’s asset is the seller’s liability. If by the exercise date the share price is below the exercise price, the buyer will not exercise call, and the sellers liability will be zero.

16. Cont.
If it rises above the exercise price, the buyer will exercise and the seller will give up the shares. The seller loses the difference between the share price and the exercise price received from the buyer.
NB: it is always the buyer who has the option to exercise, option sellers simply do as they are told.
Suppose the price of stock turns out to be $80, which is above the option exercise price of $60. in this case the buyer will exercise the call. The seller is forced to sell stock worth $80 for only $60 and so has a payoff of -$20.

17. Swap
A swap is an agreement between two companies/ parties to exchange cash flows in the future. The agreement defines the dates when the cash flows are to be paid and the way in which they are to be calculated.
Usually, the calculation of the cash flows involves the future values of interest rates, exchange rates, or other market variables.
A forward contract can be viewed as a simple example of a swap. Whereas a forward contract is equivalent to the exchange of cash flows on just one future date, swaps typically lead to cash flow exchanges taking place on several future dates.

18. Cont.
The most common type of swap is the plain vanilla interest rates swap where a fixed rate of interest is exchange for LIBOR (London inter bank offer rate- the rate is the interest rate that banks charge each other)
In a swap, Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional principal on specific dates for a specified period of time.

19. Cont.
Concurrently, Party B agrees to make payments based on a floating interest rates to Party A on that same notional principal on the same specified dates for the same specified time period.
In a plain vanilla swap, the two cash flows are paid in the same currency. The specified payment dates are called settlement dates, and the time between are called settlement periods.

20. Cont.
Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other interval determined by the parties.
For example, on December 31, 2006, Company A and Company B enter into a five-year swap with the following terms: Company A pays Company B an amount equal to 6% per annum on a notional principal of $20 million.
Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a notional principal of $20 million.

21. Cont.
For simplicity, let's assume the two parties exchange payments annually on December 31, beginning in 2007 and concluding in 2011.
At the end of 2007, Company A will pay Company B $20,000,000 * 6% = $1,200,000. 
On December 31, 2006, one-year LIBOR was 5.33%; therefore, Company B will pay Company A $20,000,000 * (5.33% + 1%) = $1,266,000. 

22. Cont.
In a plain vanilla interest rate swap, the floating rate is usually determined at the beginning of the settlement period.
Normally, swap contracts allow for payments to be netted against each other to avoid unnecessary payments. Here, Company B pays $66,000 and Company A pays nothing.
At no point does the principal change hands, which is why it is referred to as a "notional" amount.

23. Derivative Market and Financial Risk
Derivatives play a vital role in risk management of both financial and non-financial institutions. But, in the present world, it has become a rising concern that derivative market operations may destabilize the efficiency of financial markets.
In today’s’ world the companies the financial and non-financial firms are using forward contracts, future contracts, options, swaps and other various combinations of derivatives to manage risk and to increase returns.
It is true that growth of derivatives market reveal the increasing market demand for risk managing instruments in the economy. But, the major concern is that, the main components of Over the Counter (OTC) derivatives are interest rates and currency swaps. So, the economy will suffer surely if the derivative instruments are misused and if a major fault takes place in derivatives market.