derivatives instruments

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TABLE OF CONTENT

I. Introduction............................................................................................................. 1

1. Overview of Derivative instruments .................................................................. 1

2. Participants in the future market ...................................................................... 2

II. Types of Derivative instruments............................................................................ 3

1. FORWARD CONTRACTS................................................................................ 3

1.1 Definition ....................................................................................................... 3

1.2 Characteristics of this contract is: ................................................................ 4

2. FUTURE CONTRACTS .................................................................................... 5

2.1 Definition ....................................................................................................... 5

2.2 Types of future contract................................................................................. 6

2.3 Advantages and disadvantages...................................................................... 7

2.4 Example of future contract ........................................................................... 7

3. OPTION CONTRACTS ..................................................................................... 8

3.1 Definition ....................................................................................................... 8

3.2 Types of Options ............................................................................................ 8

3.3 Participants in the Options Market ............................................................... 9

3.4 Purposes of options ...................................................................................... 10

3.5 Example of Call and Put options ................................................................ 11

4. SWAP CONTRACTS ....................................................................................... 12

4.1 Definition ..................................................................................................... 12

4.2 Types of swap contracts ............................................................................... 13

4.3 Example of Swap contracts ......................................................................... 14


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I. Introduction1. Overview of Derivative instruments

Derivative instruments have been a feature of modern financial markets for several

decades. They play a vital role in managing the risk of underlying securities such as

bonds, equity, equity indexes, currency, and so on.

A working definition of a derivative will help lay the foundation of this text, that is,

an instrument whose existence and value is contingent upon the existence of another

instrument or security. The major derivative instruments, which in some respects may

be regarded as building blocks, can be categorized as follows: options, forwards,

futures, and swaps.

Forward is a tailored contract between two parties, where payment takes place at a

specific time in the future at today's pre-determined price.

Futures are contracts to buy or sell an asset on or before a future date at a price

specified today. A futures contract differs from a forward contract in that the futures

contract is a standardized contract written by a clearing house that operates an

exchange where the contract can be bought and sold; the forward contract is a non-

standardized contract written by the parties themselves.

Options are contracts that give the owner the right, but not the obligation, to buy or sell

an asset. The price at which the sale takes place is known as the strike price. If the

owner of the contract exercises this right, the counter-party has the obligation to carry

out the transaction. Options are of two types that is call option and put option. The

buyer of a Call option has a right to buy a certain quantity of the underlying asset, at a

specified price on or before a given date in the future, he however has no obligation

whatsoever to carry out this right. Similarly, the buyer of a Put option has the right to

sell a certain quantity of an underlying asset, at a specified price on or before a given

date in the future, he however has no obligation whatsoever to carry out this right.

Swaps are contracts to exchange cash on or before a specified future date based on the

underlying value of currencies exchange rates, bonds/interest rates, stocks or other

assets. Swaps can basically be categorized into two types:


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Interest rate swaps: These basically necessitate swapping only interest associated cash

flows in the same currency, between two parties.

Currency swaps: In this kind of swapping, the cash flow between the two parties

includes both principal and interest. Also, the money which is being swapped is in

different currency for both parties.

Each instrument has its own characteristics, which offer advantages in using them but

bring with them disadvantages. Hence, users are made aware of the risks associated

with the derivative contracts they enter into and are made aware of the instruments

appropriateness for the purpose it is to perform.

2. Participants in the future marketInvestors use derivatives for several purposes. Derivatives may be used to speculate,

hedge a portfolio of shares, bonds, foreign currency, undertake arbitragei.e. benefit

from mispricing and engineer or structure desired positions. For those purpose, the

players in the futures market fall into two categories: hedgers and speculators.

Hedgers

Hedgers in future market can be farmers, manufacturers, importers and exporter. Ahedger buys or sells in the futures market to secure the future price of a commodity

intended to be sold at a later date in the cash market. This helps protect against price

risks.

The buyers of the commodity are trying to secure as low a price as possible, whereas

the sellers of the commodity will want to secure as high a price as possible. The

futures contract, however, provides a definite price certainty for both parties, which

reduces the risks associated with price volatility.

Speculators

Other market participants - the speculators do not aim to minimize risk but to benefit

from the inherently risky nature of the futures market. They aim to profit from the

price change that hedgers are protecting themselves against. Hedgers want to minimize

their risk no matter what they're investing in, while speculators want to increase their

risk and therefore maximize their profits.
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In the futures market, a speculator who buys a contract low so that he or she can sell

high in the future would most likely be buying that contract from a hedger who sells a

contract low to protect from declining prices in the future.

Actually, the speculator does not seek to own the commodity but will enter the market

seeking profits by offsetting rising and declining prices through the trading of

contracts.

II. Types of Derivative instruments1. FORWARD CONTRACTS1.1Definition

A forward contract is an agreement between two parties to buy or sell an asset at a

predetermined time in the future at a price agreed upon today. Therefore, in this type

of contract, signing date and the date of delivery is completely separated. In the

forward contract, the two parties shall be bound by strict legal customs to perform

contractual obligations, unless both parties agree to cancel the contract.

Forward contracts are used for hedging, such as currency devaluation risk (forward

contracts on USD or EUR) or risk of fluctuations in the price of a certain commodity

(forward contracts with oil).

In the forward contract, one party agrees to buy, and the other party agrees to sell, with

a forward price is agreed before, with no actual payment at the time of signing. In

contrast to the forward price is the spot price (spot price), the price of the property was

delivered on the spot (spot date), usually within 2 days from the day of signing. The

difference between the forward price and the spot price is called forward premium if

the forward price is higher than, or forward discount if the forward price is lower.

Futures are standardized contracts, traded on centralized market called futures

contracts. Futures contract is a forward contract but it has its very own characteristics.

Study the following example to better understand the characteristics of a forward

contract:


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Suppose Mr. X wants to buy a house in the next one year, and Mr. Y owns a house and

he wants to sell at the same time. Italy agreed to sell the house of Y for X one year

from now for $ 104,000, this contract is a forward contract. Since X is X buyers

should expect prices to increase in the future, on the contrary, He wanted to reduce

prices. Last year, assuming the market price of the house at that time was $ 110,000,

while Y is obliged to sell to X for $ 104,000 as committed to in the contract should be

considered as Y has holes $ 6000, while X interest $ 6,000 (because X can buy Y

home for $ 104,000 and sold on the market for $ 110,000).

In general, without taking into account other factors, the forward price is always

greater than the spot price, because it includes both the interest rate.

Continuing the above example, suppose the current price of the home is $ 100,000,

then Y can be sold immediately to bring the bank to earn interest at the rate of 4% /

year. After one year of Y would have amounted to $ 104,000 without having to take

any risks. Whereas if X wanted to buy the house you're going to a bank loan of $

100,000, and also pay interest of 4% / year. And vice versa if the contract purchase

forward he would not have to pay interest on X are also willing to spend $ 104,000 to

buy a house in the next one year. That is why the forward price was agreed at $

104,000 rather than $ 100,000.

1.2Characteristics of this contract is: Normally the contract is made between financial institutions with each other, or

between financial institutions with non-financial corporate customers (contracts areusually signed bilateral).

In this contract the buyer is called the one hold that long position, the seller is calledkeep its short position.


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The contract will only be made at maturity: Up to maturity short position holder mustsell assets to keep the position and received a sum of money from the buyer at

predetermined prices in the contract, even though at that time the market price of the

asset is higher or lower than the price specified in the contract. If the market price is

higher than the contract price, the holder of the position will be profitable (positive

values), did someone hold the position was negative;, and vice versa.

Figure 1. Long position and short position payoff

2. FUTURE CONTRACTS2.1Definition

Futures contract is an agreement which is generally made on the trading floor of a

futures exchange, to buy or sell a particular commodity or financial instrument at a

pre-determined price in the future on a known date under specified conditions. In

general, it seems to be similar with forward contract, but, in fact, there are some

special differences as following:

Futures contracts are usually signed and performed through a broker on thestock market; and buyers and sellers often do not know each. So, brokerage

agent often point out some standard requirements for these contracts. Currently,

the stock markets buying and selling futures contracts are the Chicago Board of

Trade (CBOT), Chicago Mercantile Exchange (CME) and The London


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International Financial Futures Exchange (LIFFE). The commodity traded on

the stock market buying and selling future contracts includes pork, beef, sugar,

wool, etc., financial products including stock indexes, foreign exchange, bonds

companies, and government bonds.

Delivery date is not defined correctly such as buy-sell agreements, which arespecified by month and time of the month to deliver. The brokers determine the

volume and quality of traded goods, delivery method, contract price, and can

also determine the value of the futures contract may change in a day.

Buyers and sellers pay a commission to the broker, and the sale price isdetermined on the stock exchanges.

There are two types of traders on the trading floor: The first is the broker, theywill make purchases based on investors' orders and figure out their

commissions; the second one is the investors

To avoid risks when making futures purchase contract that the buyer or seller may

withdraw from the contract because of adverse price movements in the market, or due

to insufficient financial ability at the time of payment. Office stock must make

regulations on minimum reserve requirements (initial margin), typically 5%-15% of

the contract's value for investors signing futures contracts with the broker. Reserve

funds are held in the investors account opened at the stock office.

2.2Types of future contractEnergies: Oil, gasoline, diesel, heating oil, natural gas, ethanol.

Currencies: Euro, Pound, Yen, Peso, etc.

Financials: Interest rate futures in mostly Dollar and Euro.

Indices: Multiple stock indices of different countries.

Metals: Aluminum, gold, palladium, copper, silver, uranium.

Agricultural commodities: Corn, wheat, soybeans, rice, coffee, oats, cattle, hogs, pork

bellies, cotton, lumber, cocoa, milk, sugar, orange juice


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Exotics: weather (heat), hurricane, snowfall, frost, economic event (statistical

releases), commercial/residential real estate.

2.3Advantages and disadvantagesStrengths

Futures are extremely useful in reducing unwanted risk. Futures markets are very active, so liquidating your contracts is usually easy.

Weaknesses

Futures are considered as one of the riskiest investments in the financialmarkets - they are for professionals only.

In volatile markets, it's very easy to lose your original investment. The very high amount of leverage can create enormous capital gains and losses,

you must be fully aware of any tax consequences.

2.4Example of future contractOn November 5, 2010, an futures contract of December light sweet crude oil (with

0.42% sulfur or less) for $87.18 per barrel (42 gallons), and the company want to take

delivery was traded at the New York Mercantile Exchange (now CMEGroup), one of

many futures exchanges in the United States.

The initial margin requirement is $5,063 for whom was not member of the exchange

and $3,750 for member. So, the maintenance margin was $3,750. The last trading date

of this contract was the third business day prior to the 25 th day of the month in the

preceding month of the contract (Nov 22 for Dec). The delivery date was arranged by

two parties of the contract, it could be anytime in the month of the contract.

Company X bought this contract. Spot price in on the day company X entered the

contract is $86.49. When Nov 22 arrived, spot price had risen to $91.50. Thus,

company X took delivery of the oil in Dec at the Nov 22 spot $91.50, not $87.18 so

the company paid $91.50 and the company had gained $4,320 with 1,000 barrels in its


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3.3Participants in the Options MarketThere are four types of participants in options markets depending on the position they

take including buyers of calls, sellers of calls, buyers of puts, and sellers of puts.

People who buy options are called holders and those who sell options are

called writers; furthermore, buyers are considered to have long positions, and sellers

are considered to have short positions. Call holders and put holders (buyers) are not

obligated to buy or sell. They have the choice to exercise their rights if they

choose. Inversely, call writers and put writers (sellers), however, are obligated to buy

or sell. This means that a seller may be required to make good on a promise to buy or

sell.

The price at which an underlying stock can be purchased or sold is called the strike

price. This is the price a stock price must go above (for calls) or go below (for puts)

before a position can be exercised for a profit. All of this must occur before

the expiration date.

For call options, the option is said to be in-the-money if the share price is above the

strike price. A put option is in-the-money when the share price is below the strike

price. The amount by which an option is in-the-money is referred to asintrinsicvalue.When the price of the underlying security is equal to the strike price, an optionis at-the-money.A call option is out-of-the-money if the strike price is greater than the

market price of the underlying security. A put option is out-of-the money if the strike

price is less than the market price of the underlying security. Below is an example for

it.

Option Strike Stock

At-the-money

In-the-mone

Out-of-the-money

Call 35 $29 out-of-the-money

Put 45 $52 out-of-the-money

Call 25 $25 at-the-money

Put 100 $101 at-the-money

Call 10 $16 in-the-money

Put 40 $25 in-the-money


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The total cost (the price) of an option is called thepremium. This price is determinedby factors including the stock price, strike price, time remaining until expiration (value

of time) andvolatility.

3.4Purposes of optionsIn an usual way, investors use Options mostly to speculate and to hedge.

You can think of speculation as betting on the movement of a security. The advantage

of options is that you aren't limited to making a profit only when the market goes up.

Because of the versatility of options, you can also make money when the market goes

down or even sideways.

Speculation is the territory in which the big amount of money is made and lost. The

use of options in this manner is the reason options have the reputation of being risky.

This is because when you buy an option, you have to be correct in determining not

only the direction of the stock's movement, but also the magnitude and the timing of

this movement. To succeed, you must correctly predict whether a stock will go up or

down, and you have to be right about how much the price will change as well as the

time frame it will take for all this to happen.

The other function of options is hedging. People think of this as an insurance policy.

For example you insure your house or car, options can be used to insure your

investments against a downturn. Critics of options say that if you are so unsure of your

stock pick that you need a hedge, you shouldn't make the investment. On the other

hand, there is no doubt that hedging strategies can be useful, especially for large

institutions. Even the individual investor can benefit. Imagine that you wanted to take

advantage of technology stocks and their upside, but you also wanted to limit any

losses. By using options, you would be able to restrict your downside while enjoying

the full upside in a cost-effective way.


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3.5Example of Call and Put optionsa) Call option

Assume that the price of IBM stock is 80 USD/stock at the moment. After analysis,

you are expected that the price of IBM stock will increase. If you would like to investin 1000 stocks of IBM, you will have to invest 80,000 USD equivalent. But if the price

of IBM will not go as you expect and it will reduce to 40 USD/stock, then you will

lose 40,000USD. To reduce the risks happening, a call option will be effective.

You will buy a call option with the strike price of 80 USD/stock in time period of 2

months, an amount of 1000 stocks, option fee of 2 USD/stock. In this time period, if

price of IBM increase over 80 USD/stock as expected, you could buy in the call option

and sell in the market to receive 18,000 USD profit (20,000 USD minus 2,000 option

fee). But if the price of IBM stock does not increase as expected and decreases

continually until the last day of call option, then you will have the right not to exercise

the call option. As a result, you just loss an amount of option fee, that is, 2000 USD,

which is much less than 40,000 USD loss if you do not go into the call option. The call

option buyer just loss in the maximum of option fee but the expected profit is

enormous. And also the call option seller gets profit from collecting the option fees.

b) Put optionWith the same assumptions mentioned above, if an investor worries about the

reduction of stock price, he could choose put option to protect himself. With 1000

stocks of IBM with the value of 80 USD/stock, you could buy a put option with an

exact option fee. Hence, with the participation in the buyer of put option, you could

sell 1000 stocks with the price of 80 USD/stock anytime. Hence, if the price of IBM

stocks in the market decreases, you will not have to worry about the decrease in value

of your IBM stocks because there is put option seller to ensure the price for the stocks.

The put option sellers also get profit from the option fees.


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To summarize, an option is a contract giving the buyer the right but not the obligation

to buy or sell an underlying asset at a specific price on or before a certain date.

Options are derivatives because they derive their value from an underlyingasset.

A call gives the holder the right to buy an asset at a certain price within aspecific period of time.

A put gives the holder the right to sell an asset at a certain price within aspecific period of time.

There are four types of participants in options markets: buyers of calls, sellersof calls, buyers of puts, and sellers of puts.

Buyers are often referred to as holders and sellers are also referred to as writers. The price at which an underlying stock can be purchased or sold is called

the strike price.

The total cost of an option is called the premium, which is determined byfactors including the stock price, strike price and time remaining

until expiration.

A stock option contract represents 100 shares of the underlying stock. Investors use options both to speculate and hedge risk.

4. SWAP CONTRACTS4.1Definition

Swaps are contracts to exchange cash flow on or before a specified future date based

on the underlying value of currencies exchange rates, bonds or interest rate,

commodities exchange, stock or other assets. Another term which is commonly

associated to Swap is Swaption which is basically an option on the forward Swap.

Similar to a Call and Put option, a Swaption is of two kinds: a receiver Swaption and a

payer Swaption. While on one hand, in case of a receiver Swaption there is an option

wherein you can raceive fixed and pay floating, a payer Swaption on the other hand is

an option to pay fixed and receive floating

While the standardization of futures and options contracts make trading easy and limit

exposure to default risk, the downside to standardization is that it "one size fits all." In


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other words, banks cannot custom tailor those contracts to match their specific risk

exposure. Its like the restaurant menu, where they have chicken marsala and veal

piccata, but you really want chicken piccata.

4.2Types of swap contractsSwap contracts are custom-tailored arrangements between financial institutional. Each

party of the swap contract trades one set of payments they receive for a set of

payments the other party receives. There are three main kinds of Swaps, namely:

- Interest Rate Swap: involves a counterparty paying a floating exchange rate besed onan agreed-upon index and the other counterparty paying a fixed rate, both bases on a

specific notional amount of money, for the entire term of the contract. The person who

pays fixed rate is called fixed rate payer, and the other who pay floating rate is called

float rate payer.

- Currency Swap: in this kind of swapping, the cash flow between the two partiesincludes both principal and interest. Also, the money which is being swapped is in

different currency for both parties. Currency swap have two main uses: to secure

cheaper debt (by borrowing at the best available rate regardless of currency using a

back-to-back loan), and to hedge against exchange rate fluctuation.For instance, a US-

based company needing to borrow Swiss francs, and a Swiss-based company needing

to borrow a similar present value in US dollars, could both reduce their exposure to

exchange rate fluctuations by arranging any one of the following:

If the companies have already borrowed in the currencies each needs theprincipal in, then exposure is reduced by swapping cash flows only, so that each

company's finance cost is in that company's domestic currency.

Alternatively, the companies could borrow in their own domestic currencies(and may well each have comparitive advace when doing so), and then get the

principal in the currency they desire with a principal-only swap

- Equity Swap: is a swap where a set of future cash flows are agreed to be exchangebetween two counterparties at set dates in the future.The two cash flows are usually

referred to as "legs" of the swap; one of these "legs" is usually pegged to a floating rate

such as LIBOR. This leg is also commonly referred to as the "floating leg". The otherleg of the swap is based on the performance of either a share of stock or a stock market


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index. This leg is commonly referred to as the "equity leg". Most equity swaps involve

a floating leg vs. an equity leg, although some exist with two equity legs.

Generally swap is prefered in financial market where there various cash flows, a

swaption can be incredibly complicated, but we will focus on a basic interest rate

swap (known as the plain vanilla swap).

The interest rate swap specifies the interest rate each party will exchange(typically one interest rate is fixed and one is variable, or both are variable),

the notional principal that determines the size of the payment, the time period

over which payments will be swapped. The principal never gets exchanged,

only the interest payments.

The person who pays fixed rate is called fixed rate payer, and the other who payfloating rate is called float rate payer.

The floating rate use to be LIBOR or LIBOR+ spread.

4.3Example of Swap contractsCompany A has a loan of $ 100 million with floating interest rate = LIBOR+ 150bps

(1.50%). Company B has a loan of $ 100 million with fixed interest rate =8.50%. But

A wants to pay fixed rate, and B want to pay floating rate. So two companies signed a

interest rate swap contract agreed that A will pay B fixed rate 8.65%, and B will pay A

floating rate LIBOR+0.70%.

So company A is paying fixed rate, and company B is paying floating rate. At the endof the contract, after one year, the interest rate of A and B is:


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IR of A= ( LIBOR + 0.7%) - ( LIBOR + 1.50%)8.65% = - 9.45%

Company A has to pay fixed interest rate= 9.45%IR of B = 8.65% - ( LIBOR + 0.70%)8.50% = - (LIBOR + 0.55%)

Company B has to pay floating interest rate = LIBOR+ 0.55%What's the point? Well, recall that A, as an Saving and Loan company, has many rate-

sensitive liabilities (deposits) but few rate-sensitive liabilities (mostly fixed-rate

mortgages). By receiving the variable rate payments from company B, A gains from

rising short-term interest rates in their swap position to offset losses in their traditional

activities. What's in it for B as a finance company? They may have more rate-sensitive

assets than liabilities, or they may simply be speculating that interest rates will fall. By

using a swap, A1 can hedge its interest rate risk and tailor the assets to its exact needs.

There are two big disadvantages to swaps. First, there is substantial default risk. There

is no exchange to guarantee this transaction. If B goes bankrupt, A is left without any

protection against rising short-term interest rates. Second, because the swaps are

custom-tailored for A and B, the swap is not liquid. If A wanted to get of the contract

during the next ten years, it might be impossible to find a buyer. Also, A and B may

have difficulty finding each other in the first place.

High profile losses from derivatives trading, including the Orange County bankruptcy

in 1994 and the bailout of Long-Term Capital Management in 1999 (see the link

below), have caused some to be concerned about whether derivatives are safe enough

assets. However, the truth is the derivative use allows many financial institutions to

reduce their risks and regulator guidelines supervise and limit trading activities.


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