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Uses of Financial derivatives in financial markets with the better man of financial institutions and others

Abstract

-------- To day is fine but what will be in t-o-m-o-r-r-o-w?

Risk is always staying beside business. Business will not be stop due torisk. Some business has more or some has low risk. Business people eithercan averse the risk or can take the risk. Some risks are unavoidable;which will obligate the businessman to let the business. Again, somebusiness has opportunities to enjoy profit through elimination of risk. S/heis successful businessman who can conquer the risk.

It is widely recommended that Prevention is better than cure . It is truethat, there has different mechanism or tools and techniques for analysis of risk such as sensitivity analysis, duration, standard deviation or betacalculation. But for the prevention of risk or reducing risk, few tools andtechniques are necessary for business people or corporation orinstitutions. And, yes, derivatives are a mechanism for prevention of riskand enjoy profit from assumption.

Commodities are homogeneous raw materials traded in large volumes

everyday. To protect themselves against the risk of adverse pricefluctuations in these commodities, business people have developedfinancial instruments called commodity future contracts. Then the use of commodity future contracts has turned into financial market as financialfuture contract or financial derivatives through the utilization of interestrate, stock index and currency.

The aim of this paper is to explain the overall knowledge about financialderivatives. It has tried to focus the process trading future contractsthrough different examples and illustrations; those have collected fromvarious secondary sources. Moreover, it also covers the purposes of

futures contracts. Finally, the discussion will clarify the uses derivativessecurity for the better man of financial institutions, firms and individuals inperspective of developing and developed countries.

Keywords: Forward Contracts, Future Contracts, Call options, Put options,Speculation, and Hedging.

Md. Jahangir Alam, Lecturer in Finance, Asian University of Bangladesh,Uttar, Dhaka.Monir Ahammad, Lecturer in Finance, Asian University of Bangladesh,Uttar, Dhaka.

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1. Introduction :---------------------------------------------- The future is not what it used tobe ---- Paul Valery 1 . Business peoples or financial institutions arenot certain for next days situation. They are uncertain regardingtheir loss or risk. This uncertainty move forward a business man toprotect his/her losses and for reducing risk occurring in every daytransaction.

I dipt into the future far as human eye could see, saw the vision of the world all the wonder that would be ------- Alfred Lord Jennyson(1842) 2 .

The Term Derivatives evolved from such feelings or risk of local andinternational businessmen. This word often conjures up vision of

speculative dealings, a big boom and a big crash. Bad news spreadfast and brings collapse of business. But this notion is not true. Usedcarefully, Derivative transaction helps cover risks which would ariseon the trading of securities on which the derivatives is based.

Literally, Derivatives means to get a thing (product or financialinstruments) from other things. Such as, Sugar is derived fromsugarcane through few processes. Financial Derivatives(Derivatives Security) are financial contracts that derive their valuefrom some underlying asset (bank, stock or currency). For example Bank X agrees to purchase of $1million Treasury bill (T- bill) at $95each from Bank Y maturity 3 months. If the spot rate after 90 daysis $95.50, Bank X will derive the value of $ 500,000 (0.50 x1,000,000) from contract.

Most common financial derivatives are debt securities such as; Treasury bills, Treasury notes, Treasury bonds and corporate bondwhich are referred as Interest rate futures . There are also financialfutures contracts on stock index such as Dow Jones IndustrialAverage (DJIA), S &P 500 index, Mini S&P 500 index which arereferred as Stock index futures and currency future markets. 3

The purposes of derivative securities are Speculation (i.e. withthe objectives of earnings profit through assumption or predictionfrom future situation) and Hedging (i.e. minimizing risk frombusiness transactions through long or short position).

2. Features of different Financial Derivatives : Transaction in derivative market takes place either through acurrency futures (forward contracts and future contracts) orcurrency option. For example A farmer may wish to enter a

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Sources: International Finance, Chapter Forward exchange, Maurice D. Levi (3rd

Edition)2 Multinational Financial Management, Currency Futures and Option Markets, Alan C. Shapiro, 6 th Edition.3 Financial Institutions and Markets, Chapter- Financial future market, Jeff, Madura (6 th edition)

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contract to sell his harvested crops sometime in future to eliminatethe ever prevailing risk of price fluctuations. They can enter intoeither a forward contract or a future contract. The prices on thederivative market are driven by the spot market price of underlyingassets (in the case of spot price of future in the commodity market).

In the above example, if investors in stock market enter into acontract to sell their stock sometime in future to eliminate the everprevailing risk of price fluctuation will be treated as financial futuremarket.

2.1 Forward Contract versus Future Contract :2.1.1. Forward Contract : A forward contract is an agreementbetween a corporation and a commercial bank to exchange aspecified amount of asset (viz-currency, stock and others) at aspecified price on a specified date in the future.When Financial Institution or Multinational Corporations (MNCs)anticipate future need or future receipt of a foreign currency, theycan set up forward contracts to lock in the exchange rate.Forward contracts are often valued at $1 million or more, and arenot normally used by consumers or small firms. As with the case of spot rates, there is a bid (buying price of bank) and ask (sellingprice of bank) spread on forward rates.

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Illustration A bank may set up a contract with one firm agreeingto sell the firm Singapore dollar 90 days from now at$.510/Singapore dollar. This represent the ask rate. At the sametime, the firm may agree to purchase (bid) Singapore dollars 90days from now form some other firm at $.505 per Singapore dollar.So the spread of forward contract is $.005 ($.510 - $.505).Forward rates may also contain a premium or discount. If theforward rate exceeds the existing spot rate, it contains a premium .If the forward rate is less than the existing spot rate, it contains adiscount .

2.1.2. Forward hedge : MNCs use forward contracts to hedge theirimports and export. They can lock in the rate at which they canpurchase and sell foreign currencies respectively.5Illustration : Truz, Inc. is an Multinational company based inChicago that will need 1,000,000 Singapore dollars (S$) in 90 daysto purchase Singapore imports. The spot rate of Singapore dollars is$.50/S$. At this spot rate the firm would need$500,000 (computedS$1,000,000 x $.50/S$). However, it does not have the funds rightnow to exchange for Singapore dollars. It could wait 90 days andthen exchange dollars for S$ at the spot rate existing at that time.

4 Source International financial Management, Currency derivatives, Jeff Madura 7 th edition.5 Same

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But, Turz does not know what the spot rate will be at that time. If therate rises to $.60 by then Turz will need $600,000 (computed asS$1,000,000 x $.60/S$), an additional outlay of $100,000 due to theappreciation of the S$.

To avoid exposure to exchange rate risk, Turz can lock in the rate itwill pay for Singapore dollars 90 days from now without having toexchange dollars for Singapore dollar immediately. Specifically, Turzcan negotiate a forward contract with a bank to purchase S$1,000,000 90 days forward.

The specified price in a forward contract is referred to as thedelivery price . At the time the contract is entered into, the value of the forward contract to both parties is zero. This means that it costnothing to take either a long or short position 6 .

A forward contract is settled at maturity. The most common forwardcontracts are for 30, 60, 90, 180, and 360 days although otherperiods (including longer periods) are available. The holder of ashort position delivers the asset to the holder of the long position inreturn for cash amount to the delivery price. On the settlement datethe forward contract can have a positive or negative valuedepending upon the movement of the price of the underlying asset.It is pertinent to note that the forward price and the delivery price of the underlying asset are both equal at the time the contract isentered into. Over a period of time (duration of the forwardcontract), the forward price tends to fluctuate but the deliverypriced remains constant.

Forward markets however, have their share of drawbacks. A forwardcontract is not dealt with on an exchange. Thus, Illiquidity andcounter- party risks are the main problem.

2.2. Future Contract: The drawbacks of forward contract areeliminated in a future. While, a futures contract is also a contract tospecifying a standard volume of a particular currency to beexchanged on a specific settlement date, such contracts arenormally traded on a stock exchange. This leads to standardization,imparts liquidity and creates a set of rules and regulations whichhave to be adhered to by the parties to the transaction.Currency futures contracts are available for several widely tradedcurrencies at the Chicago Mercantile Exchange (CME), and thecontract for each currency specifies a standardized number of units.Such as Australian dollar 100,000 Brazilian real 100,000, Britishpound 62,500, Canadian dollar 100,000, Euro 125,000, Japaneseyen 12,500,000, Mexican peso 500,000, New Zealand dollar100,000, Russian ruble 500,000, South African rand 500,000 andSwiss franc 125,000 7 .

6 Options, Futures and Other Derivative Securities, By John C. Hull7 Source www.cme.com

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Currency futures contracts typically specify the third Wednesday inMarch, June, September and December as the settlement date.

There is also an over-the- counter (OTC) currency futures contractswith specific settlement date.

When participants in the currency futures market take a position,they need to establish an initial margin. The initial margin showshow much money must be in the account balance when the contractentered into. A margin call is issued if because of losses on thefutures contract the balance in the account falls below themaintenance margin .For example- if contract start with initial margin of $ 1,418 in youraccount on a pound futures contract and the loses, say, $700 invalue, the margin call will $ 332 [computed as $1050 + ($1418-$700)], where maintenance margin is $1,050.

To ensure that every customer stands behind the financialobligations of his contracts the exchange clearing house valueseach contract in every account at the end of each trading day andreadjusts the cash balance of each traders margin accountaccordingly using a computerized risk-management program callSPAN (Standard portfolio Analysis of Risk). This is called marking tomarket , since the trader is credited with any gains and debited anylosses in his account.

8Illustration: On Tuesday morning, an investor takes a long position

in a Swill franc futures contract that matures on Thursday afternoon. The agreed-on price$0.75 for SFr 125,000. To begin, the investormust put $1,620 into his initial margin.

Time Action Cash Flow Tuesdaymorning

Investors buys SFr futures contractthat matures in two days. Price is$0.75

none

Tuesdayclose

Futures price rises to $0.755.Position is marked to market.

Investor receives125,000 x (0.755 -0.75) =$625

Wednesdayclose

Futures price drops to $0.743 Investor pays125,000 x (0.755 0.743) =

$1,500. Thursdayclose

Futures price drops to $0.74.a) Contract is marked to

marketb) Investor takes delivery of

SFr 125,000.

a) Investor pays125,000 x (0.743 0.74) = $375

b) Investors pays125,000 x 0.74 = $92,500.Net loss on futures contract= $1,250

Sellers on the goods or commodity are also subject to minimumcapital requirement and other regulation.

8 Source - Multinational Financial Management, Currency Futures and Option Markets, Alan C. Shapiro, 6 th

Edition.

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9Illustration : The oldest future markets in the USA are inagricultural commodities, such as sugar, corn, hogs and cattle.

Today, the largest volume of trading is in financial futures, stocksand bonds. These commodity exchanges bring together producersand buyers of commodities looking to lock in future prices andspeculators who are willing to take on the risk which the former wishto avoid.Futures commodity markets make it easy to profit from pricechanges or guard against them. Although commodity futurescontracts provides for the actual delivery of the commodity as onthe closing date, very few purchasers have any intention of actuallyreceiving the delivery of such goods, on the delivery date specifiedin the contract.

2.2.1 Speculation with future contract: Currency futures contractsare sometime purchased by speculators who are simplyattempting to capitalize on their expectation of a currencysfuture movement (appreciates). Also sold by speculators whoexpect that the spot rate of a currency will be less(depreciates) that the rate at which they would be obligatedto sell it.

10 Illustration: Assume that as of April 4, a futures contractspecifying 500,000 Mexican pesos and a June settlement date ispriced at $0.90. On April 4 speculators who expect the peso willdecline sell futures contracts on pesos. Assume that on June 17 (thesettlement date), the spot rate of the peso is $.08. So, the gain from

selling currency futures shown below April 4 June 171. Contract to sell 500,000pesos @ $.09/peso ($45,000)on June 17.

2. Buy 500,000 pesos @ $.08/peso($40,000) from the spot market.3. Sell the pesos for $45,000 to fulfillcontract and gain $5,000.

This future contract is also applicable for bond referred as interestrate future and stocks index future through long and short position.

The following example shows how speculators use interest ratfuture.

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Illustration : In February, Jim sanders forecast that interest ratewill decrease over the next month. If his expectation is correct, themarket value of T-bills should increase. Sanders call a broker andpurchase a T-bill futures contract. Assume that the price of thecontract was 94.00 (a 6% discount) and that the price of T bills asof the March settlement date is 94.90 (a 5.1% discount). Sanderscan accept delivery of the T-bills and sell them for more than hepaid for them. Because T-bill futures represent $1 million of parvalue the nominal profit from this speculative strategy is $ 9,000.(Based on long position).

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Source - Strategic Management Issues Derivatives for decision makers by George Crawford & Bidyut Sen.10 International financial Management Jeff Madura (7 th edition), chapter Currency derivatives11 Financial Institutions and Markets, Chapter- Financial future market, Jeff, Madura, 6 th edition.

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Selling price = $949,000 (94.90% of $1,000,000)Purchase price = - $940,000 (94.00% of $1,000,000)Profit = $9,0002.2.2 Hedging with Future contract :

Financial institutions can classify their assets and liabilities bysensitivity of their market value to interest rate movement. Thedifference between a financial institutions volume of rate-sensitiveassets and rate sensitive liabilities represents its exposure tointerest risk. Most commonly use interest rate futures are shorthedge and long hedge .

Consider a commercial bank that currently holds a large amount of corporate bonds and long term fixed rate commercial loans. Itsprimary sources of funds have been short-term deposits. The bankwill be adversely affected if interest rates rise. In the near futurebecause its liabilities are more rate-sensitive than its assets. Onepossible strategy is to sell Treasury bond futures because the pricemovements of T-bonds are highly correlated with movements incorporate bond prices.If interest rates rise as expected the market value of existingcorporate bonds held by bank will decline. Yet, this decline could beoffset by the favorable impact of the future position.

2.2.3 Closing out the Futures Position :If a firm holding a futures contract decides before the settlementdate that it no longer wants to maintain its position, it can close out

the position by selling an identical futures contract. Sellers may alsoclose out their positions by purchasing similar contracts. The gain orloss to the firm from its previous futures position is dependent onthe price of purchasing futures versus selling futures. Such as aspeculator contract to purchase A$100,000 at $.53/A$ expectingappreciates the US dollar in January 10 maturity at 19 march. ButFebruary he wishes to close out the contract that why he madeanother counter sell contract of same amount A$100,000 for$.50/A$ matured at 19 march. Therefore in March 19 the position of speculator is net loss $ 3000 12 .

January-10 February-15 March -191. Contract tobuy A$100,000 @$.53/A$ ($53,000)on March 19.

2. Contract to sellA$100,000 @ $.50/A$($50,000) on March 19.

3. Incurs $3000loss from offsettingpositions in futurescontracts.

2.2.4 Distinction between Forward and Future Contract : The discussion of the distinction will make clear the concept andconfusion regarding futures market for readers is depicted below:

1. Size of Contract:

12 Source International financial Management Jeff Madura (7 th edition), chapter Currency derivatives

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Forward contracts are individually tailored and tend to be much largerthan the standardized contracts on the future market.Futures contracts are standardized in terms of currency amount.2. Trading :Forward contracts are traded by telephone or telex. So, risk is relatively

highFuture contracts are traded in stock exchange such as CME. So risk is low.3. Delivery date:Bank offer forward contracts for delivery on any dateFutures contracts are available for delivery on only few specified dates ayear (such as; March, June, September and December.)

4. Settlement:Forward contract settlement occurs on the agreed on between the bankand the customer.

Futures contract settlements are made daily via the Exchange clearinghouse; gains on position values may be withdrawn and losses arecollected daily.

5. Quotes:Forward prices generally are quoted in European term (Units of localcurrency per U.S$)Futures contracts are quoted in American terms (dollar per one foreigncurrency unit).6. Transaction cost:Cost of forward contracts are based on bid-ask spreadFuture contracts entail brokerage fees for buy and sell orders.

7. Margin:Margin are not required in the forward marketMargins are required of all participants in the futures market8.Credit Risk:

The credit risk is borne by each party to a forward contract, credit limitsmust be therefore be set for each customer.

The Exchanges Clearing House becomes the opposite side to eachfutures contract, thereby reducing credit risk substantially.

3. Option Market :Having distinguished between a forward and future contract, it is

now essential to know how option work. An option is simply theright (but the obligation) to buy or sell something at the stated dated at a stated price .Options are traded on many different exchanges through the world.

The underlying assets include stocks, stock index, foreigncurrencies, debt instruments, and commodities. The standardoptions that are traded on an exchange through brokers areguaranteed, but require margin maintenance

Unlike the currency future contract traded on an exchange, currencyoptions are tailored to the specified needs of the firm. Since the

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options are not standardized, all the terms must be specified in thecontracts. The number of units, desired strike price and expirationdate can be tailored to the specific needs of the client.

There are basically two types of options viz: Call option and Put option . However, as either type can be bought or sold . It can be saidthere exists four distinctly different types of option instruments.

3.1. Call options:A currency call option grants the holder the right to buy a specificcurrency at a specific price (called the Exchange rate / exercise orstrike price) within a specific period of time. Call option are desirablewhen one wishes to lock in a maximum price to be paid for acurrency in the future. A call option is in the money , if (spot rate >strike price), at the money , if (spot rate = strike price), out of themoney , if (spot rate < strike price).Option owners can sell or exercise (i.e. buy) their options. Theycan also choose to let their options expire . At most, they will losethe premiums they paid for their options. So, owner of the calloption is not obligated to exercise the contract (thats why givepremium)

3.1.1. Speculation with call option: As mentioned earlier, in buying acall an investor acquires the right, but not the obligation to buyunderlying assets for a specified price during a specified periodtime.

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Illustration: the investor who pays $3,000 to buy a December102 call option on a $100,000 US Treasury bond has the right, untilDecember to buy that bond at an exercise price of 102 ($102,000).If the market price of US Treasury bonds is now, 101, the call optionhas no intrinsic value and is said to be out of money, because noone would like to exercise the call option to buy a treasury bond for102 when the bond could be purchased on the open market for 101.However, the call option would still sell for $3,000 because of thepossibility that the price of T-bonds may rise before December,when the option expires. This $3,000 price is called its time value(premium).

If the price of the treasury bonds falls to $93, the price of the calloption will fall; because it will take a bigger market price increasesto give the call option any intrinsic value before it rises. For the calloption to have any intrinsic value the market price must rise abovethe strike price of 102.

3.1.2 Hedge with call option: Corporation or MNCs can purchase calloptions on a currency to hedge future payable.

13 Source Strategic Management Issues Derivatives for decision makers, by George Crawford &Bidyut Sen

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14 Illustration : when Pike Co. of Seattle orders Australian goods, itmakes a payment in Australian dollars to the Australian exporterupon delivery. An Australian dollar call option locks in a maximumrate at which pike can exchange dollars for Australian dollars. Thisexchange of currencies at the specified strike price on the calloption contract can be executed at any time before the expirationdate. In essence, the call option contract specifies the maximumprice that Pike pay to obtain these Australian dollars. If theAustralian dollars value remains below the strike price, Pike canpurchase Australian dollars at the prevailing spot rate when it needsto pay for its imports and simply let its call option expire.

Options may be more appropriate than futures or forward contractsfor some situation. Such as; Intel corp. uses options to hedge itsorder backlog in semiconductors. If an order is canceled, it has theflexibility to let the option contract expire. With a forward contract, itwould be obligated to fulfill its obligation even though the order wascanceled.3.2. Put option:A currency put option grants the holder the right to sell a specificcurrency at a specific price (the strike price) within a specific periodof time.

The owner of the Put option is not obligated to exercise the option. Therefore the maximum potential loss to the owner of the put optionis the price (or premium) paid for the option market.A put option is in the money , if (spot rate < strike price) at

the money , if (spot rate = strike price), out of the money , if (spotrate > strike price).

3.2.1. Speculation with Put option:Individuals may speculate with currency put options based on theirexpectations of the future movements in a particular currency.Speculators who expect the currency will depreciate can purchase aput option. On the other hand, speculators can also attempt to profitfrom selling put option if assumes that currency will appreciate.

15 Illustration A put option contract on British pounds specifiesthat premium on 1= $.04 unit, strike price or exercise price is 1=$.40 and contract size is 31,250.A speculator who had purchased this put option decided to exercise the option shortly before theexpiration date, when the spot rate of the pound was$1.30. The netprofits to the purchaser of put option are as follows:

Per unit Per contractSelling price of $1.40 $43,750 (1.40 x 31,250

units)- Purchase price of -$1.30 -$40,625 (1.40 x 31,250

units)

14 Source International financial Management Jeff Madura (7 th edition), chapter Currency derivatives15 Source International financial Management , Currency derivatives Jeff Madura ,7 th Edition

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- Premium paid for option -0.04 -$1,250 (1.40 x 31,250units)

Net profit = $.06 = 1,875 (.06 x 31.250units)

3.2.2 Hedge with Put option: Like currency call options, currency putoptions can be a valuable hedging device.16 Illustration : Knoxville, Inc., (exporter) transport goods to NewZealand and expects to receive NZ$600,000 in about 90 days.Because it is concerned that the NZ$ may depreciate against theUS$, Knoxville is considering purchasing put options to cover itsreceivables. The NZ$ put options considered here have an exerciseprice of $.50 and a premium of $.03 per unit. Knoxville anticipatesthat the spot rate in 90 days will be either $.44. $.46 or $.51. Theamounts to be received are $282,000, $282,000 and $288,000

respectively.4. Institutional use of Financial Derivatives :

They are commonly used by MNCs used to hedge their foreigncurrency position. In addition, they are traded by speculators whohope to capitalize on their expectations of exchange ratemovements. A buyer of currency futures contract locks in theexchange rate to be paid for a foreign currency at a future point intime. Alternatively, a seller of a currency futures contract locks inthe exchange rate at which a foreign currency can be exchanged forthe home currency.

Some commercial bank and saving institutions use a short hedge toprotect against a possible increase in interest rates.Some bond mutual funds, pension funds, and life insurancecompanies take short position in interest rate futures to insulatetheir bond portfolios from a possible increase in interest rates.Securities firms execute futures transactions for individuals andfirms. They also take position in future contract to hedge their ownportfolios against stock market or interest rate movement.

Thus, financial institutions and other corporation or individualgenerally use futures contracts to reduce risk, earning profit fromspeculation, and hedge to payable or receivable position.

5. Conclusion :Financial future contracts are still a fairly new product; new productsare still rapidly emerging, and much growth in the futures industrylies ahead. In recent years, financial derivatives have received muchattention both because they have the potential to generate largereturns to speculators and because they entail a high degree of riskin international financial market. Financial derivatives are also nowwidely using to hedge in the currency value movement without

using any cash transaction which is an immense benefit of financial16 International Financial Management Jeff Madura, Managing Transaction Exposure, 7 th Edition

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institution specially which has shortage of liquidity for internationaltransaction.

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References:

Alan C. Shapiro , Multinational Financial Management (1999),currency future and option market; 6th edition.

George Crawford and Bidyut Sen , Strategic Management Issues,Derivatives for decision makers

Jack Clark Francis , Investments- Analysis and Management (1991),Future contracts , 5 th edition.

Jeff Madura , Financial Markets and Institutions (2003), FinancialFuture Market ; 6 th Edition

Jeff Madura , International Financial Management (2003) Currency derivatives, and Managing Transaction Exposure , 7 th edition.

John C. Hull , Options, Futures and other Derivative Securities

Maurice D. Levi , International Finance The markets and FinancialManagement of Multinational Business (1996), Forward Exchange ,3 rd edition.

www.cme.com

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