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    Financial Derivatives: Sessions 1-2

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    Amit babar
    This document provides an overview of financial derivatives. It defines a derivative as a financial contract whose value is based on an underlying asset. Common underlyings include commodities, equities, bonds, currencies, and indexes. Derivatives are used by end users, arbitrageurs, and intermediaries for hedging risks and speculating. The global over-the-counter and exchange-traded derivatives markets are enormous in size. An example is given of AIG, which suffered massive losses from derivative bets tied to subprime mortgages. The basic types of derivatives - forwards, futures, options, and swaps - are introduced along with how they can be used for hedging and speculation.

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    Financial Derivatives: Sessions 1-2

    Uploaded by

    Amit babar
    62 views8 pages
    This document provides an overview of financial derivatives. It defines a derivative as a financial contract whose value is based on an underlying asset. Common underlyings include commodities, equities, bonds, currencies, and indexes. Derivatives are used by end users, arbitrageurs, and intermediaries for hedging risks and speculating. The global over-the-counter and exchange-traded derivatives markets are enormous in size. An example is given of AIG, which suffered massive losses from derivative bets tied to subprime mortgages. The basic types of derivatives - forwards, futures, options, and swaps - are introduced along with how they can be used for hedging and speculation.

    Original Description:

    Derivatives introduction and types of derivatives.

    Original Title

    Session_1_2

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    This document provides an overview of financial derivatives. It defines a derivative as a financial contract whose value is based on an underlying asset. Common underlyings include commodities, equities, bonds, currencies, and indexes. Derivatives are used by end users, arbitrageurs, and intermediaries for hedging risks and speculating. The global over-the-counter and exchange-traded derivatives markets are enormous in size. An example is given of AIG, which suffered massive losses from derivative bets tied to subprime mortgages. The basic types of derivatives - forwards, futures, options, and swaps - are introduced along with how they can be used for hedging and speculation.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    62 views8 pages

    Financial Derivatives: Sessions 1-2

    Uploaded by

    Amit babar
    This document provides an overview of financial derivatives. It defines a derivative as a financial contract whose value is based on an underlying asset. Common underlyings include commodities, equities, bonds, currencies, and indexes. Derivatives are used by end users, arbitrageurs, and intermediaries for hedging risks and speculating. The global over-the-counter and exchange-traded derivatives markets are enormous in size. An example is given of AIG, which suffered massive losses from derivative bets tied to subprime mortgages. The basic types of derivatives - forwards, futures, options, and swaps - are introduced along with how they can be used for hedging and speculation.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 8

    24-07-2020

    Financial Derivatives
    Sessions 1-2

    Dilip Kumar 1

    What is a financial derivative?


    “A financial contract is a derivative security, or a contingent claim,
    if its value at expiration date T is determined exactly by the market
    price of the underlying cash instrument at time T.”
    - Ingersoll, 1987.
    Contingent claim: A claim that can be made if certain specified outcomes occur.
    Requirements for underlier
    It can be quantified
    Many buyers and sellers of derivatives exist based on this quantified measure.
    Common underliers: Commodities, Financial securities (Equities and Bonds
    (Interest rates)), Currencies.
    Underliers that cannot be delivered: Weather conditions, creditworthiness, stock index.
    Dilip Kumar 2

    1
    24-07-2020

    Who buy and sell derivatives?


    End users:
    Individuals, Companies, Financial institutions
    • Buy and sell derivatives to hedge positions or to speculate.
    Arbitrageurs (Take advantage of mis-pricing)
    Not interested in owning derivatives.
    Make small and (virtually) risk-free profits by simultaneously buying and selling
    derivative instruments.
    Intermediaries (Connect buyers and sellers)
    Create innovative solutions for customer of financial derivatives.
    Brokers, Banks, Exchanges and an army of financial wizards.
    Revenue: Commissions, fees and difference between bid and ask rates on derivative
    contracts they buy and sell.
    Dilip Kumar 3

    Derivative Markets
    Exchange-traded futures and options
    standardized products
    trading floor (human outcry) or computerized trading
    virtually no credit risk (counterparty is clearing house)
    Contracts are directly between clearing members (brokers) and
    clearing house.
    Over-the-Counter forwards, options, & swaps
    often non-standard (customized) products
    Connected by global network of telephone, telex, fax, and high-speed
    internet connections.
    Credit risk is present
    Dilip Kumar

    2
    24-07-2020

    Current size of derivatives market


    You can get data on current size of derivatives market from BIS
    website.
    For Exchange traded contracts: See the following link
    https://www.bis.org/statistics/extderiv.htm?m=6%7C32%7C616
    For OTC contracts: See the following link
    https://www.bis.org/statistics/derstats.htm?m=6%7C32%7C71

    Dilip Kumar 5

    The tale of AIG (American International Group)


    AIG-FP (Financial Products)
    Sold $500 billion worth insurance (jargon: CDS protection), with atleast $64 bn
    tied to subprime mortgages. AIG, initially rated AAA, didn’t have even a fraction
    of that amount in cash to cover the bets!.
    September 2008 -- The Bailout Begins ($85 bn)
    Just a week after the U.S. government let Lehman Brothers file for
    bankruptcy, the Treasury Department steps in to rescue AIG, which
    had been brought to its knees by a big move into risky financial
    products like insurance-type contracts on mortgage-related securities.

    Dilip Kumar 6

    3
    24-07-2020

    The Four Basic Derivatives


    Forward Contracts

    Futures Contracts

    Options Contracts

    Swaps Contracts

    Dilip Kumar

    Uses of Derivatives
    To hedge or insure risks; i.e., shift risk.
    To reflect a view on the future direction of the market, i.e., to
    speculate.
    To lock in an arbitrage profit

    Dilip Kumar

    4
    24-07-2020

    Understanding the product space


    We will first understand the payoffs from two popular class of
    derivative instruments: forwards (or futures) and options
    As we will see later, it is also instructive to classify these class of
    instruments as below:
    Linear derivatives
    Non-linear derivatives

    Dilip Kumar 9

    Derivatives: Hedging
    Let us now talk about a “textbook farmer”. His harvest is due
    after three months. What are the risks he faces? How can he
    hedge himself?
    If he finds someone who promise to buy wheat at 100 (for 5 kg),
    he has removed his price risk
    ?
    up=120
    Let us study the cash-flows
    ?

    down=90
    ?
    t=0 t=3m

    Dilip Kumar 10

    5
    24-07-2020

    Derivatives: Hedging
    If the farmer can find someone who promises to buy wheat at 100,
    he has removed his price risk.
    Note: the farmer is said to be short the wheat forward
    Sell at 100
    up=120

    No Cash-flow

    down=90
    Sell at 100
    t=0 t=3m
    The farmer doesn’t pay/receive any premium upfront.
    Who is likely to be a counterparty for this contract.
    Dilip Kumar 11

    Derivatives: Hedging
    The counterparty could be a consumer of wheat, say a bread
    manufacturer.
    Note: the consumer here is said to be long the wheat forward.
    Buy at 100
    up=120

    No Cash-flow

    down=90
    Buy at 100
    t=0 t=3m

    The counterparty could also be a trader taking speculative position


    Dilip Kumar 12

    6
    24-07-2020

    Derivatives: Trading
    The long counterparty could also be a trader who is merely speculating
    on the price of wheat going up.
    Profit=20
    up=120

    No Cash-flow

    down=90
    Loss=10
    t=0 t=3m

    If the price goes to 120, he can buy wheat in forward at 100, sell
    it in spot market for 120, and make a profit of 20.

    Dilip Kumar 13

    Defining Forward Contracts


    A Forward contract is an agreement to buy or sell an underlying
    asset, for a specified price, at a specified time in the future.
    Both parties are obliged to honour the contract
    The person who has agreed to buy the asset in future is said to be
    long.
    The person who has agreed to sell the asset in future is said to be
    short.
    The price at which the parties agree to buy/sell is the forward
    price.
    They do not pay any premium for entering this contract.
    Dilip Kumar 14

    7
    24-07-2020

    Distinguishing between Forwards and Futures


    A Futures contract is similar to a forward contract in terms of
    terminal payoffs; but there is a key difference
    Futures are traded in exchange and are standardized
    Forwards are traded over-the-counter and can be easily customized
    While some people use the two terms interchangeably, it helps
    to remember that they are not identical products.

    Dilip Kumar 15

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