Financial Derivatives

Ilacad, Madrid, Uy, Sanchez, Tauyan, Villamor

Financial Derivatives
❖ A financial instrument whose value is dependent on an underlying asset.
The most common underlying assets for derivatives are stocks, bonds,
commodities, currencies, interest rates, and market indexes.
❖ Examples:
1. A stock option is a derivative whose value is dependent on
the price of a stock.
2. A contract allowing a company to purchase coffee beans at a
designated future date, at a predetermined price.
❖ A derivative is a financial instrument:
3. That requires no initial net investment or little net
investment relative to other types of contracts that have a
similar response to changes in market conditions; and
4. That is settled at a future date.
o A derivative contract is essentially a contract. The
contract specifies that some future commodity may be
exchanged at a later date at a price fixed today. Notice
the fact that the agreement would basically be
worthless if not for the time difference between the
setting of the price and the actual execution of the
trade.
o Since the price is set today, let’s say at Php 100 and
the transaction takes place a month from now when
the price could be any amount greater or lower than
Php 100, the derivative contract becomes valuable.
The derivative contract becomes a license to purchase
commodities at below market prices and book an
immediate gain.
Importance and Uses
❖ Uses. Derivatives can be used to either mitigate risk (hedging) or assume
risk with the expectation of commensurate reward (speculation).
1. Hedging. Companies use derivatives to protect against cost
fluctuations by fixing a price for a future deal in advance. By
settling costs in this way, buyers gain protection - known as a
hedge - against unexpected rises or falls in, for example, the
foreign exchange market, interest rates, or the value of the
commodity or product they are buying.
2. Speculation. Investors may buy or sell an asset in the hope of
generating a profit from the asset's price fluctuations. Usually
this is done on a short-term basis in assets that are liquid or
easily traded. Example: An investor notices a company's share
price is going up and buys an option on the share. An option
gives a right to the holder to buy shares at a future date.
 If share prices do rise, the investor can profit by buying
at a fixed option price and selling at the current higher price.
If share prices fall, the investor can sell the option or let
it lapse, losing a fraction of the value of the asset itself.
❖ Importance. Derivatives are important for managing risks. They lock in
prices, hedge against unfavorable movements in rates, and mitigate risks.
In addition, financial derivatives enable parties to trade specific financial
risks (such as interest risk, currency, equity and commodity price, and
credit risk) to other entities more willing or better suited, to take or
manage these risks.

A derivative can be traded on an

1. Exchange-traded market. A derivatives exchange is a market

where individuals trade standardized contracts that have
been defined by the exchange.

2. Over-the-counter (OTC) market. Are customized, flexible,

and more private and less regulated than exchange-traded
derivatives, but are subject to a greater risk of default.
Banks, other large financial institutions, fund managers,
and corporations are the main participants in OTC
derivatives markets.

Hedging
❖ Hedging is a type of investment done to lessen the risk of unexpected
fluctuations in an asset's price. A hedge typically involves taking a position
that is opposed to the investment being hedged. It is occasionally
contrasted with an insurance policy. When someone purchases a home,
he would want to safeguard it against unforeseen events like a fire. He can
lessen the losses he would suffer from the fire by purchasing fire
insurance, for which he would have to pay a premium.
❖ Importance- Hedging provides a means for traders and investors to
mitigate market risk and volatility. It minimises the risk of loss. Market
risk and volatility are an integral part of the market, and the main motive
of investors is to make profits. However, you are not in a position to control
or manipulate markets in order to safeguard your investments. Hedging
might not prevent losses, but it can considerably reduce the effect of
negative impacts. It is crucial to remember that hedging has costs.
Investment in hedging consumes a proportionately smaller amount of
capital than investment in the asset being hedged. Nevertheless, investors
frequently take this approach to reduce risk.

Relevance to Derivatives
o Companies use derivatives to protect against cost
fluctuations by fixing a price for a future deal in
advance. By settling costs in this way, buyers gain
 protection - known as a hedge against unexpected
rises or falls in, for example, the foreign exchange
market, interest rates, or the value of the commodity
or product they are buying.
o Derivatives are one of the most often used hedging
strategies. Options, swaps, futures, and forward
contracts, among other derivatives, invariably move in
the same direction as the underlying asset. Investors
may employ derivatives to create trading strategies in
which a gain in a derivative contract might offset a
loss on an investment.

Forwards
❖ A contract under which one party agrees to buy a commodity at a
specific price on a specific future date and the other party agrees to make
the sale.
❖ A forward contract usually is not traded on market exchange. These are
available over-the-counter and are not marked-to-market. Marked to
market is an accounting practice that involves adjusting the value of an
asset to reflect its value as determined by current market conditions.
❖ When a forward contract expires, the transaction is settled in one of two
ways. The first way is through a process known as physical delivery and
the other one is cash settlement.
Importance
❖ The company has the advantage of knowing exactly how much it will
spend for the cost it requires in advance. Entering a forward contract
facilitates financial planning much more easily.
Function
❖ Forward contracts were used for commodities such as wheat, where
farmers would sell forward contracts to millers, enabling both parties to
lock in prices and thus reduce their risk exposure. To hedge against
potential losses by avoiding the volatility in pricing.
❖ Forwards are also commonly used to hedge against changes in currency
exchange rates when making large international purchases.
❖ Forward contracts can also be used purely for speculative purposes. If a
speculator believes that the future spot price of an asset will be higher
than the forward price today, they may enter into a long forward position.
If the future spot price is greater than the agreed-upon contract price,
they will profit.
Advantages

❖ Fixing the future date, thus eliminating the downside risk exposure
❖ Flexibility with the amount to be covered.
 ❖ Being able to manage the costs within a definite budget.

Disadvantages

❖ Contractual commitment that must be completed on the due date

because if not, you will be held liable for the obligations you didn't perform.
❖ No opportunity to benefit from unfavorable movement in exchange rates.
Example
Assume that a company like XYZ believes that the price of ABC shares will
increase substantially in the next three months. Unfortunately, it does not
have the cash resources to purchase the shares today. XYZ therefore enters
into a contract with a broker for delivery of 10,000 ABC shares in three
months at a price of P110 per share. XYZ has entered into a forward
contract, a type of derivative. As a result of the contract, XYZ has received
the right to receive 10,000 ABC shares in three months. Further, it has an
obligation to pay P110 per share at that time
Question: What is the benefit of this derivative contract?
Answer: XYZ can buy ABC shares today and take delivery in three months If
the price goes up, it expects XYZ profits. If the price goes down, XYZ loses

Futures
❖ Futures are a type of derivative contract agreement to buy or sell a specific
commodity asset or security at a set future date for a set price. Futures
contracts, or simply "futures," are traded on futures exchanges like the
CME Group and require a brokerage account that’s approved to trade
futures.
❖ A futures contract involves both a buyer and a seller, similar to an options
contract. Unlike options, which can become worthless at expiration, when
a futures contract expires, the buyer is obligated to buy and receive the
underlying asset and the seller of the futures contract is obligated to
provide and deliver the underlying asset.
❖ A futures contract gets its name from the fact that the buyer and seller of
the contract are agreeing to a price today for some asset or security that
is to be delivered in the future.
❖ These contracts trade on organized futures exchanges with a clearing
association that acts as a middleman between the contracting parties.
❖ Every futures contract represents a specific quantity. It is not negotiated
by the parties to the contract.

Clearing house/Association
It is a financial institution formed to facilitate the exchange of
payment, securities, or derivatives transactions. It stands between two
clearing firms. Its purpose is to reduce the risk of a member firm failing to
honor its trade settlement obligation.
Importance
❖ Futures are an important vehicle to hedge or manage different kinds of
risks. Companies engaged in foreign trade use futures to manage foreign
exchange risk, interest rate risk if they have an investment to make, and
lock in an interest rate in anticipation of a drop in rates, and price risk to
lock in prices of commodities such as oil, crops, and metals that serve as
inputs.
❖ Futures and derivatives help increase the efficiency of the underlying
market because they lower the unforeseen costs of purchasing an asset
outright. Studies have shown that the introduction of futures into markets
increases the trading volumes underlying as a whole. Consequently,
futures help reduce transaction costs and increase liquidity as they are
viewed as an insurance or risk management vehicle.

Advantages
❖ Opens the Markets to Investors
• Futures contracts are useful for risk-tolerant investors. Investors
get to participate in markets they would otherwise not have access
to.

❖ Stable Margin Requirements

• Margin requirements for most of the commodities and currencies
are well-established in the futures market. Thus, a trader knows
how much margin he should put up in a contract.

❖ No Time Decay Involved

• In options, the value of assets declines over time and severely
reduces the profitability for the trader. This is known as time decay.
A futures trader does not have to worry about time decay.

❖ High Liquidity
• Most of the futures markets offer high liquidity, especially in case
of currencies, indexes, and commonly traded commodities. This
allows traders to enter and exit the market when they wish to.

❖ Simple Pricing
• Unlike the extremely difficult Black-Scholes Model-based options
pricing, futures pricing is quite easy to understand. It's usually
based on the cost-of-carry model, under which the futures price is
determined by adding the cost of carrying to the spot price of the
asset.

❖ Protection against Price Fluctuations

• Forward contracts are used as a hedging tool in industries with high
level of price fluctuations. For example, farmers use these contracts
to protect themselves against the risk of drop in crop prices.
Disadvantages
❖ No Control over Future Events
• One common drawback of investing in futures trading is that you
don't have any control over future events. Natural disasters,
unexpected weather conditions, political issues, etc. can
completely disrupt the estimated demand-supply equilibrium.

❖ Leverage Issues
• High leverage can result in rapid fluctuations of futures prices. The
prices can go up and down daily or even within minutes.

❖ Expiration Dates
• Future contracts involve a certain expiration date. The contracted
prices for the given assets can become less attractive as the
expiration date comes nearer. Due to this, sometimes, a futures
contract may even expire as a worthless investment.

Example
Say for instance a farmer is planting wheat, and she expects to
harvest 8,000 bushels of wheat when the crop is ready. Unsure of
the prices at the time of harvest, she can sell the entire crop at a
fixed price well before the actual harvest, with delivery to be made
at a future date such as five months from the date of agreement.
Although the farmer does not get the sale proceeds at the time of
the agreement, the transaction offers her protection against any
possible fluctuations in currency exchange rates and price drops in
the wheat market.

Type #1 Commodity Futures

A commodity futures contract is an agreement to buy or sell a
predetermined amount of a commodity at a specific price on a
specific date in the future. Commodity futures can be used to hedge
or protect an investment position or to bet on the directional move
of the underlying asset.

Type #2 Financial Futures

Contracts to buy or sell something such as foreign currency or
securities (shares, bonds, or other investments) at a particular
future date and at a particular price.

Index Futures
Futures that are based on the stock index.
 Foreign Government Debt Futures
Most Government Issue debt that are corresponded to the futures
markets that are listed around the world.

Swap Futures
This is generally agreements that are between two parties to
exchange periodic interest payments.

Forex Futures
This type of futures is to manage the risks and take advantage of
related forex exchange rate fluctuations.

Swaps
❖ A swap is a derivative contract through which two parties exchange the
cash flows or liabilities from two different financial instruments. Most
swaps involve cash flows based on a notional principal amount such as a
loan or bond, although the instrument can be almost anything. Usually,
the principal does not change hands. Each cash flow comprises one leg of
the swap. One cash flow is generally fixed, while the other is variable and
based on a benchmark interest rate, floating currency exchange rate, or
index price
❖ The most common kind of swap is an interest rate swap. Swaps do not
trade on exchanges, and retail investors do not generally engage in swaps.
Rather, swaps are over-the-counter (OTC) contracts primarily between
businesses or financial institutions that are customized to the needs of
both parties.
❖ The market for swaps represents 80% of the global derivatives market.
Since these products are generally adapted to the needs of the client and
not easily standardized, so as to be traded on an exchange, the swap
market has always been considered an Over the Counter Market.
However, the swap market is one of the largest, most liquid and most
competitive in the world.
❖ A swap is defined technically in function of the following factors:
• The start and end dates of the swap.
• Nominal: The amount upon which the payments of both parties
are calculated.
• Interest rate or margin of each of the contracting parties.
• Index of reference for the variable part.
• Periodicity or frequency of payment.
❖ Swapping allows companies to revise their debt conditions to take
advantage of current or expected future market conditions.
❖
 Importance
1. Borrowing at Lower Cost. Swap facilitates borrowings at lower cost. It
works on the principle of the theory of comparative cost.
2. Access to New Financial Markets. Swap is used to have access to new
financial markets for funds by exploring the comparative advantage
possessed by the other party in that market.
3. Hedging of Risk. Swap can also be used to hedge risk. For instance, a
company has issued fixed rate bonds. It strongly feels that the interest
rate will decline in future due to some changes in the economic scene.
4. Tool to correct Asset-Liability Mismatch. Swap can be profitably used
to manage asset-liability mismatch.
5. Additional Income. By arranging swaps, financial intermediaries can
earn additional income in the form of brokerage.

Advantages
1) Swap is generally cheaper. There is no upfront premium and it reduces
transactions costs.
2) Swap can be used to hedge risk, and long time period hedge is possible.
3) It provides flexible and maintains informational advantages.
4) It has longer term than futures or options. Swaps will run for years,
whereas forwards and futures are for the relatively short term.
5) Using swaps can give companies a better match between their liabilities
and revenues
Disadvantages
1) Early termination of swap before maturity may incur a breakage cost.
2) It is subject to default risk

Interest Rate Swap

❖ An interest rate swap is an agreement between two parties to exchange one
stream of interest payments for another, over a set period of time.
❖ There are contracts to exchange cash flows as of a specified date or a series of
specified dates based on a notional amount and fixed and floating rates.
❖ Over 70% of derivatives are interest rate swaps. These contracts exchanged
fixed interest payments for floating rate payments, or vice versa, without
exchanging the underlying principal amounts.
❖ For example, suppose you owe P100,000 on a 30% fixed rate home loan. You
envy your neighbor who is also paying 10% on her P100,000 mortgage, but hers
is a floating rate loan, so if market rates fall, so will her loan rate. To the
contrary, she is envious of your fixed rate, fearful that rates will rise, increasing
her payments. A solution would be for the two of you to effectively swap interest
payments using an interest rate swap agreement. The way a swap works, you
 both would continue to actually make your own interest payments, but would
exchange the net cash difference between payments at specified intervals. So, in
this case, if market rates (and thus floating payments) increase, you would pay
your neighbor, if rates fall, she pays you. The net effect is to exchange the
consequences of rate exchanges. In other words, you have effectively converted
your fixed rate debt to floating rate debt; your neighbor has done the opposite.

Currency Swaps
❖ A currency swap, sometimes referred to as a cross-currency swap, involves the
exchange of interest—and sometimes of principal—in one currency for the same
in another currency. Interest payments are exchanged at fixed dates through
the life of the contract. It is considered to be a foreign exchange transaction and
is not required by law to be shown on a company's balance sheet.

Options
❖ It is a contract giving the right but not the obligation to buy or sell a specified
underlying instrument at a specified price until or at specified future date.

KEY TERMINOLOGIES
❖ Option Exercise- the process by which a call option is used to purchase or a
put option is used to sell the underlying
❖ Strike Price - the price at which you can buy or sell the underlying
❖ Option Premium - the price paid for an option in the market
❖ Expiration date - the date specified in the options contract

TYPES OF OPTION DERIVATIVES

Call Option
• an option to buy
• gives the holder the right but not the obligation to buy an asset by a
certain date for a certain price.
• Investors buy calls when they believe the price of the underlying asset
will increase and sell calls if they believe it will decrease.

Payoff for buyer of call option

• The profit/loss that the buyer makes on the option depends on the spot
price of the underlying.
• If upon expiration, the spot price exceeds the strike price, he makes a
profit. Higher the spot price, more is the profit he makes.
• If the spot price of the underlying is less than the strike price, he lets
his option expire un-exercised.
 • His loss in this case is the premium he paid for buying the option

Payoff profile for writer of call options

• For selling the option, the writer of the option charges a premium.
• The profit/loss that the buyer makes on the option depends on the spot
price of the underlying.
• Whatever is the buyer's profit is the seller's loss. If upon expiration, the
spot price exceeds the strike price, the buyer will exercise the option
on the writer. Hence as the spot price increases the writer of the option
starts making losses. Higher the spot price, more is the loss he
makes.
• If upon expiration the spot price of the underlying is less than the strike
price, the buyer lets his option expire un-exercised and the writer gets
to keep the premium.

Put Option
• an option to sell
• gives the holder the right but not the obligation to sell an asset by
a certain date for a certain price.
• The writer (seller) of the put option is obligated to buy the asset if
the put buyer exercises their option. Investors buy puts when they
believe the price of the underlying asset will decrease and sell puts
if they believe it will increase.

Payoff profile for buyer of put options

• Put option gives the buyer the right to sell the underlying asset at the
strike price specified in the option.
• The profit/loss that the buyer makes on the option depends on the spot
price of the underlying.
• If upon expiration, the spot price is below the strike price, he makes a
profit.
• Lower the spot price, more is the profit he makes.
• If the spot price of the underlying is higher than the strike price, he lets
his option expire un-exercised.
• Loss in this case is the premium he paid for buying the option

Payoff profile for writer of put options

• For selling the option, the writer of the option charges a premium.
• The profit/loss that the buyer makes on the option depends on the spot
price of the underlying
• Whatever is the buyer's profit is the seller's loss.
• If upon expiration, the spot price happens to be below the strike price,
the buyer will exercise the option on the writer.
 • If upon expiration the spot price of the underlying is more than the
strike price, the buyer lets his option un-exercised, and the writer gets
to keep the premium.

Types of Option Investor

• Bullish Investor
• A bullish investor, also known as a bull, is one who believes prices
will go up. Someone can be bullish about either the market,
individual stocks, or specific sectors. Someone who believes
BakaTresAko Corp.’s stock will soon go up is said to be bearish on
that company. An example of a bullish investor is the holder/buyer
of an option.
• Bearish Investor
• A bearish investor, also known as a bear, is one who believes prices
will go down. Someone can be bearish about either the market,
individual stocks, or specific sectors. Someone who believes
BakaKwatroPa Corp.’s stock will soon go down is said to be bearish
on that company. An example of a bearish investor is the
writer/seller of an option.

• Option Timing
• American Option
• options that can be exercised at any time up to the expiration
date.
• European Option
• options that can be exercised only on the expiration date.

NOTE: The distinction between American and European options has

nothing to do with geography, only with early exercise. Many options on
stock indexes are of the European type. Because the right to exercise early
has some value, an American option typically carries a higher premium
than an otherwise identical European option. This is because the early
exercise feature is desirable and commands a premium.

Moneyness of an Option
Call Option Put Option
Spot Price > Strike Price ITM OTM
Spot Price < Strike Price OTM ITM
Spot Price = Strike Price ATM ATM

Importance
• It gives the investor an option whether to exercise or not the contract.
• It allows the investors to speculate on or hedge against the volatility of an
underlying stock.

Example
Problem no. 1 – CALL OPTION
A contract or call option allows the holder to call (purchase) at any time in
the next 12 months 10,000 shares of AEIOU Co. share at a price of P50
per share. If the call is exercised, it can be settled by payment by the
contract issuer to the contract holder of an amount equal to 10,000 times
the difference between the market price of AEIOU Co. share on the call
date and the strike price of P50 Assume that AEIOU Co. is a publicly
traded company with a current market price of P50. The underlying is the
share price of ABC share, as the price of this contract will depend on this
underlying variable. The notional amount is the 10,000 shares that can be
called.

The holder can acquire the call contract at a considerably lower cost than
that of actually buying the 10,000 shares at P50 per share. Holding the
call option contract has the same response to market price changes as
does holding the individual shares themselves.

The contract need not require the actual transfer of shares upon the
contract being exercised. The issuer of the contract can settle with
payment of cash in an amount equal to the gain of the holder.

Problem #2 (PUT OPTION)

FM111 Inc acquired 1,000 shares of ACC102 Company on January 2,
2014, at a cost of P50 per share. FM111 does not plan to sell the shares
until mid-2015 at the earliest and therefore classifies this investment, as
financial asset at fair value. FM111 however, does not want to be exposed
to possible declines in the fair value of the investment. FM111 therefore
acquires a put option to sell the 1,000 shares at a price of P50 per share
on June 10, 2015. The cost of the put option contract is zero for minimal.
FM111 designates the put contract as a fair value hedging contract for the
investment in ACC102 Company.

Advantages
• An option is not binding
• It is not binding in the way that it does not obligate one to buy an
underlying. It gives you the right to buy and so when the strike price
is higher than the current market price, you can just let the option
expire and buy at the spot price.
 • Useful source of leverage and risk hedging
• ability to hedge risk from adverse market changes on assets with
floating value
• some structured solutions provide not only the ability to hedge
from adverse market movements but also reverse position to profit
from such changes
• High Return Potential:
• The returns on options trading would be much higher than buying
shares on cash. As such, the option pays equal profit as the simple
stock buying if had chosen the right strike. As we are getting options
on lower margin and getting the same profitability the percentage
return would be much higher comparatively.
• Lower Risk:
• Options are riskier than owning equities; however, there are also
times when options are used to avoid risk. Options are used widely
to hedge the positions. The risk in options is predefined as the
maximum loss can be the premium paid to buy the option.
• More Strategy Available:
• There are more strategies available in the options market to trade
options. The trades can be combined to create a strategic position
with the help of a call and put options of different expiries and strike
prices.

Disadvantages

• Options contracts are complex and difficult to price

• Pricing an option relies on complex mathematical formulas, but the
direct inputs into an option's price include the price of the
underlying asset, the option's strike, time to expiration, interest
rates, and implied volatility.
• Option traders need to understand additional variables that affect
an option's price and the complexity of choosing the right strategy.
• complicated structures require expertise in utilizing options as a
form of hedge or investment, creating the need to hire specialist
personnel or service providers

• Time decay
• Time decay is a measure of the rate of decline in the value of an
options contract due to the passage of time. Time decay accelerates
as an option's time to expiration draws closer since there's less time
to realize a profit from the trade.

• High Commissions
• Option trading is more expensive as compared to future or stock
trading. Options can be unusually expensive when the time value
until expiration is lengthy, unpredictable events exist, such as
upcoming earnings announcements, or when volatility is unusually
high.