Derivative Markets and Instruments

Introduction A derivative is a security that derives its value from the value or return of another asset or security. Derivative instruments are used to hedge the risk of corporate and customers

Instruments Futures Forwards Options Swaps

Futures A futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price.

Forward A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time. Therefore, the trade date and delivery date are separated. It is used to control and hedge risk, for example currency exposure risk (e.g., forward contracts on USD or EUR) or commodity prices (e.g., forward contracts on oil).

Options Options are financial instruments that convey the right, but not the obligation, to engage in a future transaction on some underlying security, or in a futures contract

Swaps Swap is a derivative in which two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap

Forward Rate Agreements A FRA can be viewed as a forward contract to borrow/lend money at a certain rate at some future date.

Forward Rate Agreements A long position in a FRA is the party that would borrow the money and vice versa. If the reference rate at the expiration date is below the contract rate, the short will receive a cash payment from the long

Example FRA price is 6.47% - 6.50% BUYER ( Implied Borrower ) The party wishing to protect against a RISE in interest rates. They buy the FRA at 6.50% SELLER ( Implied Lender ) The party wishing to protect against a FALL in interest rates. They sell the FRA at 6.47%

Example Consider a FRA that: Expires / settles in 30 days Is based on a notional principal amount of $1m Is based on 90-day LIBOR Specifies a forward rate of 5% 90-day LIBOR at expiration is 6%

Solution (0.06 – 0.05)(90/360) x 1 million = $2,500

Futures Initial Margin – the amount deposited in a futures account. It equals about one day’s price fluctuation. Maintenance margin – the amount of margin that must be maintained in a future account. Variation margin – is the funds that must be deposited to bring it back to the initial margin

Margin Borrowed money that is used to purchase securities. This practice is referred to as "buying on margin". The amount of equity contributed by a customer as a percentage of the current market value of the securities held in a margin account

Margin Buying with borrowed money can be extremely risky because both gains and losses are amplified Margin also subjects the investor to a number of unique risks such as interest payments for use of the borrowed money

Example An investor purchases 100 shares of a stock for $75 per share and later sells at $150 per share. Compute the return with an initial margin requirement of 60%

Solution Cost of investment = 0.6 x ($75 x 100) = $4,500 Return = $15,000 - $3,000 = $12, 000 $12,000 / $4,500 – 1 = 167%

Margin Call Trigger (margin purchase) = 1 – initial margin x P0 1 – maint. Margin Trigger (margin sale) = 1 + initial margin x P0 1 + maint. margin

Example Assume you bought a stock for $40 per share. If the initial margin requirement is 50% and the maintenance margin requirement is 25%, at what price will you get a margin call?