INTRODUCTION TO DERIVATIVES Introduction Definition of Derivative Types of Derivatives Derivatives Markets Uses of Derivatives Advantages and Disadvantages of Derivatives

Derivatives Derivatives: are financial products such as futures, option, swaps and mortgage-backed securities. Most of derivatives value is based on the value of an underlying asset, commodity or other financial instrument. They are therefore assets that derive its value from another assets. The value of cash instruments is determined directly by markets. On the other hand the value of derivative is derive from the value of some other financial asset or variable

Types of derivatives 1. FORWARDS: Is a customized contract between two entities where settlement takes place on a specific date in the future at today’s pre-agreed price. 2. FUTURES: is an agreement between two parties to buy or sell an assets at a certain time in the future at a certain price. Futures contract are special type of forward contracts. 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. 3. OPTIONS: they are contract that gives the owner the right, but not the obligation to buy(in the case of a call option) or sell (in a case of put option) an assets. 2 types of options Call options: gives the buyer the right but not the obligation to buy a given quantity of the underlying assets, at a given price on or before a given future dates Puts options: give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date

The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. European option: the owner has the right to require the sale to take place on the maturity date American option: the owner can require the sale to take place at any time up to the maturity date. If the owner of the contract exercises this right, the counter-party has the obligation to carry out the transaction. Warrants: they are long dated options usually have maturity date over 9 months and they are traded over the counter. LEAPS: means Long Term Equity Anticipation Securities. These are options having maturity up to 3 years Basket option: an option with a payoff that is linked to a portfolio or basket of assets.

SWAPS: they are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. 2 common swaps Currency swaps : these involve swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction Interest rate swaps: these deals with swapping only the interest related cash flows between the parties in the same currency

Derivative markets There are two markets for derivative contract, 1. over the counter(OTC) markets: these are contracts that are traded ( and privately negotiated) directly between two parties, without going through an exchange or an intermediary. The market is very large They are not regulated with respect to disclosure of information between the parties They are made up of banks and other sophisticated parties such as hedge funds They are subject to counter- party risk because they are not traded on an exchange and no central counter party 2. exchange traded derivative: the market trade standardized contracts that have been defined by the exchange. A derivative acts as an intermediary to all related transactions and takes initial margin from both sides of the trade to act as a guarantee

Uses of derivatives 1. provide leverage such that a small movement in the underlying value can cause a large difference in the value of the derivatives 2. speculate and make a profit if the value of the underlying assets moves the way they expect. ( e.g. moves in a given direction, stays in or out of a specified range, reaches a certain level). 3. hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out 4. obtain exposure to the underlying where it is not possible to trade in the underlying (e.g weather derivates ) 5. create option ability where the value of the derivative is linked to a specific condition or event

Advantages of derivatives 1. price discovery: futures market prices depends on a continuous flow of information from around the world and require a high degree of transparency. A wide range of factors (climatic conditions, political situations, debt default, environmental health etc) impact on the demand and supply assets/commodities and hence the current and future prices of the underlying asset on which the derivative contract is based. 2. risk management: is the process of identifying the desired level of risk, identifying the actual level of risk and altering the latter to equal the former. The process can fall into the categories of hedging and speculation. Hedging is a strategy for reducing the risk in holding a market position while speculation is taking a position in the way the market will moves 3. improve market efficiency for the underlying assets: 4. reduce market transaction costs: because they are a form of insurance or risk management, the cost of trading in them has to be low or investors will not find it economically sound to purchase such insurance for their positions

5. facilitates the buying and selling of risk: and people consider it to have a positive impact on the economic system. 6. they are innovative financial products: there is no risk, no scenarios, which derivatives cannot take care. Disadvantages 1. lifespan: they are time wasting assets. As each day passes and the expiration date approaches, you lose more and more ‘time’ premium and the options value decreases. 2. direction and market timing: in order to make money with many derivatives, investors must accurately predict the direction in which the market or index will move (up or down) and the minimum magnitude of the move during a set period of time. 3. cost: the bid/ask spreads of more common derivatives such as options can be discouraging. 4. it fails to help investors achieve their objectives; the derivative itself is blamed for ensuring losses when, in fact, its often the investor who did not fully understand how it should be used, its inherent risk. etc

Factors influencing option price Exercise price: the less an investor has to pay to convert a call option into a more valuable share, the greater the option’s worth. Thus for a call, a lower exercise price means a more valuable option. For a put option, a higher exercise price makes the option more valuable Stock price: because the holder of a call benefits by receiving a more valuable share upon exercising an option, a higher stock price means a more valuable option. In the case of a put option, a higher stock price reduced the value of the option since the investor has the option of selling the underlying asset in the open market.

Volatility: as volatility increases, there is a higher probability that the stock will dramatically increase or decrease in value. If the stock has a huge increase in price, a call option increases in value from its upside exposure. However, if the stock falls in price, the option’s downside exposure is limited. This makes option owners prefer high volatility in the price of the underlying stock. As it increases the chance that the option will be very valuable without exposure to large losses. All things being equal, then, higher stock price volatility translates into a higher time value. This applies for both call and put options. Time to expiration: the longer an option holder has before expiration, the higher the probability that the stock price will end up above the exercise price of a call option or below the exercise price of a put option. This makes options with long lives more valuables than similar options with short lives. For an American option, as the time to maturity decreases, the option price approaches the intrinsic value.

Risk free rate: purchasing a call option gives an investor the right to purchase a share at a fixed price in the future. However, a call option gives its owner an interest free loan in the amount of the exercise price for the length of the option. The value of this loan increases with the length of the option life and the risk free rate. Thus, a call option’s value increases as the risk free rate increases. Conversely, a higher interest rate will reduce the postponement of the proceeds of sale, thus increasing the opportunity cost. Dividends: when a company pays a dividend, the stock’s price is lowered precisely by the dividend amount. Thus, while dividend may be an important part of total shareholder returns, they always lower a stock’s absolute price level, accordingly, the value of an option to buy that stock also falls. When valuing an option with a short life, the value of the underlying share price should be lowered by the present value of dividend expected to be received over the option’s life. By the same reasoning, put option’s value will increase as the stock price drops because of higher dividends.