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Index Overview of Derivative Instruments....................................................................................2

Purpose of Derivative Instruments......................................................................................4

Derivatives as Means of Speculation....................................................................................5

References........................................................................................................................... 7

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Overview of Derivative Instruments

You own a company and you have imported a machine from US costing $50,000 against the credit of six months. Now, this deal is not risk free because the prize of dollar may swing on the either side by the end of six months and that may cost or bring gain to you depending on which side would the exchange rate be when your payment would be due. That’s a blind bet.

What is the solution to cover such risk? – Derivative Instrument, it is a financial instrument whose value is derived from the value of the underlying asset. (Bala & Pttabhi, 2014)

The value of the derivative changes with the price of the underlying asset. Since it derives its value from the asset, therefore, it is known as derivative. The underlying asset could be equity shares, commodity, interest rate of financial asset, foreign exchange rate or market index. (Raymonds, 2012)

“ the process of financial innovation described in Chapter 9 came to the rescue by producing new financial instruments that helped financial institution managers manage risk better. “These instruments, called derivatives, have payoffs that are linked to previously issued securities and are extremely useful risk reduction tools." (Mishkin, 2006)

Chicago Mercantile Exchange launched futures contracts written on financial instruments in 1972 or May/June 1973 The Black-Scholes Model is Published.

The Chicago Board of Trade introduced the first interest rate futures contracts in 1975.

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Following are the types of derivative instruments:

Forward Contract – This is the contract to insulate you from the rate swings and fixes the price at which you can purchase the foreign currency (US dollar in the above case) at a certain rate on a certain date.

Features of forward contract:

Unique- It is on one on one basis.

Performance Obligation- Both the parties to the contract have obligation to perform their part irrespective of the prevailing currency exchange price.

No margins: Usually no deposit or premium is made because both the parties have equal rights and obligations.

Illiquid- Forward contract is not tradable. Since it is unique and is on one on one basis therefore there is lack of liquidity. (Khan & Jain, 2012)

Future Contract- This is the contract in which the future performance of contract is assured to you. It is a standardized contract where one parties buys and the other sells a certain asset at a certain rate on a certain date.

The difference between forward and future contract is that in latter there is guarantee of performance and it is marketable instrument. The performance is guaranteed by clearing house. The deal is divided into two parts; the buyer and seller deal with clearing house. Even if one party defaults in performing its obligation the clearing house fulfills its part to the other part.

Options Contract- As the name suggests, the option is the right purchased by the buyer to buy or sell a standard quantity of financial instrument at or before a certain date at a certain price. It is to be noted that the buyer here buys the right and is under no obligation to perform his part of contract but the seller of this right is under obligation.

When the option is the “right to buy” it is called a call option and when it is a “right to sell” it is called the put option.

Therefore, Call option is the right to buy for the holder and obligation to sell for the seller, whereas, the Put option is right to sell for the holder and obligation to buy for the seller.

Option premium is the price that the price that the buyer has to pay to purchase such option.

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Similarly Interest rate swaps and currency swap agreements are types of Derivatives.

Purpose of Derivative Instruments

Hedging, Speculation & Arbitraging: Different participants in the market have different purposes. Hedgers, like in the above mentioned example, want to insulate themselves from the risk of price movements. Speculators want to make profits through the price movements. Arbitrageurs want to make profit through the difference in the prices of spot and derivative market. Derivative instruments serve all of them. (Bartram, Brown & Fehle, 2007)

Price Discovery: The derivative market is called the market of high informed participants. Therefore, the price changes are first reflected in the derivative market and then it is caught by the spot market.

Risk transfer: Derivative market is like insurance company, it redistributes the risk amongst the players. Similarly it charges premium to protect the market participant from the risk. (Brown & Greg, 2001)

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Purpose of Derivative Instruments

Hedging,

Speculation &

Arbitraging

Price

Discovery

Risk

Transfer

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The Total Amount Outstanding of Over the counter derivatives by risk category and instrument:

(Source: Bank for International Settlements)

Derivatives as a Means of Speculation

Some market operators are criticized for using derivates solely for the purpose of speculation.

How speculation is done?

Without actually having the interest in the underlying asset, some players because of their heterogeneous expectations about the price of such asset, i.e. one party may believe that the prices would go up while the other holds the opposite opinion, may enter into a derivative contract. Such transactions lead to too much of risk exposure to the parties and the volume of such transacts are huge enough to influence the real price of the underlying asset and therefore these transactions have the potential to destabilize the financial system itself. (Adam, Tim & Fernando, 2006)

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Lack of transparency, in addition to the operational risk, is the key risk that is present in the derivatives. This means that the actors or supervisors are unable to monitor or insulate against the systematic risks. Besides the inter linkages of the derivatives has been created in the market, which means that default of one major party may lead to the far reaching repercussions to the entire financial system. (FSA,2009)

There are many examples in the financial history of the damage caused by the speculative trading. These damages are not just brought to the entities themselves but because of the ‘Domino effect’ causes damage to the entire financial system. Some of them are- Metallgesellshaft made loss of $1.5 billion on oil futures in 1994, Enron went bankrupt in 2001, AIB lost $750 million in 2002, a trader causes havoc in the oil market in 2009.

Given the varied benefits of the derivatives, I would like to conclude this report with the view of Warren Buffet:

"We view them as time bombs both for the parties that deal in them and the economic system ... In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."- Warren Buffett

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References

Khan, Jain. (2012). Financial Management. Retrieved from:

http://www.amazon.in/Financial-Management-M-Y-Khan/dp/933921305X/ref=sr_1_1?

s=books&ie=UTF8&qid=1430305751&sr=1-1

Bala, SB; Ram, V Pattabhi. (2014). Strategic Financial management: Core concepts. Retrieved from:http://www.amazon.in/V-Pattabhi-Ram-S-D-Bala/e/B00R1NBTTU

Brooks M Raymonds. (2012). Financial management: Core concepts. Retrieved from:http://www.amazon.com/Financial-Management-Core-Concepts-2nd/dp/0132671034/ref=sr_1_4?s=books&ie=UTF8&qid=1430690643&sr=1-4&keywords=financial+management

Robert E. Whaley, Derivatives: Markets, Valuation, and Risk Management Financial Services Authority and HM Treasury, Reforming OTC Derivatives Markets: A UK

perspective, December 2009 Financial Services Authority, The Turner Review: a regulatory response to the global

financial crisis, March 2009 Chernenko, Sergey; Faulkender, Michael. The two Sides of Derivatives Usage: Hedging

and Speculating with Interest Rate Swaps Bartram, S., Greg Brown, and F. Fehle, (2007), International Evidence on Financial

Derivatives Usage, Financial Management Adam, Tim, and Chitru Fernando, (2006), Hedging, Speculation and Shareholder Value,

Journal of Financial Economics Brown, Greg, (2001), Managing Foreign Exchange Risk with Derivatives, Journal of

Financial Economics Guay, Wayne, and S.P. Kothari, 2003, “How Much Do Firms Hedge with Derivatives?”

Journal of Financial Economics http://www.bis.org/statistics/dt1920a.pdf

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