financial derivatives (1)

8/2/2019 Financial Derivatives (1)

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Financial Derivatives

Resmi B

Nidhin


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Definition of Financial Derivatives

A financial derivative is a contract between two (or more)parties where payment is based on (i.e., "derived" from)some agreed-upon benchmark.

Since a financial derivative can be created by means of amutual agreement, the types of derivative products arelimited only by imagination and so there is no definitivelist of derivative products.

Some common financial derivatives, however, aredescribed later.

More generic is the concept of hedge funds which usefinancial derivatives as their most important tool for riskmanagement.


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Repayment of Financial Derivatives

In creating a financial derivative, the means for, basisof, and rate of payment are specified.

Payment may be in currency, securities, a physicalentity such as gold or silver, an agricultural product

such as wheat or pork, a transitory commodity such ascommunication bandwidth or energy.

The amount of payment may be tied to movement ofinterest rates, stock indexes, or foreign currency.

Financial derivatives also may involve leveraging, withsignificant percentages of the money involved beingborrowed. Leveraging thus acts to multiply (favorablyor unfavorably) impacts on total payment obligationsof the parties to the derivative instrument.


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Common Financial Derivatives

Options

Forward Contracts

Futures Stripped Mortgage-Backed Securities

Structured Notes

Swaps

Rights of Use

Combined

Hedge Funds


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Options

The purchaser of an Option has rights (but not obligations)to buy or sell the asset during a given time for a specifiedprice (the "Strike" price). An Option to buy is known as a"Call," and an Option to sell is called a "Put. "

The seller of a Call Option is obligated to sell the asset tothe party that purchased the Option. The seller of a PutOption is obligated to buy the asset.

In a Covered Option, the seller of the Option alreadyowns the asset. In a Naked Option, the seller doesnot

own the asset

Options are traded on organized exchanges and OTC.


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Forward Contracts

In a Forward Contract, both the seller and the

purchaser are obligated to trade a security or other

asset at a specified date in the future. The price paid forthe security or asset may be agreed upon at the time the

contract is entered into or may be determined at

delivery.

Forward Contracts generally are traded OTC.


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Futures

A Future is a contract to buy or sell a standardquantity and quality of an asset or security at aspecified date and price.

Futures are similar to Forward Contracts, but arestandardized and traded on an exchange, and are

valued daily. The daily value provides both parties withan accounting of their financial obligations under theterms of the Future.

Unlike Forward Contracts, the counterparty to thebuyer or seller in a Futures contract is the clearing

corporation on the appropriate exchange. Futures often are settled in cash or cash equivalents,

rather than requiring physical delivery of theunderlying asset.


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Stripped Mortgage-Backed Securities

Stripped Mortgage-Backed Securities, called "SMBS,"represent interests in a pool of mortgages, called"Tranches", the cash flow of which has been separatedinto interest and principal components.

Interest only securities, called "IOs", receive theinterest portion of the mortgage payment and generallyincrease in value as interest rates rise and decrease invalue as interest rates fall.


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Structured Notes

Structured Notes are debt instruments where the

principal and/or the interest rate is indexed to anunrelated indicator. A bond whose interest rate isdecided by interest rates in England or the price of abarrel of crude oil would be a Structured Note,

Sometimes the two elements of a Structured Note areinversely related, so as the index goes up, the rate ofpayment (the "coupon rate") goes down. Thisinstrument is known as an "Inverse Floater."

Structured Notes generally are traded OTC.


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Swaps

A Swap is a simultaneous buying and selling of thesame security or obligation. Perhaps the best-knownSwap occurs when two parties exchange interestpayments based on an identical principal amount,called the "notional principal amount."


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Swaps

Interest rate swaps occur generally in three scenarios.Exchanges of a fixed rate for a floating rate, a floatingrate for a fixed rate, or a floating rate for a floatingrate.

The "Swaps market" has grown dramatically. Today,

Swaps involve exchanges other than interest rates, suchas mortgages, currencies, and "cross-national"arrangements. Swaps may involve cross-currencypayments (U.S. Dollars vs. Mexican Pesos) andcrossmarket payments, e.g., U.S. short-term rates vs.

U.K. short-term rates.


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Combined Derivative Products

The range of derivative products is limited only by thehuman imagination. Therefore, it is not unusual for

financial derivatives to be merged in various

combinations to form new derivative products.

For instance, a company may find it advantageous tofinance operations by issuing debt, the interest rate of

which is determined by some unrelated index. The

company may have exchanged the liability for interest

payments with another party. This product combines a

Structured Note with an interest rate Swap.


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Hedge Funds

A hedge fund is a private partnership aimed at verywealthy investors. It can use strategies to reduce risk.But it may also use leverage, which increases the levelof risk and the potential rewards.

Hedge funds can invest in virtually anything anywhere.

They can hold stocks, bonds, and government securitiesin all global markets. They may purchase currencies,derivatives, commodities, and tangible assets. Theymay leverage their portfolios by borrowing moneyagainst their assets, or by borrowing stocks from

investment brokers and selling them (shorting). Theymay also invest in closely held companies.


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Hedge Funds

Hedge funds are not registered as publicly tradedsecurities. For this reason, they are available only tothose fitting the Securities and Exchange Commissiondefinition of accredited investors

Institutional investors, such as pension plans and

limited partnerships, have higher minimumrequirements..

Some investors use hedge funds to reduce risk in theirportfolio by diversifying into uncommon or alternativeinvestments like commodities or foreign currencies.Others use hedge funds as the primary means ofimplementing their long-term investment strategy.


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Why Have Derivatives?

Derivatives are risk-shifting devices. Initially, they were

used to reduce exposure to changes in such factors asweather, foreign exchange rates, interest rates, or stockindexes.


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Why Have Derivatives?

More recently, derivatives have been used to segregate

categories of investment risk that may appeal to

different investment strategies used by mutual fund

managers, corporate treasurers or pension fund

administrators. These investment managers may decide

that it is more beneficial to assume a specific "risk"characteristic of a security.


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The Risks``

Since derivatives are risk-shifting devices, it isimportant to identify and understand the risks beingassumed, evaluate them, and continuously monitor andmanage them. Each party to a derivative contractshould be able to identify all the risks that are beingassumed before entering into a derivative contract.


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The Risks

Investors and markets traditionally have looked to

commercial rating services for evaluation of the creditand investment risk of issuers of debt securities.

Some firms have begun issuing ratings on a company'ssecurities which reflect an evaluation of the exposure toderivative financial instruments to which it is a party.


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The Risks

An often overlooked, but very important aspect in theuse of derivatives is the need for constant monitoringand managing of the risks represented by thederivative instruments.

Financial derivative instruments that have leveraging

features demand closer, even daily or hourlymonitoring and management.


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Leveraging

Some derivative products may include leveraging

features. These features act to multiply the impact of

some agreed-upon benchmark in the derivative

instrument.

Negative movement of a benchmark in a leveraged

instrument can act to increase greatly a party's total

repayment obligation. Remembering that each

derivative instrument generally is the product of

negotiation between the parties for risk-shiftingpurposes, the leveraging component, if any, may be

unique to that instrument.


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Trading of Derivatives

Some financial derivatives are traded on nationalexchanges. Those in the U.S. are regulated by theCommodities Futures Trading Commission.

Financial derivatives on national securities exchangesare regulated by the U.S. Securities and Exchange

Commission (SEC). Certain financial derivative products have been

standardized and are issued by a separate clearingcorporation to sophisticated investors pursuant to anexplanatory offering circular. Performance of the

parties under these standardized options is guaranteedby the issuing clearing corporation. Both the exchangeand the clearing corporation are subject to SECoversight.


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Trading of Derivatives

Some derivative products are traded over-the-counter

(OTC) and represent agreements that are individually

negotiated between parties. Anyone considering

becoming a party to an OTC derivative should

investigate first the creditworthiness of the parties

obligated under the instrument so as to have sufficientassurance that the parties are financially responsible.


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Selling of Financial Derivatives

Some brokerage firms are engaged in the business ofcreating financial derivative instruments to be offeredto retail investment clients, mutual funds, banks,corporations and government investment officers.

Before investing in a financial derivative product it is

vital to do two things.l First, determine in detail how different economic

scenarios will affect the investment in the financialderivative (including the impact of any leveragingfeatures).

l Second, obtain information from state or federalagencies about the broker's record.


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financial derivatives (1)

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