CHAPTER-9

OVERVIEW OF DERIVATIVES

Dr. Priya Gupta

Derivatives and Risk Hedging

• A derivative is a financial instrument whose pay-offs is derived from some

other asset which is called as an underlying asset.
• There are a large number of simple derivatives like futures or forward
contracts or swaps. Options are more complicated derivatives.
• Derivatives are tools to reduce a firm’s risk exposure. Hedging is the term used
for reducing risk by using derivatives.
Advantages of Risk Management through Hedging

• Debt capacity enhancement

• Increased focus on operations
• Isolating managerial performance
 RISK HEDGING WITH OPTIONS
• An option is a right to buy or sell an asset at a specified exercise price at a
specified period of time.
• Foreign currency option is a handy method of reducing foreign exchange risk.
Similarly, options on interest rates and commodities are quite popular with
managers to reduce risk.
• Many options trade on option exchanges. However, in practice, banks and
companies strike private option deals.
FORWARD CONTRACTS
• A forward contract is an agreement between two parties to exchange an asset for cash at a
predetermined future date for a price that is specified today.
• In case of a forward contract, both the buyer and the seller are bound by the contract while
Under an option, the buyer has a right to decide whether or not she would exercise the
option.
• Forward contracts are flexible. They are tailor-made to suit the needs of the buyers and
sellers. Foreign currencies forwards have the largest trading.
FUTURES CONTRACTS

• Future contracts are forwards contracts traded on organised exchanges in standardised contract size.
For example, the standard contract size for barley in the barley international exchange is 20 metric
ton.
• The short hedge is a common occurrence in business, and it takes place whenever a firm or an
individual is holding goods or commodities (or any other asset) or is expecting to receive goods or
commodities
• Generally, a long hedge occurs when a person or the firm is committed to sell at a fixed price.
• Unlike options but like forward contracts, future contracts are obligations; on the due date the seller
(farmer) has to deliver barley to the buyer (miller) and the buyer will pay the seller the agreed price.
In the futures contracts, like in the forward contracts, one partly would lose and another will gain.
Financial Futures
• Financial futures, like the commodity futures, are contracts to buy or sell
financial assets at a future date at a specified price.
• Financial futures, introduced for the first time in 1972 in USA, have become
very popular. Now the trading in financial futures far exceeds trading in
commodity futures.
 Futures Contracts Vs. Forward Contracts

• Organised futures exchanges

• Standardised contracts
• Margin
• Marked to market
• Delivery

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 SWAPS
• A swap is an agreement between two parties, called
counterparties, to trade cash flows over a period of time.

• Two most popular swaps are currency swaps and interest-

rate swaps.

• Currency swap involves an exchange of cash payments in one

currency for cash payments in another currency.

• The interest rate swap allows a company to borrow capital at

fixed (or floating rate) and exchange its interest payments
with interest payments at floating rate (or fixed rate).

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 USES OF DERIVATIVES
• The objective of firms using derivatives is to reduce
the cash flow volatility and thus, to diminish the
financial distress costs.

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Example
• Apex Corporation must pay its Japanese supplier ¥125 million in three months.
It is thinking of buying 20 yen call options (contract size is ¥6.25 million) at a
strike price of $0.00800 in order to protect against the risk of a rising yen. The
premium is 0.015 cents per yen. Alternatively, Apex could buy 10 three-month
yen futures contracts (contract size is ¥12.5 million) at a price of $0.007940 per
yen. The current spot rate is ¥1 = $0.007823. Suppose Apex's treasurer
believes that the most likely value for the yen in 90 days is $0.007900, but the
yen could go as high as $0.008400 or as low as $0.007500.
Solution
• In all the following calculations, note that the current spot rate is irrelevant.
When a spot rate is referred to, it is the spot rate in 90 days. If Apex buys the
call options, it must pay a call premium of 0.00015 x 125,000,000 = $18,750. If
the yen settles at its minimum value, Apex will not exercise the option and it
loses the call premium. But if the yen settles at its maximum value of
$0.008400, Apex will exercise at $0.008000 and earn $0.0004/¥1 for a total
gain of .0004 x 125,000,000 = $50,000. Apex's net gain will be
$50,000 - $18,750 = $31,250.