Financial Derivatives

Financial Derivatives A ‘derivative’ is a financial product the value of which is derived from the value of the underlying asset. Derivatives are widely used in developed financial markets to speculate on currencies and financial assets. Also used to hedge portfolio risk and hedging exposures by corporate finance managers.

Types of derivatives a) Future contract b) Option contracts c) Swaps d) Engineered products based on the

combination of futures, options, equity and bonds

Swaps: swap is an agreement between two or more parties to exchange sets of cash flows over a period in future. Basic kinds of swaps: 3. Currency swaps 4. Interest rate swaps An interest rate swap is an arrangement whereby one party exchanges one set of interest rate payment for another.

Types 1) 2) 3) 4) 5) 6) 7) 8)

Plain vanilla swaps Forward swaps Extendable swaps Callable swap Puttable swap Zero coupon for floating swaps Rate capped swaps Equity swaps

Swap facilitators economic agents who bring together counterparties and help consummate the swap contract. Two types: 3. Broker- agents that identify and bring together counter parties. 4. Swap dealers- themselves become counterparties and assume risk. Face two problems: 6. How to price swaps to provide for the services. 7. How to manage portfolios.

Swap market

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The market where the counter parties meet and arrange transactions for exchanging the cash flow. Characteristics Limitations

Risks of interest rate swaps   

Basic risk Credit risk Sovereign risk

Price determination on swaps Setting interest rate for a swap transaction is k/a pricing a swap. Main determinant:  Prevailing market interest rates  Availability of counterparts  Credit risk involved  Expected sovereign risk

Mechanism Nature of company Quantity co.

Fixed rate bond 9%

Variable rate bond LIBOR + 0.5%

Risky co.

10%

LIBOR + 1%

Swap structure Quantity co. 9%

Investor

Risky co. LIBOR + 1%

Investor

Currency swaps Agreement whereby currencies are exchanged at specified exchange rates at specified intervals currency swaps can be used to hedge the payments which may have to be paid as a result of debt as interest rate payment in future.

Future market A future contract is an arrangement for future delivery of a specified quantity of an asset at a specified price.

Principal features      

organized exchange Standardization Clearing house Margins Marking to market Actual delivery is rare

Options markets

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Option means a ‘choice’ available to investors regarding honoring the contract to buy or sell a currency at some future date. Call option Put option Strike price/ exercise price Maturity date American option European option Premium (option price, option value)