Financial Derivatives - Introduction

Updated on March 31, 2013

Introduction - Risk Management

Risk is inherent in all the activities we perform in our day-to-day life, and all of us remain concerned about it. Risk can be defined as deviations of the actual results from expected ones. We all tried to eliminate the risk and live in a world of certainty. But this complete elimination of risk is impossible, but it can be mitigated by following certain step to a considerable extent.

Risk magnitude is estimated from 2 factors :

1. The Probability of an adverse event happening
2. the magnitude of the loss it can cause in case the event occurs

So, Risk can be classified in 2 ways:

1. Risk of small losses with high probability
2. Risk of high losses with low probability.

Risk of small losses with high probability are changes in stock prices, commodity prices where the changes are small but occur frequently.

In second category i.e. Risk of high losses with low probability are earthquakes, tsunami, thefts etc which cause huge losses but probability of their occurrence is far lower.

Even though the expected loss in both categories may be same but the strategies of Risk Management would be different.

In business enterprises the risk management is mainly confined to situations of high probability of small losses. With Derivatives we tries to manage the risk of small losses with high probability. In other words Derivatives are used to mange risks that emanate from conduct of business.

Types of Business Risks are :

1. Price Risk
2. Exchange rate Risk
3. Interest Rate Risk

Derivatives

Derivatives are agreement which derives their values on the basis of some asset called underlying asset. These underlying assets can be physical or notional. Underlying assets are Gold, Commodity, Shares, Currencies, Indices, Interest Rates etc.

Classification of Derivatives :

There is a wide range if instruments available as derivatives. Each of the instruments is different in some respect or the other, conceptually, operationally, or in its uses. But there are four basic derivative products which are :

1. Forwards :

Forwards are contracts where the buyer and seller agree to exchange the asset and its price at a future date, at a price fixed in advance.

2. Futures :

Futures are similar to forwards contracts in term of their pricing and concept, but are operationally different from forwards in terms of other features. The shortest definition of futures is that it is an exchange traded forward contract. The features of futures contracts are standardized in terms of quantity, delivery dates, delivery venue etc., unlike forward contracts which are basically tailor made contracts.

3. Options :

Options are contracts for delivery in future liked forwards and futures, except that one of the two parties involved holds an option whether to enforce the contract or not, while the other party is obliged to perform at the option of the first party. In other words, Option is a right without an obligation to buy or sell an asset at a predetermine price within a specified time interval.

4. Swaps :

Swaps are agreements between two parties to exchange a set of cash flows according to a predetermined method. For example, one party may pay a fixed rate of interest in exchange of receiving a variable rate of interest on a notional principal amount for specified intervals of time.

Participants in Derivatives Markets

The participants in the derivatives markets can be broadly classified in three depending upon their motives. These are :

1. Hedgers
2. Speculators
3. Arbitrageurs

Hedgers :

Hedgers are those who enters into a derivative contract with the objective of covering risk. Normally, the Hedgers would like to conclude the contract with the delivery of the underlying asset.

Example of Hedging: A farmer growing wheat faces uncertainty about the price of his product at the time of the harvest. A flour mill needing wheat also faces uncertainty of price of input. Both the farmer and the flour mill can enter into a forward contract, where the farmers agrees to sell his product when harvested at a predetermined price to the flour mill. The farmers fears the price fall while the flour mill fears the price rise. So, both parties face price risk. A forward contract is entered into with the objective of hedging against the price risk being faced by the farmers as well as the flour mill.

Speculators :

Speculators are those who enter into a derivative contract to make profit by assuming risk. They have an independent view of future price behavior of the underlying asset and take appropriate position in derivatives with the intention of making profit later.

Example for Speculation : The forward price in US Dollar for a contract maturing in 3 months is Rs. 50.00. If one believes that 3 months later the price of US Dollar would be Rs. 52.00, one would buy forward today and sell later. On the contrary, if one believes US Dollar would depreciate to Rs. 48.00. in one month one would sell now and buy later.

The thing to be noted here is that the intention is not to take delivery of underlying asset but instead gain from the differential in price.

Speculators perform an extremely important function. They render liquidity to the market. Without Speculators in the market not only would it be difficult for hedgers to find matching parties but the hedge is likely to be far from being efficient. Presence of Speculators makes the markets competitive, reduce transaction costs, and expands the market size. More importantly, they are the ones who assume risk and serve the needs of hedgers who avoid risk.

Arbitrageurs :

The third category of participants, i.e. arbitrageurs, perform the function of making the prices in different markets converge and be in tandem with each other. While hedgers and speculators want to eliminate and assume risk respectively, the arbitrageurs take risk-less position and yet earn profit. They are constantly monitoring the prices of different assets in different markets and identify opportunities to make profit that emanate from mispricing of products.

Example for Arbitrage : The most common example of arbitrage is the price difference that may be prevailing in different stock markets. If the share price of Hindustan Unilever is Rs. 175 in National Stock Exchange (NSE) and Rs. 177 in Bombay Stock Exchange (BSE), the arbitrageur will buy at NSE and sell at BSE simultaneously and pocket the difference of Rs.2 per share.

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