IFM - Chapter 24 - The derivatives market

Why do we need derivatives?

• Increased demand for risk reduction

• This leads to a need for financial innovation

• Financial derivatives help managers reduce and manage risk effectively

What are financial derivatives?

Instruments with pay-offs linked to previously issued securities, used as risk-reduction tools.

What is a derivative (or contingent claim)?

A financial instrument whose payoff depends on one or more uncertain underlying variables.

What are the most important financial derivatives used to reduce risk?

• Linear products: Forward contracts, Futures, Swaps

• Non-linear products: Options

How are derivatives classified based on the underlying asset?

• Equity derivatives

• Interest rate derivatives

• Currency derivatives

• Commodity derivatives

• Credit derivatives

• Property derivatives

How are derivatives classified based on market nature?

• Exchange traded

• Over-the-counter (OTC)

Why are derivatives important?

• Represent huge markets—multiple times world GDP

• Help transfer risks efficiently

• Embedded in many financial products

• Real options enhance NPV by adding flexibility

Who uses derivatives?

• Hedgers

• Speculators

• Arbitrageurs

What is a spot contract?

An agreement to buy/sell an asset at a set price for almost immediate delivery (within 3 days).

What is a long position in a spot contract?

Holding an asset with gains if the price increases.

What is short selling?

Selling borrowed securities to gain if the asset price falls.

What is a forward contract?

An OTC agreement to buy/sell an asset at a future date for a set delivery price.

What are the positions in a forward contract?

• Long = obligation to buy

• Short = obligation to sell

What are the delivery modes for forward contracts?

• Physical delivery: for stocks, commodities, etc.

• Cash settlement: used when physical delivery is impractical (e.g., indices)

Why trade forward contracts?

• Hedging: manage future uncertainty (e.g., exchange/interest/commodity rates)

• Speculation: profit without existing exposure

What are the main characteristics of a forward contract?

• Bilateral and negotiated directly.

• Highly customizable.

• Settled at maturity.

• Exposed to default risk.

• Cannot be transferred unilaterally.

What is the payoff from a forward contract?

• Net cash flow at maturity.

• Equal to contract value at maturity.

• It's a zero-sum game: gain/loss of one party = loss/gain of the other.

what does it mean that a forward is a linear product?

• Payoff changes €1 for every €1 change in underlying price.

• Payoff is a shifted version of the stock’s payoff profile.

What happens if the forward price ≠ delivery price?

• Arbitrage opportunities arise:

  • If F > S: borrow S, buy S, short forward.

  • If F < S: short S, invest S, long forward.

• Only arbitrage-free price is valid.

• Market maker margin = bid-ask spread.

what is the main advantage of forward contracts?

Flexibility
→ Can completely hedge interest-rate risk of specific securities.

What are disadvantages of forward contracts?

• Low liquidity: hard to find counterparties.

• Default risk: must verify counterparty reliability.

• Costly, risk of adverse selection and moral hazard.

What was the solution to forward contract limitations?

• Introduction of futures contracts by CBoT in 1975.

How do futures differ from forwards?

• Futures = exchange traded, standardized, and unilateral exit possible.

• Default risk lies with exchange (vs. individual parties).

• Managed via margin accounts (vs. collateral).

what two types of futures are there?

A distinction is being made between financial futures and commod- ity futures depending on the nature of the underlying.

what are swaps?