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Derivatives

What Does Derivative Mean? A security whose price is dependent upon or derived from one or more underlying assets is called a Derivative. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. Explanation: Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Derivatives are contracts and can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region. Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes. For example, a European investor purchasing shares of an American company from an American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros. Rise of Derivatives The global economic order that emerged after World War II was a system where many less developed countries administered prices and centrally allocated resources. Even the developed economies operated under the Bretton Woods system of fixed exchange rates. The system of fixed prices came under stress from the 1970s onwards. High inflation and unemployment rates made interest rates more volatile. The Bretton Woods system was dismantled in 1971, freeing exchange rates to fluctuate. Less developed countries like India began opening up their economies and allowing prices to vary with market conditions. Price fluctuations make it hard for businesses to estimate their future production costs and revenues. Derivative securities provide them a valuable set of tools for managing this risk.

Derivatives market
The derivatives market is the financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets.

The need for a derivatives market;


The derivatives market performs a number of economic functions:  They help in transferring risks from risk avoiding people to risk oriented people.  They help in the discovery of future as well as current prices.  They catalyze entrepreneurial activity.  They increase the volume traded in markets because of participation of risk avoiding people in greater numbers.  They increase savings and investment in the long run

The participants in a derivatives market;


Hedgers Hedgers use futures or options markets to reduce or eliminate the risk associated with price of an asset. Speculators Speculators use futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture. Arbitrageurs Arbitrageurs are in business to take advantage of a difference between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

Types of Derivatives
Forwards A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price. Futures A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts Options Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Warrants Options generally have lives of up to one year. The majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter. LEAPS The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of up to three years. Baskets Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options. Swaps Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:  Interest rate swaps These entail swapping only the interest related cash flows between the parties in the same currency.  Currency swaps These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. Swaptions Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.

Factors driving the growth of financial derivatives;


    Increased volatility in asset prices in financial markets, Increased integration of national financial markets with the international markets, Marked improvement in communication facilities and sharp decline in their costs, Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and  Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets.

Types of Derivative Market


The market can be divided into two, that for exchange-traded derivatives and that for over-thecounter derivatives. The legal nature of these products is very different as well as the way they are traded, though many market participants are active in both.
Exchange Traded Derivatives are those derivatives which are traded through specialized derivative exchanges whereas Over the Counter Derivatives are those which are privately traded between two parties and involves no exchange or intermediary. Swaps, Options and Forward Contracts are traded in Over the Counter Derivatives Market or OTC market.

Futures markets
Futures exchanges, such as Euronext.liffe and the Chicago Mercantile Exchange, trade in standardized derivative contracts. These are options contracts and futures contracts on a whole range of underlying products. The members of the exchange hold positions in these contracts with the exchange, who acts as central counterparty. When one party goes long (buys a futures contract), another goes short (sells). When a new contract is introduced, the total position in the contract is zero. Therefore, the sum of all the long positions must be equal to the sum of all the short positions. In other words, risk is transferred from one party to another.

Over-the-counter markets
Tailor-made derivatives not traded on a futures exchange are traded on over-the-counter markets, also known as the OTC market. These consist of investment banks who have traders who make markets in these derivatives, and clients such as hedge funds, commercial banks, government sponsored enterprises, etc. Products that are always traded over-the-counter are swaps, forward rate agreements, forward contracts, credit derivatives, etc.

Hedging
What Does Hedge Mean? Making an investment to reduce the risk of adverse price movements in an asset is called hedging. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract. Explanation; An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations. Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge).
What Does Hedging Transaction Mean?

A type of transaction that limits investment risk with the use of derivatives, such as options and futures contracts is called a hedging transaction. Hedging transactions purchase opposite positions in the market in order to ensure a certain amount of gain or loss on a trade. They areemployed by portfolio managers to reduce portfolio risk and volatility or lock in profits

How Do Investors Hedge?

Hedging techniques generally involve the use of derivatives, the two most common of which are options and futures.

The process;
Say you own shares of Bank Al Habib. Although you believe in this company for the long run, you are a little worried about some short-term losses in the tequila industry. To protect yourself from a fall in Bank Al Habibs share you can buy a put option (a derivative) on the company, which gives you the right to sell Bank Al Habibs share at a specific price (strike price). If your stock price tumbles below the strike price, these losses will be offset by gains in the put option.

The other classic hedging example involves a company that depends on a certain commodity. Let's say Nishat Textile ltd is worried about the instability in the price of cotton. The company would be in deep trouble if the price of cotton were to skyrocket, which would severely eat into profit margins. To protect (hedge) against the uncertainty of agave prices, Nishat textile can enter into a futures contract (or its less regulated derivative, the forward contract), which allows the company to buy the cotton at a specific price at a set date in the future. Now Nishat Textile can budget without worrying about the fluctuating commodity. If the cotton skyrockets above that price specified by the futures contract, the hedge will have paid off because Nishat Textile will save money by paying the lower price. However, if the price goes down, Nishat Textile is still obligated to pay the price in the contract and actually would have been better off not hedging. Keep in mind that because there are so many different types of options and futures contracts an investor can hedge against nearly anything, whether a stock, commodity price, interest rate and currency investors can even hedge against the weather.

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