Chapter 1

Financial Derivative

Definition of Derivative

A derivative is a financial contract that derives its value from an underlying asset. The buyer
agrees to purchase the asset on a specific date at a specific price. 

Derivatives are often used for commodities, such as oil, gasoline or gold. Another asset class is
currencies, often the U.S. dollar. There are derivatives based on stocks or bonds. Still others
use interest rates, such as the yield on the 10-year Treasury note.

The contract's seller doesn't have to own the underlying asset. He/She can fulfill the contract by
giving the buyer enough money to buy the asset at the prevailing price. He/She can also give the
buyer another derivative contract that offsets the value of the first. This makes derivatives much
easier to trade than the asset itself.

Derivatives make future cash flows more predictable. They allow companies to forecast their
earnings more accurately. That predictability boosts stock prices. Businesses then need less cash
on hand to cover emergencies. They can reinvest more into their business.

Market for Financial Derivatives. Or Where Financial Derivatives are traded?

OTC

Over the counter market (OTC) derivatives are contracts that traded directly between two parties,
without going through an exchange or other intermediary. The OTC derivative market is the
largest market for derivatives, since the OTC market is made up of banks and other highly
sophisticated parties, such as hedge funds.

More than 95 percent of all derivatives are traded between two companies or traders that know
each other personally. These are called “over the counter” options. They are also traded through
an intermediary, usually a large bank.

Exchange-traded derivatives

Just 4 percent of the world's derivatives are traded on exchanges. These public exchanges set
standardized contract terms. They specify the premiums or discounts on the contract price.

This standardization improves the liquidity of derivatives. It makes them more or less

Exchanges can also be a clearing house, acting as the actual buyer or seller of the derivative.
That makes it safer for traders, since they know the contract will be fulfilled.
  The largest exchange is the CME Group. It's the merger between the Chicago Board of
Trade, the Chicago Mercantile Exchange (also called CME or the Merc) and the New
York Mercantile Exchange. It trades derivatives in all asset classes.

 Stock options are traded on the NASDAQ1 or the Chicago Board Options Exchange.

 Futures contracts are traded on the Intercontinental Exchange. It acquired the New York
Board of Trade in 2008. It focuses on agricultural and financial contracts, especially
coffee, cotton and currency. These exchanges are regulated by the Commodities Futures
Trading Commission or the Securities and Exchange Commission.

 NASDAQ originally stood for the National Association of Securities Dealer Automated

[Note 1: The NASDAQ Stock Market is an American stock exchange designed to enable investors to buy and sell
stocks on an automatic, transparent and speedy computer network. Also known simply as the NASDAQ, which
originally stood for the National Association of Securities Dealers Automated Quotations, its 1971 creation offered
an alternative to the in-person stock transaction system, which the NASD believed burdened investors with
inefficient trading and delays.]

Financial Market:

1. Money Market (Short term, Highly Liquid, Low Risk)

2. Capital Market (Long term)

3. Bond Market

4. Mortgage Market
5. Insurance Company
i)Pension Fund
ii)Mutual Fund
6. Derivatives Market
i) Exchange Trade Market- Future Contract
ii) Over the Counter Market- Forward Contract

Basic Type of Derivatives

Forward Contracts
Forward contracts are the simplest form of derivatives that are available today. Also, they are the
oldest form of derivatives. A forward contract is nothing but an agreement to sell something at a
future date. The price at which this transaction will take place is decided in the present.

However, a forward contract takes place between two counterparties. This means that the
exchange is not an intermediary to these transactions. Hence, there is an increase chance of
counterparty credit risk. Also, before the internet age, finding an interested counterparty was a
difficult proposition. Another point that needs to be noticed is that if these contracts have to be
reversed before their expiration, the terms may not be favorable since each party has one and
only option i.e. to deal with the other party. The details of the forward contracts are privileged
information for both the parties involved and they do not have any compulsion to release this
information in the public domain.

Futures Contracts
A futures contract is very similar to a forwards contract. The similarity lies in the fact that futures
contracts also mandate the sale of commodity at a future data but at a price which is decided in
the present.
However, futures contracts are listed on the exchange. This means that the exchange is an
intermediary. Hence, these contracts are of standard nature and the agreement cannot be
modified in any way. Exchange contracts come in a pre-decided format, pre-decided sizes and
have pre-decided expirations. Also, since these contracts are traded on the exchange they have to
follow a daily settlement procedure meaning that any gains or losses realized on this contract on
a given day have to be settled on that very day. This is done to negate the counterparty credit
risk.
An important point that needs to be mentioned is that in case of a futures contract, they buyer
and seller do not enter into an agreement with one another. Rather both of them enter into an
agreement with the exchange.

Option Contracts

The third type of derivative i.e. option is markedly different from the first two types. In the first
two types both the parties were bound by the contract to discharge a certain duty (buy or sell) at
a certain date. The options contract, on the other hand is asymmetrical. An options contract,
binds one party whereas it lets the other party decide at a later date i.e. at the expiration of the
option. So, one party has the obligation to buy or sell at a later date whereas the other party can
make a choice. Obviously the party that makes a choice has to pay a premium for the privilege.
There are two types of options i.e. call option and put option.
Call option allows you the right but not the obligation to buy something at a later date at a given
price whereas put option gives you the right but not the obligation to sell something at a later
date at a given pre decided price. Any individual therefore has 4 options when they buy an
options contract. They can be on the long side or the short side of either the put or call option.
Like futures, options are also traded on the exchange.

Swaps
Swaps are probably the most complicated derivatives in the market. Swaps enable the
participants to exchange their streams of cash flows. For instance, at a later date, one party may
switch an uncertain cash flow for a certain one. The most common example is swapping a fixed
interest rate for a floating one. Participants may decide to swap the interest rates or the
underlying currency as well.
Swaps enable companies to avoid foreign exchange risks amongst other risks. Swap contracts are
usually not traded on the exchange. These are private contracts which are negotiated between
two parties. Usually investment bankers act as middlemen to these contracts. Hence, they too
carry a large amount of exchange rate risks.
So, these are the 4 basic types of derivatives. Modern derivative contracts include countless
combination of these basic types and result in the creation of extremely complex contracts.

Risks Involved in Derivative Contracts

Derivatives are considered to be extremely risky. The market is divided in two fronts when it
comes to the opinion about risks involved in a derivative contract.

Counterparty Risk

About three quarters of the derivatives contracts across the world are entered over the counter.
This means that there is no exchange involved and hence there is a probability that the
counterparty may not be able to fulfill its obligations. This gives rise to the most obvious type of
risk associated with derivatives market i.e. counterparty risk.

Counterparty risks have many names. They are sometimes called legal risk, default risk,
settlement risk etc. Essentially all these risks refer to the same risk. When one party enters into
an agreement with another party, there is a chance that one of them may not follow through with
the commitments. This could happen at various stages. For instance, if the contract is not drafted
then it would be called legal risk. On the other hand, if the other party defaults on the day of the
settlement, then it would be called settlement risk. Hence, all these risks can be put together in
one category called counterparty risk since all of them pertain to willful or innocent default by
the counterparty.

Price Risk

Derivatives being traded on the securities exchange are a relatively new phenomenon. Hence, all
participants including the most seasoned ones are clueless as to what should the pricing of these
derivatives be. The market is functioning in terms of superior knowledge relative to peers.
Hence, there is always a risk that the majority of the market may be mispricing these derivatives
and may cause large scale default. This has already happened in an infamous incident including
the company called “Long Term Capital Management (LTCM)”. LTCM became part of a trillion
dollar default and became a prime example as to how even the smartest management may end up
wrongly guessing the price of derivatives.
Agency Risk

A very less talked about problem pertaining to derivatives market is that of agency risks. Agency
risk simply means that if there is a principal and an agent, the agent may not act in the best
interest of the principal because their objectives are different from that of the principal. In this
scenario it would mean that if a derivative trader is acting on behalf of a multinational
corporation or a bank, the interests of the organization and that of the individual employee who
is authorized to make decisions may be different. This may seem like a small problem.

Systemic Risk

Systemic risk pertaining to derivatives is widely spoken about. Yet it seems to be less understood
and almost never quantified. System risk refers to the probability of widespread default in all
financial markets because of a default that initially started in derivative markets. In simple
words, this is the belief that because derivatives are so volatile.
Systemic risk pertaining to derivatives is not faced by any particular party. It is faced by the
entire system. At the present moment, regulation is being proposed as being the viable solution
to this problem. Regulators across the world are spending days and nights working out a plan
that helps to reduce or evade systemic risk.
Therefore, dealing with derivatives is largely about learning how to manage these risks
effectively. The market is never secure when such high leveraged investments are involved.
Hence, when it comes to derivatives, a vigilant trader is a good trader.

Commonly Used Terms in Derivative Market

The derivative market can seem like a world itself. The market is so large and so different from
the other markets that it has its own language. A new person trying to trade derivatives may not
even understand the information that is being offered to them. It is therefore necessary to
understand the vocabulary of this market before making any trades.

Long Position: When we trade stocks or bonds, we are either on the buying side or on the
selling side. However, the terminology used in the derivatives market is markedly different. Here
if you are the person buying a derivative contract, then you are on the long side of the contract.
In the market, this is simply referred to as going long.

Hence, for example if you buy a contract wherein you agree to exchange $1000 for 900 Euros,
you are going long on the dollar.

Short Position: The opposite of going long is called going short. In simple words, this means
that you are the seller of a derivative contract. In the derivatives market being a seller means
having a short term horizon and therefore you are shorting the underlying financial instrument.
Hence, in the same example, if you agree to exchange $1000 for 900 Euros, then you are going
long on the dollar but short on the Euro. Similarly, if you agree to deliver 100 bushels of wheat
to someone at a later date for a fixed price, you are going short on the wheat.

Spot Contract: A spot contract is a contract for immediate delivery. Since derivatives, by
definition include delivery at a future date, spot contracts usually do not form part of the
derivatives market. However, they do form the basis for the pricing of futures, forwards and
options. If a certain financial asset is being sold for X amount in the spot market and the future
expectations are known, then the price of the derivative can be derived.

Expiration: Derivatives are time bound financial instruments. This means that they come with
an expiration date. They have intrinsic worth only up till that date and post that date they are
worthless. Expiration date is a term usually used when we refer to options in particular. When we
talk about forwards, swaps or futures, the expiration date is replaced by the settlement date.
However, the idea remains the same. Expiration date is when the contract is finally unwound and
the profits and losses due become a reality. Simply put that is the end of the agreement.

Market Maker: A market maker is someone who provides both buy and sell quotes for financial
assets. In case of derivatives market, these assets are derivatives. The purpose of the market
maker is to provide liquidity to the market. Let’s say that you wanted to sell off a derivative
security that you had and you go to the market. Now, it is a real task to find another buyer when
you want to sell. Hence, instead there is one party that is always willing to both buy as well as
sell. Hence, if you want to sell you go to the market maker and also if you want to guy to buy,
you go to the same market maker. The market maker never holds the other side of the bet. If they
go long on a certain trade with you, they will immediately find someone with whom they can go
short with. This cuts them out of the trade and in the end you are holding the long end of the deal
whereas the other party is holding the short end.

This creates liquidity in the market as the market maker is always available to take the other side
of the trade with you.

Bid Ask Spread: In derivatives markets, market makers will always give you two sets of prices.
In set it called the bid price whereas the other set is called the ask price. The difference between
the two is known as the bid ask spread.

The bid price is the highest price which the bidder would agree to pay you in case the transaction
for a particular security would go through. Hence, for you, this is a selling price.

The ask price on the other hand the minimum price which the market maker expects from you
when they transact with you. Since you have to pay this money to the dealer, this can be thought
of as the buying price for you.

However, there is always a small difference between the bid price and the ask price. This might
seem like an arbitrage opportunity for the market maker since they can make a risk free profit.
However, it isn’t. The market maker has to hold the security for a few minutes before they can
make an opposite bet and move out of the trade. However, since securities are volatile, they
could drastically change value within these few minutes. The bid ask spread is therefore a
compensation provided to the market maker to help them offset the risk that they undertake when
they enter into open ended transactions.