FINANCIAL DERIVATIVES (4TH YEAR) CHAPTER # 1

CHAPTER # 1
DERIVATIVE MARKETS AND INSTRUMENTS

1. Introduction
Equity, fixed-income, currency, and commodity markets are facilities for trading the basic assets of an
economy.
 Equity and fixed-income securities are claims on the assets of a company.
 Currencies are the monetary units issued by a government or central bank.
 Commodities are natural resources, such as oil or gold. These underlying assets are said to
trade in cash markets or spot markets and their prices are sometimes referred to as cash prices
or spot prices.
Somewhat less familiar are the markets for derivatives, which are financial instruments that derive
their values from the performance of these basic assets.
2. Derivatives: Definitions and Uses
The most common definition of a derivative reads approximately as follows:
A derivative is a financial instrument that derives its performance from the performance of an
underlying asset.
A derivative contract is a legal agreement between counterparties that defines the rights of each party
involved. There are two parties participating in the contract: a buyer and a seller.
Long: Buyer of the derivative is said to be long on the position. He has the right to buy the underlying
according to the conditions mentioned in the contract.
Short: Seller of the derivative is said to be short. Remember “s” is for short and seller.
Note: Instruments that transform the value of payoffs of an underlying is a derivative. Instruments
that merely pass-on the payoffs are not derivatives. E.g. Mutual funds or ETF units.
Characteristics of derivatives
 helps to create strategies not possible with underlying alone. (e.g. short selling real estate)
 high degree of leverage.
 lower transaction costs.
 often more liquid and cost-effective than their underlying.
 allows more effective risk management.
 a zero-sum game. When one party gains, the other must equally lose.
3. The Structure of Derivative Markets
Investors can buy and sell derivatives either through an exchange or over the counter (OTC).
3.1. Exchange-Traded Derivatives Markets
 Exchange-traded derivatives are standardized. The terms and conditions—such as the size of
each contract, type, quality, and location of underlying for commodities and maturity date—

AMNA ASIM SHAIKH

FINANCIAL DERIVATIVES (4TH YEAR) CHAPTER # 1

are set by the exchange. There is no room for customization. Standardization leads to a more
liquid and transparent market.
 Standardization also facilitates an efficient clearing and settlement process. Clearing is the
exchange’s process of verifying the execution of a transaction, exchange of payments, and
recording the participants. Settlement involves the payment of final amounts and/or delivery
of securities or physical commodities between the counterparties.
 To provide a guarantee against counterparty default, derivative exchanges require both the long
and short party to post collateral when a trade is initiated. Additional collateral may be required
based on the price movements of the underlying during the life of the trade.
 ETD markets are transparent – full information on all transactions is disclosed to the exchanges
and national regulators.

3.2. Over-the-Counter Derivatives Markets

 OTC derivatives market involve contracts between derivatives end users and dealers (financial
intermediaries such as commercial banks and investment banks).
 The terms of the contracts can be customized as per the end user’ needs. This flexibility is
important to end users seeking to hedge a specific exposure based on non-standard terms.
 OTC dealers, also called market makers, typically enter into offsetting transactions with one
another to transfer risk to other parties.
 OTC instruments have less transparency and more counterparty risk as compared to ETD.

AMNA ASIM SHAIKH

FINANCIAL DERIVATIVES (4TH YEAR) CHAPTER # 1

4. Types of Derivatives
4.1. Forward Commitments
Forward Commitments (like futures and forwards contracts) provide the ability to lock in a purchase
price of an asset at a future date and a specified price. As forward commitments are contractual
agreements to transact in the future, their payoff profiles are linear in nature and follow the price
movements of the underlying asset.
Or
Both long and short parties have an obligation to complete the transaction. Example: forwards, futures,
swaps).
There are three primary types of forwards commitment: Forward contracts, Futures contracts, and
Swaps.
4.1.1. Forward Contracts
The following is the formal definition of a forward contract:
A forward contract is an over-the-counter derivative contract in which two parties agree that one
party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date at a
fixed price they agree on when the contract is signed.
The payoff profile for a forward contract is calculated as follows:

𝑆𝑡= the price of the underlying asset when the contract expires
𝐹𝑜 (T) = the purchase price specified in the forward contract.
As you can see, the buyer is profitable if the price they locked in when the forward was created is less
than the asset’s market price at the time of contract expiration. During the life of the contract, its market
value on the balance sheet of the buyer is that difference between the contractual purchase price and
the current market value of the underlying asset.

AMNA ASIM SHAIKH

FINANCIAL DERIVATIVES (4TH YEAR) CHAPTER # 1

4.1.2. Futures
Futures Contracts are very similar to forwards, in that they oblige the buyer to purchase an underlying
asset at a specified price, but are much more standardized and typically trade on exchanges. Another
important difference is that the daily gains and losses on the contract price over time (as the underlying
asset changes in value) is settled with the exchange. If the buyer is “out of the ” because the asset price
is below the contractual price, then the buyer must supply that difference in cash as security to the
exchange. This process is known as the “mark-to-market” and is designed to prevent buyers and sellers
from being exposed to counterparty risk in the event of a buyer or seller of these contracts going
bankrupt while owing money. The payoff profiles are calculated using the same formulas as forwards.
Initial margin is:
 a percentage (typically <10%) of the purchase price of securities.
 relatively low and equals about one day’s maximum price fluctuation.
 required to be entirely paid in cash, no loan facility available.
Maintenance margin: minimum amount of equity to be maintained in margin account. (MM
<Initial margin)
Margin call: if margin balance < maintenance margin, margin call = amount that will take the
margin balance back to initial margin level. Margin account can be funded either by making additional
deposits or liquidating stocks held.
Futures price limits
Trades can occur within the price-limit band but not at the limit.
Limit up: upper limit of the price band beyond which trading stops until two parties agree on a
trade at a price lower than the upper limit.
Limit down: lower limit of the price band beyond which trading cannot take place until two
parties agree on a trade at a price higher than the lower limit.
Locked Limit: If trades cannot take place because of a limit move, either up or down, the price
is said to be locked limit since no trades can take place and traders are locked into their existing
positions.

AMNA ASIM SHAIKH

FINANCIAL DERIVATIVES (4TH YEAR) CHAPTER # 1

4.1.3. Swaps
Formally, a swap is defined as follows:
A swap is an over-the-counter derivative contract in which two parties agree to exchange a series of
cash flows whereby one party pays a variable series that will be determined by an underlying asset or
rate and the other party pays either (1) a variable series determined by a different underlying asset or
rate or (2) a fixed series.

4.2. Contingent Claims

Seller has the obligation. The buyer has a right but no obligation to complete the transaction. Example:
Options, credit derivatives.
OR
Contingent Claims, which are options (but not obligations) to transact in the future at a specified
price. Contingent claims are not obligations, so their payoff profile is dependent on the actions of the
buyers.
4.2.1. Options
The first type of contingent claim security is an Options Contract. As the name implies, an option is the
right (but not the obligation) to buy or sell an asset at a predetermined price in the future. The right to
buy a security is a Call and the right to sell is a Put. In an American-style option, the contract can be
exercised any time before its expiration date, while a European-style contract can only be exercised at
the expiration date. The predetermined price at which the option can be exercised is known as the
Strike Price.
The payoff profile is similar to that of futures contracts but with an added consideration. Since the
buyer will only exercise the option if it is “in the money”, then their payoff will either be the amount
by which the market price of the underlying asset exceeds the strike price (or the opposite for a put
option) or 0. Since the total profit from an options contract also includes the premium that the buyer
paid to the seller to initiate it, the profit calculations are as follows (for a call contract):

AMNA ASIM SHAIKH

FINANCIAL DERIVATIVES (4TH YEAR) CHAPTER # 1

The fixed price at which the underlying asset can be purchased is called the exercise price (also
called the “strike price,” the “strike,” or the “striking price”).

The worst that the buyer can do is lose the value of the premium they paid, but they
have unlimited upside to their profit, while it’s the exact opposite for the seller. This calculation applies
to call options. For put options, the calculation for the payoffs reverses the St and X values, since it is
profitable for the buyer when the security they are selling is worth less than the strike price.

Concept of moneyness
Moneyness refers to whether an option is in-the-money or out-of-the-money.
In the money: When immediate exercise of the option will generate a positive payoff for the
holder.
Out of the money: When immediate exercise will generate a negative payoff for the holder.

AMNA ASIM SHAIKH

FINANCIAL DERIVATIVES (4TH YEAR) CHAPTER # 1

At the money: When immediate exercise will result in neither a positive nor a negative payoff for
the holder.

4.2.2. Credit Derivatives

Credit Derivatives are another common form of contingent claim. These are used to provide
protections to buyers in the event of a credit event. Total Return Swaps are commonly used wherein
the buyer agrees to pay a specified interest rate while the seller pays the total return (interest and
capital) of a given bond security. The seller must continue to make these payments even if the bond
defaults, so the buyer is now exposed to the returns from that bond with no risk of losing out in the
event of default. Credit Spread Options are similar to typical options except that they are based on the
credit spread of a specified bond, rather than the cash price. The credit spread of a bond is the amount
by which its yield exceeds a given rate, which is usually a Treasury rate of the same maturity. Credit
Default Swaps act like insurance policies for default events. In exchange for a series of regular
payments from the buyer, the seller agrees to pay a specified amount to the buyer if the underlying
bond goes into default
4.2.3. Asset-Backed securities
Asset-backed Securities, which you should remember from the fixed income section, are also a form
of contingent claim contract. They divide up the cash flows from a pool of assets into different levels
(“tranches”) based on the different levels of risk that buyers want to take on. The riskiest tranches have

AMNA ASIM SHAIKH

FINANCIAL DERIVATIVES (4TH YEAR) CHAPTER # 1

the highest yields but are also the first to lose principal value if there are defaults or prepayments in
the pool of assets. ABS securities made up of mortgage loans are known as Collateralized Mortgage
Obligations (CMO) and ones made up of bonds are Collateralized Bond Obligations (CBO) or
Collateralized Loan Obligations (CLO), both of which fall under the broader classification of
Collateralized Debt Obligation (CDO).
4.3. Hybrids
Some of these types of contracts are referred to as hybrids because they combine the elements of
several other types of contracts. All of them are indications of the ingenuity of participants in today’s
financial markets, who are constantly creating new and useful products to meet the diverse needs of
investors. This process of creating new financial products is sometimes referred to as financial
engineering. These hybrid instruments represent the effects of progress in our financial system. They
are examples of change and innovation that have led to improved opportunities for risk management.
4.4. Derivatives underlying’s
The most common derivative underlying’s include equities, fixed income and interest rates, currencies,
commodities, and credit.
Equities
Equity derivatives can be based on an individual stock, a group of stocks, or a stock index.
 Options on individual stocks are often used by companies as compensation for their employees.
Options encourage employees to work to increase the equity value of the company.
 Index swaps, also known as equity swaps, allow investors to pay the return on one stock index
in exchange for the return on another index or interest rate.
 Derivatives are also available based upon the realized volatility of equity index prices over a
certain period. This allows investors to manage the magnitude of price changes separately from
the direction of the change.
Fixed-Income Instruments
 Derivatives based on bonds are widely used. Since government issuers have many similar bond
issues outstanding, bond futures typically allow more than one bond issue to be delivered to
settle the contract.
 Derivatives based on interest rates are also common. Here the underlying is not an asset.
 Interest rate swaps can be used to convert from a fixed to a floating interest rate exposure over
a certain period. A market reference rate (MRR) is the most common interest rate underlying
used in interest rate swaps. These rates are based on a daily average of observed market
transactions, e.g., the Secured Overnight Financing Rate (SOFR) is an overnight cash
borrowing rate collateralized by US Treasuries.
Currencies
Currency derivatives are often used to hedge the exposure of commercial (e.g. exporters and
importers) and financial transactions (e.g. an investor holding foreign securities) that arise due to
foreign exchange risk.

AMNA ASIM SHAIKH

FINANCIAL DERIVATIVES (4TH YEAR) CHAPTER # 1

Commodities
 Commodities can be classified into soft commodities (agricultural products such as cattle and
corn) and hard commodities (natural resources such as crude oil and metals).
 Commodity derivatives are often used to hedge the price risk of commodities. For example, an
airline may purchase oil futures to hedge against higher fuel costs in the future.
Credit
Credit derivatives are based on the default risk of a single issuer or a group of issuers in an index.
Credit default swaps (CDS) allow an investor to manage the risk of loss from borrower default
separately from the bond market.
Other
Derivatives can also be based on several different types of underlying such as weather, crypto
currencies, longevity (permanent existence) etc.

5. The Purposes and Benefits of Derivatives

Derivatives and derivative markets were initially created to remove seasonal price fluctuation, but in
contemporary finance, derivatives have the following functions.

5.1. Risk Allocation, Transfer, and Management

This refers to the process of identifying the desired level of risk, measuring the actual level of risk, and
taking actions to bring the actual level of risk to the desired level of risk. Financial derivatives provide
a powerful tool for limiting risks that individuals and firms face in the ordinary conduct of their
business. For speculators risks associated with financial derivatives are not necessarily evil because
they provide very powerful instruments for knowledgeable traders to expose themselves to calculated
and well-understood risks in pursuit of profit.

5.2. Information Discovery

The futures market aids in price discovery. Futures prices can be thought of as a forecast of future spot
prices, but in reality, they only provide a little more information than the spot price. However, they do
so in an efficient manner. A futures price also indicates what price would be acceptable to avoid
uncertainty.
In the case of options, one of the characteristics of the asset underlying the option is volatility. Using
option pricing models, the volatility of the underlying asset can be determined. This is the
volatility implied by the price of the option. The level of implied volatility is a good measure of general
uncertainty in the market or a measure of fear.

5.3. Operational Advantages

There are some operational advantages to the derivative market:
 Derivatives have lower transaction costs than transacting in the equivalent underlying asset.

AMNA ASIM SHAIKH

FINANCIAL DERIVATIVES (4TH YEAR) CHAPTER # 1

 Derivatives markets typically have greater liquidity than the underlying market.
 Derivatives allow short positions to be entered into easily.
5.4. Market Efficiency
Markets can be thought of as reasonably efficient. When prices deviate from fundamental values, the
derivatives market offers a low-cost way to exploit the mispricing. Less capital is required, transaction
costs are lower, and shorting is made possible.
Investors are also far more willing to trade if they know they can manage their risks. This increased
willingness to trade increases the number of market participants, which increases market liquidity.

6. Criticisms and Misuses of Derivatives

The main arguments against derivatives are that they allow investors to obtain unsustainable positions
that elevate systematic risk so much that they can be equated to legalized gambling.
6.1. Speculation and Gambling
Derivative markets functions when speculators buy risks from hedgers, speculators typically have such
a short-term horizon that their trading hurts the market efficiency in the long run. This is why some
people label derivatives as legalized gambling.
6.2. Destabilization and Systemic Risk
Lower transaction costs and lower capital requirements may encourage speculators to enter into highly-
leveraged positions which are too risky and any advance movement may cause financial distress not
only for the speculator but for its creditors and this can spread to the whole financial system (and
economy) through the process of contagion.
7. Elementary Principles of Derivative Pricing
This principle of derivative valuation relies completely on the ability of an investor to hold or store the
underlying asset. Let us take a look at what that means.
7.1. Storage
Storage is an important linkage between spot and derivative markets. Many types of assets can be
purchased and stored. Holding a stock or bond is a form of storage. Even making a loan is a form of
storage. One can also buy a commodity, such as wheat or corn, and store it in a grain elevator. Storage
is a form of investment in which one defers selling the item today in anticipation of selling it at a later
date. Storage spreads consumption across time.
Because prices constantly fluctuate, storage entails risk. Derivatives can be used to reduce that risk by
providing a means of establishing today the item’s future sale price. This suggests that the risk entailed
in storing the item can be removed. In that case, the overall investment should offer the risk-free rate.
Therefore, it is not surprising that the prices of the storable item, the derivative contract, and the risk-
free rate will all be related.
7.2. Arbitrage
Arbitrage is an opportunity to make a profit at no risk and with the investment of no capital.

AMNA ASIM SHAIKH

FINANCIAL DERIVATIVES (4TH YEAR) CHAPTER # 1

 -Investors trade quickly and prices adjust to eliminate the opportunity.

 -It improves the rate at which prices converge to their relative fair values and hence
improves market efficiency and price discovery.
 -An illiquid position is a limit to arbitrage because it may be difficult to realize gains of an
illiquid offsetting position.
 -Some arbitrage opportunities represent such small discrepancies such that they are not
worth exploiting because of transaction costs.
Law of one price: Two securities or portfolios that have identical cash flows in the future,
regardless of future events, should have the same price.

Reference:
These handouts are based on upon these two books chapter:

1. Chapter 1 from book Derivatives by Wendy L. Pirie, CFA.

2. Chapter 1 from book An Introduction to Derivatives and Risk Management by Don M. Chance

and Robert Brook.

AMNA ASIM SHAIKH