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Financial Markets and Institutions FINANCIAL DERIVATIVES

A derivative is a financial instrument based on the performance of separately traded commodities

or financial instruments.

Contract that promises to deliver the products at some time in the future or give the right to buy or

sell in the future may be traded in markets different from the original commodities and financial

markets. These contracts are known as derivatives.

Classification:

Forward contracts in which both parties are obliged to conduct the transaction at the specified

price and on the agreed date;

Swaps, which may be viewed as a subset of forwards and involve the exchange of one asset (or

liability) against another at a future date; and

Options, which give the holder the right but not the obligation to require the other party to buy

or sell an underlying asset at the specified price on or by the agreed date.

Financial Futures

Futures contract like any forward contract is an agreement to exchange a given commodity at a price

established when the contract is signed.

The buyers go long in the cash market (a long position is associated with an obligation to purchase

an asset (foreign exchange, securities, commodities loans). The sellers go short (a short position an

obligation to sell).

Futures contracts differ from other forward contracts (such as in forward exchange) in the form

of operation of the market, the terms of the contract, and the likelihood of their leading to delivery of

the underlying.

A future contract is tradable and is sold on an exchange rather than being OTC business (over-the-

counter).

Trading at a futures exchange takes place in trading pits. Direct method of trading between members

allowing all traders to hear every negotiated price, is known as open outcry.

Financial futures may also be traded by speculators who wish to profit from the rises or falls in

interest rates, stock exchange or commodities can go short by selling a future contracts.

To reduce default riska clearing house covers any default arising from contracts.(margin accounts)

Three principal types of agents:

- hedgers

- speculators

- arbitrageursOPTIONS

An option gives the right to buy or sell a given amount of a financial instrument or commodity an

agreed price (known as the exercise orstrike price) within a specified time, but does not oblige

investors to do so.

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Options contracts are offered both on cash securities (short- and long-term interest rates, exchange

rates, equities, etc.) and on future contracts.

Banks may construct non-tradable, custom made options for their customers. These are known as

over-the-counter (OTC) options.

The buyer of call option acquires the right to buy the specified instrument.

Example: An investor who think that GBP will rise against USD could buy GBP/USD option, giving

a right to buy GBPs at a specified price, $1.45=GBP1. The holder of option then has the right to

acquire GBPs at that price at any time during the life of option and is thus in a position to benefit

from a rise in the spot price of GBP.

If the spot exchange rate were to rise to $1.50=GBP1, the option holder could acquire GBPs at $1.45

under the term of the option and sell them in the spot market at $1.45=GBP1.

The buyer of a call option thus assumes a long position in the underlying instrument (GBP).

The buyer of a put option acquires the right to sell and thus assumes a short position in the specified

instruments.

The buyer of a put option stands to gain from a fall in the price of the underlying.

So, if you buy a put option at $1.45=GBP1 you will be hoping that the value of the GBP will fall

below the level. You will be able to buy GBPs in the spot market at let say $1.40 =1GBP and then

exercise the option in order to sell the GBPs at $1.45=GBP1.

SWAP

Currency swap typically not only involves an exchange of coupon payments but also anexchange of principal. As an example of a typical situation, American Firm A would like to

borrow pounds, and British Firm B wants to borrow dollars. Because it is better known in

the US, Firm A can borrow dollars at a lower interest rate than Firm B, while Firm B,

because it is better known in the UK, can borrow pounds at a lower interest rate than Firm

A. So ifFirm A borrows dollars in the US and Firm B borrows pounds in the UK, but then

they swap their obligations, each firm can benefit from the other firms superior borrowing

rate in its domestic currency.

To be more specific, say Firm A wants to borrow 10,000,000 for two years, Firm B wantsto borrow $16,000,000 for two years, and the current ($/) pound exchange rate is 1.6.

Assume that Firm A can borrow dollars at 8%, and Firm B can borrow pounds at 10%. The

swap transactions that accomplish this are:

Firm A borrows $16,000,000 in its domestic US market; and Firm B borrows 10,000,000

in its domestic UK market; Firm A pays $16,000,000 to Firm B; and Firm B pays 1

0,000,000 to Firm A. At the end of the first year: Firm A pays 10,000,000 x .10 =

1,000,000 to Firm B which Firm B in tum pays to its domestic lender; and Firm B pays

$16,000,000 x .08 = $1,248,000 to Firm A which Firm A in tum pays to its domestic lender.

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At the end of the second year: Firm Apays 10,000,000 x .10 = 1,000,000 to Firm B which

Firm Bin tum pays to its domestic lender; ar1d Firm Bpays $16,000,000 x .08 = $1,248,000

to Firm A which Firm A in tum pays to its domestic lender.

Also, at the end of the second year, Firm A repays 10,000,000 to Firm B; Firm B repays

$16,000,000 to Firm B; and each finn in tum uses this to repay its domestic lenders.

Typically, the swap is set up so that its value, based on the current exchange rate is zero.

Indeed, in our example, the initial value of the swap in dollars is $16,000,000 - 1.6

1,000,000 = 0. Nonetheless, both counterparties benefit from the swap because they end

up borrowing at lower foreign interest rates than they could have on their own.

In many cases in practice, one of the firms does not have an absolute advantage over the

other firm in borrowing in its own domestic market, and yet the swap can be mutually

beneficial. All that is necessary is that each firm have a comparative advantage in its

domestic market. For example, firm A (which has a comparative advantage in dollars) can

on its own borrow dollars at 8% and pounds at 11%, while Firm B (which has a comparative

advantage in pounds) can on its own borrow dollars at 10% and pounds at 11.5%.

What is an interest rate swap?

An interest rate swap is a contractual agreement entered into between two

counterparties under which each agrees to make periodic payment to the other for

an agreed period of time based upon a notional amount of principal.

The principal amount is notional because there is no need to exchange actual

amounts of principal in a single currency transaction: there is no foreign exchange

component to be taken account of. Equally, however, a notional amount of principal

is required in order to compute the actual cash amounts that will be periodically

exchanged.

Under the commonest form of interest rate swap, a series of payments calculated by

applying a fixed rate of interest to a notional principal amount is exchanged for a

stream of payments similarly calculated but using a floating rate of interest.

This is a fixed-for-floating interest rate swap. Alternatively, both series of cash flows

to be exchanged could be calculated using floating rates of interest but floating rates

that are based upon different underlying indices. Examples might be Libor and

commercial paper or Treasury bills and Libor and this form of interest rate swap is

known as a basis or money market swap.

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