Introduction to Financial Derivatives

Introduction to Financial Derivatives

• Financial derivatives are contracts whose value is derived from an underlying asset, which can be anything from a stock to a currency.
• Their value changes based on the performance of the underlying asset, offering opportunities for risk management and speculation.

Types of Derivatives

• Futures: Standardized contracts to buy or sell a specific asset at a set price on a future date, offering leverage through margin deposits and potential for hedging.
• Options: Contracts giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a set price before or on a specific date.
• Forwards: Similar to futures, but traded over the counter rather than on an exchange, offering customization but higher counterparty risk.
• Swaps: Agreements to exchange one asset for another, often involving interest rates or currencies, useful for hedging against exchange rate risks.

Futures Contracts: A Simplified Explanation

• Standardization: Futures contracts have specific terms, including the underlying asset, quantity, delivery date, and trading exchange, making them highly liquid.
• Leverage: Futures contracts require a small margin deposit, allowing investors to control a large amount of the underlying asset with a relatively small investment, amplifying both gains and losses.
• Hedging: Futures contracts can be used to offset price fluctuations in the underlying asset, for example, a farmer can use futures contracts to lock in a price for their crops.
• Speculation: Futures contracts can be used to profit from price movements, for example, a trader might buy a futures contract if they believe the price of an asset will rise.

Forwards: A Simplified Explanation

• Customization: Forwards are typically customized contracts negotiated between two parties, unlike standardized futures contracts.
• Settlement: Forwards can be settled physically or with cash, while futures contracts are typically settled in cash.
• Counterparty Risk: Forwards involve counterparty risk, meaning that one party may default on the contract, a risk mitigated by clearinghouses in futures contracts.
• Key Uses of Forwards: Used for hedging, speculation, and financing, for example, a company might use a forward contract to sell its products at a future date, securing cash flow upfront.

Derivatives and Risk Management

• Hedging: Derivatives can protect against price fluctuations in underlying assets, interest rate changes, and exchange rate fluctuations.
• Speculation: Derivatives can be used to profit from price movements in underlying assets.
• Arbitrage: Derivatives can be used to exploit price differences in different markets, buying and selling an asset simultaneously to gain profit.
• Portfolio Optimization: Derivatives can adjust a portfolio's risk-return profile, allowing for better risk management and maximizing returns.

Pricing of Futures Contracts

• Cost of Carry Model: This model determines the futures price based on the spot price of the underlying asset, interest rates, and the cost of carrying or benefit from holding the asset until the delivery date.

Key Factors Affecting Futures Prices

• Spot Price: The current market price of the underlying asset.
• Interest Rates: Higher interest rates generally lead to higher futures prices for non-dividend-paying assets like commodities.
• Dividend Yield: For stocks, higher dividend yields can result in lower futures prices.
• Storage Costs: Higher storage costs for commodities can lead to higher futures prices.
• Contango and Backwardation:
  • Contango: When the futures price is higher than the spot price, indicating a positive cost of carry.
  • Backwardation: When the futures price is lower than the spot price, indicating a negative cost of carry.

Hedging and Speculation Using Futures

Hedging with Futures

• Commodity Price Hedging: Farmers can use futures contracts to lock in a price for their crops, protecting against price declines.
• Interest Rate Hedging: Companies concerned about rising interest rates on their debt can use interest rate futures to mitigate potential increases in interest expenses.
• Currency Hedging: Companies involved in foreign markets can use currency futures to hedge against exchange rate fluctuations.

Speculation with Futures

• Bullish Speculation: Traders who believe an asset's price will rise can buy a futures contract, selling it later for a profit if the price increases.