Understanding Derivative Instruments

• The objective is to provide students with fundamental training in the operational description and management of derivative instruments
• The contents aim to describe trading and quotation of the primary derivative instruments on a wide range of underlying financial assets
• Organized derivatives markets and over-the-counter (OTC) markets will be covered
• This text aims to distinguish derivatives between futures, swaps, and options
• It covers design, valuation, and management of financial risks through derivatives
• The derivatives will be addressed for equities, currencies, interest rates and commodities
• The knowledge of derivative instruments from a practical approach is covered
• The uses for derivatives in speculative operations, hedging, and arbitration will be explained

Typology of Derivatives

• Derivatives are financial products generated from simpler assets using leverage
• Trading derivatives entails obligations or rights, depending on their definition
• Derivatives can establish bullish or bearish positions on underlying assets, either mandatorily or voluntarily

Futures and Forwards

• Futures/Forwards are derivative instruments requiring the purchase/sale of an underlying asset (S) at a future date, at a price agreed upon when the contract is made
• These derivatives lock in the asset's purchase/sale price
• The derivatives also eliminate uncertainty about future performance
• The most active financial forward market involves foreign exchange, where currencies can be bought/sold at any maturity

Swaps

• Swaps are derivatives obliging parties to exchange fixed for variable interest payments in one or more currencies, depending on swap type
• Swaps enable ensuring payment/collection of a fixed interest rate in exchange for a variable interest rate tied to a reference index like Euribor or Libor
• Currency swaps exchange principal during the beginning, duration, or maturity
• No exchange of a principal usually occurs and only only of the interest

Options

• Options grant the buyer the right, but obligate the seller, to buy (call) or sell (put) an underlying asset over time (American) or on a future date (European) at a predetermined price
• Options assure the maximum purchase or minimum sale price of an underlying asset, eliminating uncertainty about its future evolution
• The buyer of the option must pay a premium for the right to buy or sell, knowing the right can be unexercised
• The option writer charges a premium and assumes the risk of the option's exercise

Typology of Markets

• The type of market in which derivatives are traded is an issue of prominence
• The two main areas for markets are organized and unorganized

Organized Markets

• The former are characterized by a clearing house, creating a collateral structure
• Agents recognize profits/losses daily, configuring the "safest" environment
• The Central Clearing House (CCH) acts as a counterparty on both sides of the transaction
• Organized markets are subject to CC credit risk exposure and margin requirements by the CCH
• The number of standardized products is limited
• Valuation is transparent at day's end and trades have simple settlements

Unorganized Markets

• Derivatives activity in bilateral OTC markets has enormous flexibility and adaptation qualities
• OTC markets have reconverted, consolidating risk mitigation mechanisms that have largely assimilated them to organised markets
• Mechanisms to reduce risk include quasi-introduction of netting arrangements with party, OTC transaction clearing, and collateralization

Collateralization Agreements

• Collateralisation agreements provide potential counterparty default protection in a derivative transaction
• The agreements are used primarily for insurance on a bilateral basis in financial transactions and applied to entire portfolios or individual deals
• International legislation is governed by the Credit Support Annex (CSA) of the International Swaps and Derivatives Association (ISDA) annexed to the Master Agreement
• The legal document allows parties to mitigate credit risk inherent in derivatives activity
• The legal doc standardizes the risk mitigation mechanism by defining the assets deliverable to secure obligation
• Valuation frequency is the times valuations are updated for change in market value
• Independent Amount is an additional percentage or amount charged to market value that is agreed between the parties
• A Threshold specifies value above which contractual obligations must be collateralized
• Minimum Transfer Amount is the minimum amount required for a party to deliver collateral
• Rounding refers to amount of rounding in payments
• An Acceptable collateral includes cash, securities, equity, etc
• Haircuts are percentage valuation of the collateral exchanged, depending the type Distributions cover the interest earned on the collateral, remuneration, and treatment of coupons
• Margin call is when a party requests one party to cover a risk based on its valuation
• Organized markets generate counterparty credit risk
• Negotiated settlements & early terminations are complex

Futures and Forwards Definition

• Futures/Forwards are first-generation derivative instruments through which assets are bought/sold
• Price is fixed when contracting, and the settlement may be by physical delivery of the underlying or settling by difference
• Financial futures/forwards let financial instruments be bought/sold in future without collections/payments until maturity
• They pre-establish future purchase/sale price agreements
• The primary nuance between Futures and Forwards hinges on the type of market where theyre traded

Forward Contract

• Forwards are contracts where two traders agree to buy and sell a resource at a specific price at a specific date in the future
• The prices of the asset's are agreed upon when the contract is initiated
• Forward quotation is carried out bilaterally
• There is no arbitration nor regulatory agent
• Lack of contract standardization makes it easy to adapt to the needs of the counterparties leading to "tailor-made" nature
• Lower liquidity and settlement before maturity are limitations compared to futures in some cases

Futures Contract

• Futures commit two parties: one to buy, the other to sell a specific asset at a pre-specified price on a future date
• A purchaser has a right to trade the asset being traded, and the obligation to oay for it on the maturity date
• There may be the opportunity for a cash difference to occur
• Futures generally trade in an established marketplace and feature a clearing house to regulate risk and clear transactions
• Futures are also recognized by having standardized contract clauses
• On maturity of the agreement' price (F) tends to coincide with the place of the price (S)

Differences Between Futures and Forwards

• Futures: organized market, standards conditions, standard maturities, anonymous participants, obligatory update P/G, obligatory guarantees, clearinghouse credit risk
• Forwards: unorganized Market type, tailor-made conditions, tailor-made maturities, direct participants, it does not exist update P/G, it does not exist guarantees, counterparty credit risk

Market Members

• The markets futures are operated by the regulators, which can work directly based on its functions within the market
• There are a couple ways to have roles as members as acting own account or on behalf, settling amount members, and acting as a capacity in the market

Clearing house

• The functions performed by houses are as follows: acts as counteroarty to the contracting partier,
• The settlement of the orders that the market participants enter into the system
• It acts as a counterpartier to partiers also determining positions with daily basis It is known that the controller will use such factors to be stable with the environment

Guarantees or margins

• Fulfilment of obligations contracted margins or obligations are usually from members Depending on this collateral, the form real assets or financial
• It makes sense repayed on contract with other mainetnce
• It refers to initita margin and Maintanence margin
• An increase market means to pay back money

Valuation

• The price of a future each day is based on the evolution It shows their repsercitve balances with an count Whatever is listed, should be repienished And if you see how they make profits

Clearing at the End

1. In each session, the Clearing House carries out the daily variation of prices, demanding margin calls for positions that incurred losses, and allowing withdrawals for positions with profits
2. After a future contract ends, clearing house will create final price change, based on what was agreed on originally

Equity Futures

• The share of the definition should buy a negotiate price For types of market it should be the clearing houses For differences of physical delrivey based on it it