Module 5: Derivative Instruments PDF

**MODULE 5:** **DERIVATIVE INSTRUMENTS** **CAPITAL MARKET** **TEAM THREE-O** **AGUILAR, TRICIA S.** **RAYOS, CRISTHEL MAE D.** **REMOQUIN, KRISTINE JOY A.** **\ ** **TABLE OF CONTENTS** Learning Objectives............................................................................1 Introdu...

**MODULE 5:** **DERIVATIVE INSTRUMENTS** **CAPITAL MARKET** **TEAM THREE-O** **AGUILAR, TRICIA S.** **RAYOS, CRISTHEL MAE D.** **REMOQUIN, KRISTINE JOY A.** **\ ** **TABLE OF CONTENTS** Learning Objectives............................................................................1 Introduction.......................................................................................2 Discussion of Main Topics and Subtopics................................................2 Introduction to Derivatives...........................................................2 Purposes of Derivatives..............................................................5 Basic Options Strategies.............................................................6 Role of Derivatives in Risk Management.........................................8 Conclusions......................................................................................11 References.......................................................................................12 **Learning Objectives/Outcomes** a. Identify and describe the fundamental characteristics and functions of futures, forwards, options, and swaps. b. Explain how derivatives are used for hedging, speculation, and arbitrage with practical examples. c. Demonstrate the implementation of basic options strategies including calls, puts, and spread trades. d. Analyze how derivatives can be used to mitigate financial risks in various market conditions. **Introduction** In financial markets, derivative instruments---such as futures, options, and swaps---are essential tools that help manage risk and enhance investment opportunities. These financial contracts derive their value from underlying assets or indices, offering versatile strategies for various market conditions. This report explores the fundamental concepts of derivatives, including their structure and function. Futures contracts obligate parties to transact an asset at a future date, options provide the right but not the obligation to trade at a set price, and swaps involve exchanging cash flows based on underlying variables. We will examine the primary purposes of derivatives: hedging to mitigate risk, speculation to profit from market movements, and arbitrage to capitalize on price discrepancies. Additionally, basic options strategies, including calls, puts, and spreads, will be discussed to illustrate how these instruments can be used to achieve specific financial goals. Understanding these concepts is crucial for effectively utilizing derivatives in risk management and optimizing financial strategies. This report aims to provide insights into how derivatives function and their significant role in modern financial practice. **Derivative Instruments** A derivative instrument is a contract between a buyer and a seller based on their views about an underlying assets' future price movement. An underlying asset can be any financial instrument like *stocks*, *bonds, commodities, currencies, interest rates* and even *indices*. So, the value at which this contract or derivative instrument is traded is based on the value of its underlying asset. In essence, the value of this underlying asset determines the derivative\'s value. For instance, if one and another party enter into a contract that is contingent on an increase or decrease in the price of oil, the contract\'s value will fluctuate in tandem with the price of oil. Therefore, the whole point of derivatives is to foresee future changes in the value of these assets and profit from them. The most common *types of derivatives* include futures, forwards, options, and swaps. Each type has unique characteristics and applications that make them suitable for different financial strategies and risk management needs. 1. **Futures and Forwards** ***Futures:*** Futures contracts are standardized agreements that obligate the buyer to purchase, or the seller to sell, an asset at a predetermined price on a specified future date. These contracts are traded on organized exchanges, which standardize the terms of the contract, such as the quantity, quality, and delivery date of the underlying asset. Futures are highly liquid due to their standardization and the fact that they are traded on exchanges. This standardization includes fixed contract sizes and delivery dates, which ensures that buyers and sellers can easily enter and exit positions. One of the key features of futures contracts is daily settlement. This means that gains and losses are calculated and settled at the end of each trading day. This daily settlement process reduces credit risk but requires participants to maintain margin accounts to cover potential losses. Futures contracts are commonly used by traders and investors to hedge against price changes in the underlying asset or to speculate on future price movements. For instance, a company expecting to purchase raw materials in the future might use futures contracts to lock in prices, thereby mitigating the risk of price increases. ***Forwards:*** Forwards are similar to futures in that they are agreements to buy or sell an asset at a future date for a price agreed upon today. However, forwards are customized and traded over-the-counter (OTC), not on exchanges. Unlike futures, forward contracts can be tailored to the specific needs of the parties involved. This customization includes the contract size, delivery date, and other terms. This flexibility makes forwards suitable for more bespoke arrangements. Forward contracts are typically settled at maturity, and there is no daily settlement of gains and losses as in futures contracts. This means that the risk of default is higher, as the parties are exposed to changes in market conditions until the contract's expiration. Forwards are used by businesses and financial institutions to hedge against specific risks, such as currency or commodity price fluctuations, tailored to their particular requirements. 2. **Options** Options are financial derivatives that give the holder the right, but not the obligation, to buy or sell an asset at a predetermined price within a specified time frame. Unlike futures and forwards, options provide flexibility rather than imposing an obligation. Options are classified as either options or call options. ***Call Options:*** A call option gives the holder the right to purchase the underlying asset at a set price (strike price) before the option's expiration date. Investors typically buy call options when they anticipate that the price of the underlying asset will increase. ***Put Options:*** A put option provides the holder the right to sell the underlying asset at a set price before the option's expiration date. Put options are generally used when an investor expects the price of the underlying asset to decrease. **Features and Variants:** a. **Short-term Options:** These are traded on organized exchanges and are standardized in terms of contract size and expiration dates. b. **Convertible Securities:** These are fixed-income instruments that can be converted into common stock at the holder's discretion. c. **Warrants:** These are long-term options issued by companies, allowing investors to purchase shares at a set price. d. **Rights Offerings:** These give existing shareholders the opportunity to purchase additional shares at a discounted price, usually below the market value. Options are versatile tools used for hedging, speculation, and income generation through strategies such as buying calls or puts, or writing (selling) them. 3. **Swaps** Swaps are derivative contracts in which two parties agree to exchange cash flows or financial obligations based on underlying assets or indices. Unlike futures and options, swaps are traded OTC, which allows for customization according to the parties\' needs. **Interest Rate Swaps:** Counterparties agree to exchange one stream of future interest payments for another, based on a predetermined notional principal amount. Generally, interest rate swaps involve the exchange of a fixed interest rate for a floating interest rate. **Currency Swaps:** Counterparties exchange the principal amount and interest payments denominated in different currencies. These contract swaps are often used to hedge another investment position against currency exchange rate fluctuations. **Commodity Swaps:** These derivatives are designed to exchange floating cash flows that are based on a commodity's spot price for fixed cash flows determined by a pre-agreed price of a commodity. Despite its name, commodity swaps do not involve the exchange of the actual commodity. **Credit Default Swaps (CDS):** A CDS provides insurance from the default of a debt instrument. The buyer of a swap transfers to the seller the premium payments. In case the asset defaults, the seller will reimburse the buyer the face value of the defaulted asset, while the asset will be transferred from the buyer to the seller. Credit default swaps became somewhat notorious due to their impact on the 2008 Global Financial Crisis. **Purposes of Derivatives** Derivatives are financial instruments that derive their value from an underlying asset. They are often used for various purposes, including hedging, speculation, and arbitrage. 1. **Hedging** 2. **Speculation** 3. **Arbitrage** **Basic Options Strategies** Options trading provides investors with a variety of strategies to leverage their market outlook. Among the fundamental options strategies are calls, puts, and spreads. Each type of option serves a unique purpose and comes with its own set of characteristics and risks. a. **Call Options** A call option grants the holder the right, but not the obligation, to buy an underlying asset, such as a stock, at a specified strike price within a predetermined time period. This type of option is advantageous if the holder expects the price of the underlying asset to rise. **Key Variables Influencing Call Options:** 1. **Exercise Price vs. Stock Price:** The intrinsic value of a call option is influenced by the difference between the exercise (or strike) price and the current stock price. A call option becomes more valuable as the stock price exceeds the strike price. 2. **Time to Expiration:** The value of a call option is positively related to the time remaining until expiration. The longer the time frame, the greater the chance that the underlying asset\'s price will move favorably, increasing the option\'s value. 3. **Interest Rates:** Higher interest rates can increase the value of call options. This is because higher rates make the cost of holding an asset (and thus the opportunity cost) more expensive, which can make buying options relatively more attractive. 4. **Stock Price Volatility:** The greater the volatility of the underlying asset, the higher the call option's premium. Increased volatility raises the probability of the stock price moving above the strike price, which can make the option more valuable. Investors buy call options when they anticipate that the price of the underlying asset will increase. Conversely, they sell call options when they believe the asset\'s price will decrease or remain stable. b. **Put Options** A put option provides the holder with the right, but not the obligation, to sell an underlying asset at a specified strike price within a designated time frame. This option is beneficial when the holder expects the price of the underlying asset to fall. **Key Variables Influencing Put Options:** 1. **Exercise Price vs. Stock Price:** The intrinsic value of a put option is determined by the difference between the strike price and the current stock price. A put option gains value as the stock price falls below the strike price. 2. **Time to Expiration:** Similar to call options, the value of a put option increases with more time until expiration, as there is a greater chance of the stock price falling below the strike price. 3. **Interest Rates:** Higher interest rates generally decrease the value of put options. This is because higher rates make holding the underlying asset more expensive, which can reduce the attractiveness of selling the asset at a fixed price. 4. **Stock Price Volatility:** Increased volatility can make put options more valuable. Greater price fluctuations increase the probability that the stock price will drop below the strike price, enhancing the option\'s value. Investors buy put options when they expect the underlying asset's price to decline. They sell put options if they anticipate that the asset's price will rise or remain steady. c. **Spreads** A spread involves the simultaneous buying and selling of options on the same underlying asset, but with different strike prices or expiration dates. The spread strategy can be used to limit potential losses and profits, offering a more controlled risk profile. **Types of Spreads:** 1. **Price Spreads (Vertical Spreads)** 2. **Time Spreads (Calendar Spreads)** 3. **Diagonal Spreads** **Role of Derivatives in Risk Management** Derivatives play a critical role in risk management by allowing investors to hedge against potential losses in underlying assets. They can be used to protect against various types of risks such as interest rate risk, currency risk, commodity price risk, etc. Derivatives provide a more structured capital allocation, ease international capital flows, and expand prospects for portfolio diversification by enabling investors to unbundle and transfer such risks. This shows how financial derivatives are vital for the growth of capital markets that function efficiently. A derivative can both reduce risk, by providing insurance (which, in financial parlance, is referred to as hedging), and magnify risk, by speculating on future events. Financial derivatives are vital tools in managing various types of financial risks. They allow market participants to hedge against uncertainties, such as price fluctuations, volatility, and interest rate movements. Below is a detailed explanation of their roles: 1. **Hedging**: Derivatives are widely used for hedging purposes to offset potential losses from adverse price movements in underlying assets. ***Example:*** Futures contracts allow participants to hedge against the risk of price changes in commodities, currencies, or financial instruments. By taking an opposite position in the derivative contract, investors can protect their portfolios from potential losses. 2. **Price Discovery:** Derivatives facilitate price discovery by providing a platform for participants to express their views on future asset prices. 3. **\ **Derivatives enable the transfer of risks from one party to another. ***Example***: Options contracts allow investors to transfer the risk of adverse price movements to the option writer, who assumes the obligation to buy or sell the underlying asset at a predetermined price. 4. **Leverage and Speculation**: Derivatives provide opportunities for leverage, allowing investors to amplify their exposure to underlying assets without committing the full capital required for direct investment. 5. **Portfolio Diversification:** Derivatives offer an avenue for portfolio diversification by providing exposure to different asset classes and market segments. 6. **Risk Measurement and Management:** Institutional investors, such as banks and insurance companies, use derivatives to construct complex risk models that assess the potential impact of market fluctuations and portfolio exposures. 7. **Arbitrage:** Derivatives facilitate arbitrage opportunities by exploiting price discrepancies between related assets or markets. 8. **Capital Efficiency:** Derivatives enhance capital efficiency by reducing the amount of capital required for certain transactions. ***Example**:* Margin requirements for futures contracts are generally lower than the full value of the underlying asset. By utilizing derivatives, investors can achieve similar exposure with a smaller capital outlay, freeing up capital for other investments. 9. **Synthetic Exposure:** Derivatives allow investors to create synthetic exposure to underlying assets without directly owning them. ***Example**:* An investor can replicate the return profile of a stock index using index futures or options contracts, providing a cost-effective alternative to purchasing individual stocks. **Conclusions** Derivatives, financial instruments whose value is derived from an underlying asset, play a crucial role in modern financial markets. They offer a versatile toolkit for managing risk, speculating on price movements, and engaging in arbitrage. It comes in different types: futures, forwards, options, and swaps. Futures and forwards are contracts that obligate the buyer to purchase and the seller to deliver a specified quantity of an underlying asset at a predetermined price on a future date. *Futures* offer standardization, daily settlement, and reduced counterparty risk, making them more suitable for retail investors. *Forwards*, on the other hand, provide customization and can be tailored to specific needs but come with higher counterparty risk and may be less liquid. *Options*, however, provide the buyer with the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a specified expiration date. Options strategies, including calls, puts, and spreads, provide investors with various ways to participate in the market and manage risk. Finally, agreements to exchange cash flows based on two different underlying assets, are called *swaps*. The most common type is an *interest rate swap*, where one party exchanges fixed-rate interest payments for floating-rate payments, and vice versa. Other types of swaps include *currency swaps*, where parties exchange principal amounts and interest payments in different currencies, *commodity swaps*, where parties exchange cash flows based on the price of a commodity, and *credit default swaps (CDS)* which provide protection against the risk of a debt issuer defaulting on their obligations. In conclusion, although derivatives are used to manage risk and speculate on market movements, they can be complex and involve risks. Regardless, they can also offer opportunities for profit. However, understanding their underlying principles, potential risks, and appropriate usage is crucial to harness their benefits effectively. While it can be helpful, it is important to understand how they fully work and the risks that are involved before using them. **References** **Altai, W. (2023). *The Role of Financial Derivatives in Risk Management.* ** **Anon (2019). *Reasons for the Use of Derivatives*. CubeLearn. [[https://cubelearn.com/blog/reasons-use-derivatives/]](https://cubelearn.com/blog/reasons-use-derivatives/)** **Atoklo, D. (2021, June 29). *Derivatives -- An overview. The Business & Financial Times*. ** **Borad, S. B. (2021). *Hedging vs Speculation -- All You Need to Know*. EFinanceManagement. ** **CFI Team. (2023). *Options: Calls and Puts*. Corporate Finance Institute. ** **Derivatives: Navigating Complex Risk Participation Strategies (2024). Faster Capital. Derived from:  ** **Fernando, J. (2024). *What Is a Derivative?*. Investopedia. ** **Jha, M. (2019). *Derivatives Types*. WallStreetMojo. ** **Loo, A. (2023). *Derivatives*. Corporate Finance Institute. ** **McGuigan, J. R., Kretlow, W. J., & Moyer, R. C. (2008). *Contemporary Corporate Finance*. South Western Educational Publishing.** **Nickolas, S. (2022, September 30). *How can derivatives be used for risk management?* Investopedia. Derived from:  ** **Vipond, T. (n.d.). *Futures and Forwards*. Corporate Finance Institute. **