Definition of Financial Derivatives
1. A financial derivative is a contract between two (or more) parties where payment is based on (i.e., "derived" from) some agreed- pon benchmar!. ". #ince a financial derivative can be created by means of a m t al agreement, the types of derivative prod cts are limited only by imagination and so there is no definitive list of derivative prod cts. $. #ome common financial derivatives, however, are described later. %. &ore generic is the concept of 'hedge f nds( which se financial derivatives as their most important tool for ris! management.
)epayment of Financial Derivatives
? *n creating a financial derivative, the means for, basis of, and rate of payment are specified. ? +ayment may be in c rrency, sec rities, a physical entity s ch as gold or silver, and an agric lt ral prod ct s ch as wheat or por!, a transitory commodity s ch as comm nication bandwidth or energy. ? ,he amo nt of payment may be tied to movement of interest rates, stoc! inde-es, or foreign c rrency. ? Financial derivatives also may involve leveraging, with significant percentages of the money involved being borrowed. .everaging th s acts to m ltiply (favorably or nfavorably) impacts on total payment obligations of the parties to the derivative instr ment.
/ommon Financial Derivatives
? 0ptions ? Forward /ontracts ? F t res
1|Page
? #tripped &ortgage-1ac!ed #ec rities ? #tr ct red 2otes ? #waps ? )ights of 3se ? /ombined ? 4edge F nds
0ptions
? ,he p rchaser of an 0ption has rights (b t not obligations) to b y or sell the asset d ring a given time for a specified price (the "#tri!e" price). An 0ption to b y is !nown as a "/all," and an 0ption to sell is called a "+ t." ? ,he seller of a /all 0ption is obligated to sell the asset to the party that p rchased the 0ption. ,he seller of a + t 0ption is obligated to b y the asset. ? *n a '/overed( 0ption, the seller of the 0ption already owns the asset. *n a '2a!ed( 0ption, the seller does not own the asset ? 0ptions are traded on organi5ed e-changes and 0,/.
Forward /ontracts
? *n a Forward /ontract, both the seller and the p rchaser are obligated to trade a sec rity or other asset at a specified date in the f t re. ,he price paid for the sec rity or asset may be agreed pon at the time the contract is entered into or may be determined at delivery. ? Forward /ontracts generally are traded 0,/.
F t res
? A F t re is a contract to b y or sell a standard 6 antity and 6 ality of an asset or sec rity at a specified date and price. ? F t res are similar to Forward /ontracts, b t are standardi5ed and traded on an e-change, and are val ed daily. ,he daily val e provides both parties with an acco nting of their financial obligations nder the terms of the F t re.
2|Page
? 3nli!e Forward /ontracts, the co nterparty to the b yer or seller in a F t res contract is the clearing corporation on the appropriate e-change. ? F t res often are settled in cash or cash e6 ivalents, rather than re6 iring physical delivery of the nderlying asset.
#waps
? A #wap is a sim ltaneo s b ying and selling of the same sec rity or obligation. +erhaps the best-!nown #wap occ rs when two parties e-change interest payments based on an identical principal amo nt, called the "notional principal amo nt." ? ,hin! of an interest rate #wap as follows7 +arty A holds a 18-year )#.18, 888 home e6 ity loans that has a fi-ed interest rate of 9 percent, and +arty 1 holds a 18-year )s.18, 888 home e6 ity loans that have an ad: stable interest rate that will change over the "life" of the mortgage. *f +arty A and +arty 1 were to e-change interest rate payments on their otherwise identical mortgages, they wo ld have engaged in an interest rate #wap. ? *nterest rate swaps occ r generally in three scenarios. ;-changes of a fi-ed rate for a floating rate, a floating rate for a fi-ed rate, or a floating rate for a floating rate.
/ombined Derivative +rod cts
? ,he range of derivative prod cts is limited only by the h man imagination. ,herefore, it is not n s al for financial derivatives to be merged in vario s combinations to form new derivative prod cts. ? For instance, a company may find it advantageo s to finance operations by iss ing debt, the interest rate of which is determined by some nrelated inde-. ,he company may have e-changed the liability for interest payments with another party. ,his prod ct combines a #tr ct red 2ote with an interest rate #wap.
4edge F nds
? A 'hedge f nd( is a private partnership aimed at very wealthy investors. *t can se strategies to red ce ris!. 1 t it may also se leverage, which increases the level of ris! and the potential rewards. ? 4edge f nds can invest in virt ally anything anywhere. ,hey can hold stoc!s, bonds, and government sec rities in all global mar!ets. ,hey may p rchase c rrencies, derivatives, commodities, and tangible assets. ,hey may leverage their portfolios by borrowing money against their assets, or by borrowing stoc!s from
3|Page
investment bro!ers and selling them (shorting). ,hey may also invest in closely held companies. ? #ome investors se hedge f nds to red ce ris! in their portfolio by diversifying into ncommon or alternative investments li!e commodities or foreign c rrencies. 0thers se hedge f nds as the primary means of implementing their long-term investment strategy.
2eed of Derivatives
1. Derivatives are ris!-shifting devices. *nitially, they were sed to red ce e-pos re to changes in s ch factors as weather, foreign e-change rates, interest rates, or stoc! inde-es. ". For e-ample, if an American company e-pects payment for a shipment of goods in 1ritish +o nd #terling, it may enter into a derivative contract with another party to red ce the ris! that the e-change rate with the 3.#. Dollar will be more nfavorable at the time the bill is d e and paid. 3nder the derivative instr ment, the other party is obligated to pay the company the amo nt d e at the e-change rate in effect when the derivative contract was e-ec ted. 1y sing a derivative prod ct, the company has shifted the ris! of e-change rate movement to another party. $. &ore recently, derivatives have been sed to segregate categories of investment ris! that may appeal to different investment strategies sed by m t al f nd managers, corporate treas rers or pension f nd administrators. ,hese investment managers may decide that it is more beneficial to ass me a specific "ris!" characteristic of a sec rity.
,he )is!s
? #ince derivatives are ris!-shifting devices, it is important to identify and nderstand the ris!s being ass med, eval ate them, and contin o sly monitor and manage them. ;ach party to a derivative contract sho ld be able to identify all the ris!s that are being ass med before entering into a derivative contract. ? +art of the ris! identification process is a determination of the monetary e-pos re of the parties nder the terms of the derivative instr ment. As money s ally is not d e ntil the specified date of performance of the parties< obligations, lac! of pfront commitment of cash may obsc re the event al monetary significance of the parties< obligations. ? *nvestors and mar!ets traditionally have loo!ed to commercial rating services for eval ation of the credit and investment ris! of iss ers of debt sec rities.
4|Page
? #ome firms have beg n iss ing ratings on a company
1. A financial derivative is a contract between two (or more) parties where payment is based on (i.e., "derived" from) some agreed- pon benchmar!. ". #ince a financial derivative can be created by means of a m t al agreement, the types of derivative prod cts are limited only by imagination and so there is no definitive list of derivative prod cts. $. #ome common financial derivatives, however, are described later. %. &ore generic is the concept of 'hedge f nds( which se financial derivatives as their most important tool for ris! management.
)epayment of Financial Derivatives
? *n creating a financial derivative, the means for, basis of, and rate of payment are specified. ? +ayment may be in c rrency, sec rities, a physical entity s ch as gold or silver, and an agric lt ral prod ct s ch as wheat or por!, a transitory commodity s ch as comm nication bandwidth or energy. ? ,he amo nt of payment may be tied to movement of interest rates, stoc! inde-es, or foreign c rrency. ? Financial derivatives also may involve leveraging, with significant percentages of the money involved being borrowed. .everaging th s acts to m ltiply (favorably or nfavorably) impacts on total payment obligations of the parties to the derivative instr ment.
/ommon Financial Derivatives
? 0ptions ? Forward /ontracts ? F t res
1|Page
? #tripped &ortgage-1ac!ed #ec rities ? #tr ct red 2otes ? #waps ? )ights of 3se ? /ombined ? 4edge F nds
0ptions
? ,he p rchaser of an 0ption has rights (b t not obligations) to b y or sell the asset d ring a given time for a specified price (the "#tri!e" price). An 0ption to b y is !nown as a "/all," and an 0ption to sell is called a "+ t." ? ,he seller of a /all 0ption is obligated to sell the asset to the party that p rchased the 0ption. ,he seller of a + t 0ption is obligated to b y the asset. ? *n a '/overed( 0ption, the seller of the 0ption already owns the asset. *n a '2a!ed( 0ption, the seller does not own the asset ? 0ptions are traded on organi5ed e-changes and 0,/.
Forward /ontracts
? *n a Forward /ontract, both the seller and the p rchaser are obligated to trade a sec rity or other asset at a specified date in the f t re. ,he price paid for the sec rity or asset may be agreed pon at the time the contract is entered into or may be determined at delivery. ? Forward /ontracts generally are traded 0,/.
F t res
? A F t re is a contract to b y or sell a standard 6 antity and 6 ality of an asset or sec rity at a specified date and price. ? F t res are similar to Forward /ontracts, b t are standardi5ed and traded on an e-change, and are val ed daily. ,he daily val e provides both parties with an acco nting of their financial obligations nder the terms of the F t re.
2|Page
? 3nli!e Forward /ontracts, the co nterparty to the b yer or seller in a F t res contract is the clearing corporation on the appropriate e-change. ? F t res often are settled in cash or cash e6 ivalents, rather than re6 iring physical delivery of the nderlying asset.
#waps
? A #wap is a sim ltaneo s b ying and selling of the same sec rity or obligation. +erhaps the best-!nown #wap occ rs when two parties e-change interest payments based on an identical principal amo nt, called the "notional principal amo nt." ? ,hin! of an interest rate #wap as follows7 +arty A holds a 18-year )#.18, 888 home e6 ity loans that has a fi-ed interest rate of 9 percent, and +arty 1 holds a 18-year )s.18, 888 home e6 ity loans that have an ad: stable interest rate that will change over the "life" of the mortgage. *f +arty A and +arty 1 were to e-change interest rate payments on their otherwise identical mortgages, they wo ld have engaged in an interest rate #wap. ? *nterest rate swaps occ r generally in three scenarios. ;-changes of a fi-ed rate for a floating rate, a floating rate for a fi-ed rate, or a floating rate for a floating rate.
/ombined Derivative +rod cts
? ,he range of derivative prod cts is limited only by the h man imagination. ,herefore, it is not n s al for financial derivatives to be merged in vario s combinations to form new derivative prod cts. ? For instance, a company may find it advantageo s to finance operations by iss ing debt, the interest rate of which is determined by some nrelated inde-. ,he company may have e-changed the liability for interest payments with another party. ,his prod ct combines a #tr ct red 2ote with an interest rate #wap.
4edge F nds
? A 'hedge f nd( is a private partnership aimed at very wealthy investors. *t can se strategies to red ce ris!. 1 t it may also se leverage, which increases the level of ris! and the potential rewards. ? 4edge f nds can invest in virt ally anything anywhere. ,hey can hold stoc!s, bonds, and government sec rities in all global mar!ets. ,hey may p rchase c rrencies, derivatives, commodities, and tangible assets. ,hey may leverage their portfolios by borrowing money against their assets, or by borrowing stoc!s from
3|Page
investment bro!ers and selling them (shorting). ,hey may also invest in closely held companies. ? #ome investors se hedge f nds to red ce ris! in their portfolio by diversifying into ncommon or alternative investments li!e commodities or foreign c rrencies. 0thers se hedge f nds as the primary means of implementing their long-term investment strategy.
2eed of Derivatives
1. Derivatives are ris!-shifting devices. *nitially, they were sed to red ce e-pos re to changes in s ch factors as weather, foreign e-change rates, interest rates, or stoc! inde-es. ". For e-ample, if an American company e-pects payment for a shipment of goods in 1ritish +o nd #terling, it may enter into a derivative contract with another party to red ce the ris! that the e-change rate with the 3.#. Dollar will be more nfavorable at the time the bill is d e and paid. 3nder the derivative instr ment, the other party is obligated to pay the company the amo nt d e at the e-change rate in effect when the derivative contract was e-ec ted. 1y sing a derivative prod ct, the company has shifted the ris! of e-change rate movement to another party. $. &ore recently, derivatives have been sed to segregate categories of investment ris! that may appeal to different investment strategies sed by m t al f nd managers, corporate treas rers or pension f nd administrators. ,hese investment managers may decide that it is more beneficial to ass me a specific "ris!" characteristic of a sec rity.
,he )is!s
? #ince derivatives are ris!-shifting devices, it is important to identify and nderstand the ris!s being ass med, eval ate them, and contin o sly monitor and manage them. ;ach party to a derivative contract sho ld be able to identify all the ris!s that are being ass med before entering into a derivative contract. ? +art of the ris! identification process is a determination of the monetary e-pos re of the parties nder the terms of the derivative instr ment. As money s ally is not d e ntil the specified date of performance of the parties< obligations, lac! of pfront commitment of cash may obsc re the event al monetary significance of the parties< obligations. ? *nvestors and mar!ets traditionally have loo!ed to commercial rating services for eval ation of the credit and investment ris! of iss ers of debt sec rities.
4|Page
? #ome firms have beg n iss ing ratings on a company