QUESTION

DERIVATIVES OFFER THE TREASURER A SOPHISTICATED TOOL BOX TO

MANAGE RISK. DISCUSS THOROUGHLY.

A Derivative is a financial instrument whose value depends onis derived fromthe

value of some other financial instrument, called the underlying asset.
Common examples of underlying assets are stocks, bonds, corn, pork, wheat, rainfall, etc.
Derivatives can be classified into two: Commodity derivatives and Financial Derivatives.
commodity derivatives, the underlying asset is a commodity. It can be agricultural
commodity like wheat, soybeans, rapeseed, cotton etc. or precious metals like gold, silver etc.
The term financial derivative denotes a variety of financial instruments including stocks,
bonds, treasury bills, interest rate, foreign currencies and other hybrid
securities. Financial derivatives include futures, forwards, options, swaps,
etc. Futures contracts are the most important form of derivatives, which are in existence long
before the term derivative was coined. Financial derivatives can also be derived from a
combination of cash market instruments or other financial derivative instruments. In fact,
most of the financial derivatives are not new instruments rather they are merely combinations
of older generation derivatives and/or standard cash market instruments.
Financial derivatives include futures, forwards, options, swaps etc.

Forward contract

A forward contract is an agreement between two parties in which one party agrees to buy or
sell an asset at a fixed time in the future for a particular price that they agree upon today. The
price that the underlying asset is bought or sold for is called delivery price. This price must be
fair, that is, it must be chosen so that the value of the contract to both parties is zero at the
onset. This is the principles of no arbitrage, (arbitrage means taking advantage of price
differences in two markets.In short, a futures contract is a contract for a trade to take place in

the future. Two counterparties enter into this contract and promise to buy/sell an asset at a
specified price on a specified date.The asset to be traded is called the underlying.The date
for the trade is the settlement date or maturity date.The price to be paid/received for the
asset is the futures price.The buyer or long position in the futures contract has the
obligation to buy the underlying at the futures price on the settlement date.The seller or short
position in the futures contract has the obligation to sell the underlying at the futures price on
the settlement date.

Forward contracts are not traded on exchanges. They are over-the-counter (OTC) contracts.
Forwards are privately negotiated between two parties and they are not liquid. Forward
contracts are widely used in foreign exchange markets. The profit or loss from a forward
contract depends on the difference between the forward price and the spot price of the asset
on the day the forward contract matures. Forward contracts are settled only at maturity.

Futures contract

A futures contract is a commitment to buy or sell an asset at an agreed date and at an agreed
price. Futures contracts are created and traded on organized futures exchanges. Contracts are
highly standardized in terms of the amount and type of the underlying asset involved and the
available dates in which it can be delivered. The exchanges themselves provide assurances
that contracts will be honoured through clearinghouses.One of the primary roles of the
clearinghouse is to be the opposite party to all trades. Buyers and sellers of future contracts
do not deal directly with each other but with a clearinghouse. For examples, if you agree on
January 31 to buy 100 ounces of gold at a price of GH$ 400.00 on July 31 from a local gold
dealer, you have created six months future contracts.If you are getting involved in trading
futures, you have to be careful. Most casual traders do not want to find themselves obligated
to sign for receipt of a trainload of swine when the contract expires. But these abstract
contracts represent, and are derived from, the movement of actual goods.Many speculators
borrow a substantial amount of money to play the futures market. Its the only way to
magnify relatively small price movements to a point where they potentially create profits that
are worth the time and effort. But borrowing money also increases risk: If markets move

against you, and do so more dramatically than you expect, you could lose more than you have
invested.Leverage and margin rules are a lot more liberal in the futures and commodities
world than they are for the securities trading world. While your stock broker wont let you
borrow more than the amount you have put up, a commodities broker may allow you to
leverage 10:1 or even 20:1, depending on the contract. The exchange, typically the Chicago
Board of Exchange (CBOE), sets the rules.The greater the leverage, the greater the gains, but
the greater the potential loss, as well: A 5 percent change in prices can cause an investor
leveraged 10:1 to gain or lose 50 percent of his investment. Borrowing is the only way to
magnify relatively small price movements to a point where they potentially create profits that
are worth the time and effort. But borrowing money also increases risk: If markets move
against you, and do so more dramatically than you expect, you could lose more than you have
invested. This naturally means that speculators in the futures markets should have the
discipline not to overexpose themselves to any given risk.

There are four broad types of futures contracts:

futures on commodities (grains, metals, food),

futures on currencies,
futures on interest bearing instruments (Eurodollar deposits, treasury bonds, notes
andbills)
futures on stock indexes.

Swaps

They are arrangements whereby two companies agree to lend to each other on different terms,
such as in different currencies or at different interest rates (Hirscey&Nofsinger, 2008)Swaps
are also the arrangements between two firms to exchange a series of future payments. A swap
is essentially a long-dated forward contract between two parties through the intermediation of
a third party usually a bank.Swaps are considered to be interest rate risk management tools
because they give an efficient means of adjusting the interest rate exposure of a companys
assets and liabilities. It should be noted that other financial instruments, such as exchange-

traded interest rate futures and option contracts, are often capable of achieving the similar
results. Swaps are long-term OTC instruments. A great flexibility in setting the terms of the
swap agreement makes it a very effective instrument in risk management.Interest Rate Swap
(IRS) is an agreement between two parties to exchange cash flows based on a specified
amount of principal for a set length of time.

Conceptually, one may view a swap as either a portfolio of forward contracts, or as a long
position in one bond coupled with a short position in another bond. This article will discuss
the two most common and most basic types of swaps: the plain vanilla interest rate and
currency swaps.

The first interest rate swap occurred between IBM and the World Bank in 1981. However,
despite their relative youth, swaps have exploded in popularity. In 1987, the International
Swaps and Derivatives Association reported that the swaps market had a total notional value
of $865.6 billion. By mid-2006, this figure exceeded $250 trillion, according to the Bank for
International Settlements. That is more than 15 times the size of the U.S. public equities
market.
The motivations for using swap contracts fall into two basic categories: commercial needs
and comparative advantage. The normal business operations of some firms lead to certain
types of interest rate or currency exposures that swaps can alleviate. For example, consider a
bank, which pays a floating rate of interest on deposits (e.g. liabilities) and earns a fixed rate
of interest on loans (e.g. assets). This mismatch between assets and liabilities can cause
tremendous difficulties. The bank could use a fixed-pay swap (pay a fixed rate and receive a
floating rate) to convert its fixed-rate assets into floating-rate assets, which would match up
well with its floating-rate liabilities.
Some companies have a comparative advantage in acquiring certain types of financing.
However, this comparative advantage may not be for the type of financing desired. In this
case, the company may acquire the financing for which it has a comparative advantage, and
then use a swap to convert it to the desired type of financing.
For example, consider a well-known U.S. firm that wants to expand its operations into
Europe, where it is less known. It will likely receive more favorable financing terms in the

U.S. By then using a currency swap, the firm ends with the Euros it needs to fund its
expansion.
Sometimes one of the swap parties needs to exit the swap prior to the agreed-upon
termination date. This is similar to an investor selling an exchange-traded futures or option
contract before expiration. There are four basic ways to do this:
1. Buy Out the Counterparty: Just like an option or futures contract, a swap has a calculable
market value, so one party may terminate the contract by paying the other this market value.
However, this is not an automatic feature, so either it must be specified in the swaps contract
in advance, or the party who wants out must secure the counterparty's consent.
2. Enter an Offsetting Swap: For example, Company A from the interest rate swap example
above could enter into a second swap, this time receiving a fixed rate and paying a floating
rate.
3. Sell the Swap to Someone Else: Because swaps have calculable value, one party may sell
the contract to a third party. As with Strategy 1, this requires the permission of the
counterparty.
4. Use a Swaption: A swaption is an option on a swap. Purchasing a swaption would allow a
party to set up, but not enter into, a potentially offsetting swap at the time they execute the
original swap. This would reduce some of the market risks associated with Strategy 2.

In conclusion, swaps can be a very confusing topic at first, but this financial tool, if used
properly, can provide many firms with a method of receiving a type of financing that would
otherwise be unavailable. This introduction to the concept of plain vanilla swaps and
currency swaps should be regarded as the groundwork needed for further study. You now
know the basics of this growing area and how swaps are one available avenue that can give
many firms the comparative advantage they are looking for.

Options

This is more interesting and complicated type of derivative. In this contract one of the parties
has the option, but not the obligation, to buy or sell an underlying asset (say stock) for a fixed
price at a fixed time in the future, where buy refers to a call option and sell to put option.In

order words, these are right (but not obligation) to buy or sell an asset at a fixed price within a
specified period of time. The definition is general and applies to puts, calls, warrants and real
estate options. An option is a contract giving the holder the right to buy or sell a stated
security at a specified price, called the strike or exercise price on or before a specified date. A
call option gives the holder the right to purchase securities at a fixed price during a set period
of time. A put option also gives the holder the right to sell a given number of securities at a
fixed price during a set period of time. One way of creating options is through single
contracts that are individually negotiated between parties, usually firms and their banks (OTC
options). Organized option exchanges provide the advantages of liquidity, low transaction
costs, and safety through the standardization of the assets on which the contracts are based
and of the contract sizes and maturity dates.