INTRODUCTION These financial instruments promise payoffs that are derived from the value of something else, which

is called the underlying. The underlying is often a financial asset or rate, but it does not have to be. Some estimates of the size of the market for derivatives are in excess of $270 trillion more than 100 times larger than 30 years ago. When derivative contracts lead to large financial losses, they can make headlines. In Year 2008 years, derivatives have been associated with notable events. Either the big banks were collapsed or bailed out, which result in the Sub-Prime Mortgage Crisis. Warren Buffett made a statement that derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal. But there are two sides to this coin. Although some serious dangers are associated with derivatives, handled with care they have proved to be immensely valuable to modern economies, and will surely remain so. Derivatives come in flavors from plain vanilla to mint chocolate-chip. The plain vanilla include contracts to buy or sell something for future delivery (forward and futures contracts), contracts involving an option to buy or sell something at a fixed price in the future (options) and contracts to exchange one cash flow for another (swaps), along with simple combinations of forward, futures and options contracts. (Futures contracts are similar to forward contracts, but they are standardized contracts that trade on exchanges.) At the mint chocolate-chip end of the spectrum, however, the sky is the limit. Derivatives can be used for speculating purposes ("bets") or to hedge ("insurance"). For example, a speculator may sell deep in-the-money naked calls on a stock, expecting the stock price to plummet, but exposing him to potentially unlimited losses. Very commonly, companies buy currency forwards in order to limit losses due to fluctuations in the exchange rate of two currencies.

Types of Derivatives There are three major classes of derivatives: 1. Futures/Forwards are contracts to buy or sell an asset on or before a future date at a price specified today? A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold, while a forward contract is a non-standardized contract written by the parties themselves. 2. Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. The option contract also specifies a maturity date. In the case of a European option, the owner has the right to require the sale to take place on (but not before) the maturity date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity date. If the owner of the contract exercises this right, the counterparty has the obligation to carry out the transaction. 3. Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets. More complex derivatives can be created by combining the elements of these basic types. For example, the holder of a swaption has the right, but not the obligation, to enter into a swap on or before a specified future date. The overall derivatives market has five major classes of underlying asset: Interest rate derivatives (the largest) Foreign exchange derivatives Credit derivatives Equity derivatives

Commodity derivatives

FORWARD CONTRACTS Forward is a contract agreement between 2 parties that is initiated at one point in time, but requires the parties to the agreement to perform, in accordance with the terms of the agreement, at some future point in time. Cash market transaction in which delivery of the commodity is deferred until after the contract has been made. Although the delivery is made in the future, the price is determined on the initial trade date. Salient Features of Forward Contract: Seller / Holder of the Short Position: Party obliged to Deliver the Stated Asset Buyer / Holder of the Long Position: Party obliged to Pay for the Stated Asset Deliverable Item/ Underlying Asset: asset to be traded under the terms of the contract Settlement / Maturity / Expiration: Time at which the contract is to be fulfilled by the trading of the underlying asset. Contract Size: Quantity of the underlying asset that is to be traded at the time the contract settles Invoice Amount / Forward Contract Price: Amount that must be paid for the contract size of the underlying asset by the holder of the long position at the time of the settlement

Forward Contracts are NOT Investments; they are simply agreements to engage in a trade at a future time and at a fixed price. Thus, it costs NOTHING to enter into such a contract; Since nothing is Bought or Sold, contracts are Entered Into or Sold Out. There are THREE ways to Close Out (Settle) a contract: Enter an Offsetting Transaction: Making/Taking Physical Delivery of the underlying commodity under the terms & conditions specified by the contract: Cash Settlement

Over-the-Counter Forward Contracts are Flexible, but 3 major disadvantage o ILLIQUID: designed for specific needs o CREDIT RISK: No collateral or marked to marketing, rather it is just trust o UNREGULATED: no formal body regulates the players in the market

FUTURE CONTRACTS Futures in an special forms of forward contracts that are designed to reduce the disadvantages associated with forward agreements. Indeed, they are Forwards whose terms have been standardized to that they can be traded in a public marketplace. Less Flexible, but more liquid. Salient Features of Future Contract: o Usually traded on FUTURES exchanges, who establish terms of standardization, rules or Pit trading, daily price limit, trading hours, and settlement price methods. o Regulated by the CFTC. o Brokers: Account Executives who take orders from customers and relay them to the floor; and o Floor Brokers who operate on the floor and execute orders for others and for themselves. o CLEARINGHOUSE: interposed between each side and guarantees the contract. o POSTING MARGIN, MARKING TO MARKET o Capital Gains are based upon the NET DAILY SETTLEMENT gains or losses that occur in a tax period, rather than upon the net gains or losses that result from contracts that are closed out during a tax period. o FUTURES is a ZERO sum GAME RELATIVE CREDIT RISKS IN FORWARD v. FUTURES CONTRACS To ease Credit Risk in the Futures Market, there are 3 types of protections built-in, as opposed to a mere Forward Contract

o Daily Settlement: Unrealized Gains/Losses must be settled with cash on a Daily Basis (by way of o Margin Calls & Account Crediting/Debiting between Clearinghouse & Regular Accounts) o Margin: Accounts must maintain sufficient balances in their accounts so as to be able to cover several days worth of potential mark-to-market transfers. o Clearinghouse: Guarantees the transactions & insures settlement of the daily mark-to-market gains & losses USES OF FUTURES & FORWARDS 1. Speculation Ratio of the Profit to the amount of funds that were potentially at risk, rather than the ratio of the profit to the cash that was put up on margin is the correct way to measure the return on investment Advantages of Using Futures/Forwards for Speculative Purposes: Lower Transaction Costs and better Liquidity No need for Storage or Insurance Can Sell Short in the Futures/Forwards, which may not be possible in the Spot Market Employs a great deal of leverage

Disadvantages of Using Futures/Forwards for Speculative Purposes: o With lots of Leverage, Huge Losses could be incurred o Margin Calls means that there is a need (potentially) to have lots of free cash

2. Hedging 2 Types of Hedges: the Long Hedge where the Hedger takes a long position & the Short Hedge where the Hedger takes a Short Position

Long Hedges: are used when one is EXPECTING to acquire an asset in the future, but

there is concern that its price might rise in the meantime. To alleviate this price risk, the Hedger takes a long position in the futures contract and then if the price does rise, his profit on the Hedge can be used to offset the higher cost of purchasing the commodity. The same principal applies if the price falls. Either way, the net price paid for the commodity in the future can be fixed in the present. Short Hedges: Used to reduce risk associated with possible changes in the price of

OWNED Assets. Same Principals. Difficulties encountered when using Futures as Hedges TO succeed, need to understand complex relationships Might not work if Futures are MISPRICED Hedging Profits generate Tax consequences because the daily settlement cash inflows

from unrealized financial gains/losses on futures used as hedges are taxable, even though the offsetting loss incurred in the value of the commodity held long is NOT tax deductible until realized

3. Arbitrage Arbitrage is an opportunity to make a risk-less profit without having to make any net investment. There is a no Arbitrage principle in Financial Theory. However, market imperfections allow for some arbitrage opportunities.

SOCIAL PURPOSES of Futures: Risk Shifting from Hedgers to Speculators Price Discovery

TYPES & CHARACTERISTICS OF FUTURES CONTRACTS

COMMODITY FUTURES Position Held to Settlement Gain on Long = Loss on Short = K-Size * (Ss F0) Position NOT Held to Settlement Gain on Long = Loss on Short = K-Size * (Ft F0) Daily Settlements Gain on Long = Loss on Short = K-Size * (Ft Ft-1)

STOCK INDEX FUTURES Stock Index Futures are Settled in Cash, rather than Physical Delivery

Index Multipliers: S&P _ 500, NYSE _ 500, MMI _ 500, NIKKEI _ 5 Position Held to Settlement Gain on Long = Loss on Short = Multiplier * (Ss F0) Position NOT Held to Settlement Gain on Long = Loss on Short = Multiplier * (Ft F0) Daily Settlements Gain on Long = Loss on Short = Multiplier* (Ft Ft-1)

TREASURY BOND FUTURES Settled with the Physical Delivery of Treasury Bonds. To satisfy, the holder of the short

must deliver 100 Treasury Bonds ($100,000 par value) that mature in (or cant be called for) at least 15 years Since many Treasury Bonds could possibly be delivered, require a Conversion for Quotes

on the Deliverable Bond Invoice PriceDB = (F0 * Conversion FactorDB) + Accrued InterestDB

Position Held to Settlement Gain on Long = Loss on Short = $1,000 * (Fs - F0) * Conversion FactorDB Position NOT Held to Settlement Gain on Long = Loss on Short = $1,000 * (Ft F0) Daily Settlements Gain on Long = Loss on Short = $1,000 * (Ft Ft-1)

TREASURY BILL & EURODOLLAR FUTURES TREASURY BILL: require the holder of the short to deliver $1,000,000 face value of treasury bills that mature 3 months from the delivery date. A T-bill future (IMM index) is stated as: F0 = IMM Index = 100 R0 : R0 is the Annualized Discount Rate; i.e., 100 95 = 5 Invoice Price(%) = 100 [R0tm/360] If the quoted price is 95, that does NOT mean that when 1,000,000 face value of 3 month treasury bills are delivered at the time of settlement the invoice price to be paid is $950,000. Rather, the Quotation of 95 means that the contracted price to be paid on settlement day is a price that will correspond to an ANNUALIZED discount of 5% at that time. Will be 98./75. 1 Basis Point (.01) change in the IMM Index for 90 day treasury bills = $25 change in its

dollar value. EURODOLLAR: similar to treasury bills, but different.

R0 * = [R0/Price][360/tm] Invoice Price (%) = 100 [R0*tm/360] For Both Treasury Bill & Eurodollar Futures Position Held to Settlement Gain on Long = Loss on Short = $2,500 * (Ss F0) Position NOT Held to Settlement Gain on Long = Loss on Short = $2,500 * (Ft F0)

Daily Settlements Gain on Long = Loss on Short = $2,500 * (Ft Ft-1)

CURRENCY FUTURES Most Currency Trading takes place between banks. But, there are speculative opportunities Position Held to Settlement Gain on Long = Loss on Short = Contract SizeX/Y * (SX/Y s FX/Y 0) Position NOT Held to Settlement Gain on Long = Loss on Short = Contract Size X/Y * (FX/Y t FX/Y 0) Daily Settlements Gain on Long = Loss on Short = Contract Size/Y * (FX/Y t FX/Y t-1)

VALUING FORWARD & FUTURES CONTRACTS Forwards & Futures are NOT investable Assets. Rather, they are agreements that are valued by an arbitrage pricing model called the spot-futures parity theorem or the cost-of-carry relationship F0 = S0 * [1 + (rftm/360) + CP IP F0 is the Futures Contract Price rf is the Risk Free Rate Matures CP is the cost of Storing Insuring the Underlying asset over the life of the contract IP is the income generated by the underlying asset over the life of the contract in the form of interest or dividends, plus any interest that can be earned on such payments from the time they are received until the contract expires S0 is the Spot Price of the Underlying Asset tM is the number of days til the contract

rf is the risk free rate, and if the spot & futures markets are mispriced, it is the IMPLIED REPO rate, which is the rate that will be earned risk free by the arbitrageur Basis is the spread between the spot price of an underlying commodity and the price of a

futures contract on the commodity. Basis = S0 F0 Convergence; on settlement day, the price of a futures contract will equal the price of the

underlying commodity in the spot market (the basis will be zero). Fs = Ss Calendar Spread is the difference in price between 2 futures contracts that have the same

underlying commodity, but 2 different settlement dates. F0 Distant = F0 Near [ 1 + rf*((tm distant tm near)/360)] If the prices of Nearby Contracts are Higher than those of Distant Contracts, the futures market is said to be INVERTED

Valuing Stock Index Futures Contracts Valued according to the Spot-futures Parity Theorem. But the Cost of Storing & Insuring

is Negligible. F0 = S0 * [ 1 + (rftM/360) DP] Stock Index Arbitrage is effectuated through Program Trading.

Valuing Treasury Bond Futures Contracts Also uses the Spot-Futures Parity Theorem, but there are some unique features. For example, several bonds can satisfy the delivery requirements. But there is the conversion factor. Instead, it is a 2 Step Process: Determine the INVOICE PRICE of a Deliverable Bond & then get the FUTURE Price of the MOST Deliverable Bond (the Cheapest Bond with the HIGHEST YTM)

Invoice PriceDB = SDB * [1+ (rftm/360)] - IDB F0 = (Invoice PriceDB / Conversion FactorDB) Contract Price of a Treasury Bond Futures is based upon the Spot Price and the Conversion Factor of the most Deliverable Treasury Bond in the Market

Valuing T-Bill & Eurodollar Futures Contracts Also uses the Spot-Futures Parity Theorem to value, but the contracts are QUOTED as 100 Annualized discount rate at which they are priced. It is a Multi-step Process. Determine the Invoice Price to be paid for a 3 month treasury bill, or euro, when the

contract matures: Invoice Price = S0 * [ 1 + (rftm/360)] Determine the Dollar Discount Rate: DF = 100 Invoice Price Annualize the Dollar Discount rate to Obtain the Annualized Discount Rate that

corresponds to the Invoice Price of the 3 month Treasury at the time of Settlement.

F0 = 100 [(360/90)*Df] Maturity of T-Bill Underlying a T-Bill Future = Maturity of Contract + 3 Months Implied Repo Rate = [(Invoice Price of Contract / Spot Price of T-Bill Underlying the Contract) * (360/tm)

Arbitrage Opportunities Exit if the Implied Repo Rate is different from the borrowing

rate or risk free Rates.

Valuing Currency Futures Contracts

FY/X = SY/X [ (1+ rY Periodic) / (1 + rX Periodic)] FX/Y = SX/Y [ (1+ rX Periodic) / (1 + rY Periodic)]

Covered Interest Arbitrage Interest rate parity defines the relationship between the value of a forward currency

exchange rate and the spot exchange rate because it is a no-arbitrage Solution. If Interest rate parity does not hold, an arbitraging opportunity exists. If the Forward Market is Too Expensive, the Covered Interest Arbitrage requires the

Arbitrageur to Short the Forward and buy the Spot (and vice versa)

G. HEDGING WITH FORWARD & FUTURES CONTRACTS To Plan a Hedging Strategy, several Decisions must be made. 1. Determine the Appropriate Hedging Vehicle The Pricing Movements of the Hedging vehicle should closely correlate with the price

movements of the commodity being hedged. If not the same commodity, a cross-hedge may need to be employed. Try to choose a futures contract whose contract size divides as evenly as possible into the

quantity of the commodity being hedged. Choose a futures contract that Settles CLOSE to the Hedging Horizon. Choose a LIQUID Hedging Vehicle

2. Determine the Proper Hedge Ratio 3. Determine the Target Price that is likely to be achieved by using the hedge

May be difficult to calculate Vtarget = F0 + (SL FL) = F0 + BasisL L is the Lifting Date 4. Determine the Probable Effectiveness of the Hedge

Determining the Number of Contracts Required Performing a Total Hedge NF = - (Hedge Ratio/Contract Size)*(Quantity of the Commodity to be Hedged) Determining the Hedge Ratio

Cross-hedging When the commodity underlying the hedging vehicle the resulting hedge is a cross-hedge. If at all possible, try to avoid using a cross-hedge because of its increased riskiness The Higher the R2 between the cross-hedged commodities, the more effective the cross-hedge

Hedging Equity Portfolios with Stock Index Futures Contracts NF = NF = In theory, the hedge should be reformulated daily because futures contracts require that daily financial settlements be made. This is called TAILING THE HEDGE. Hedging with Currency Futures

NF = - (Hedge Ratio / Contract Size) * (Quantity of Currency Being Hedged)

SWAP Swap is a derivative in which counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest (or coupon) payments associated with the bonds. Specifically, the two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash flows are to be paid and the way they are calculated.[1]Usually at the time when the contract is initiated at least one of these series of cash flows is determined by a random or uncertain variable such as an interest rate, foreign exchange rate, equity price or commodity price. The cash flows are calculated over a notional principal amount, which is usually not exchanged between counterparties. Consequently, swaps can be in cash or collateral. Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices. Swaps were first introduced to the public in 1981 when IBM and the World Bank entered into a swap agreement.

Types of SWAPS Interest rate swaps The most common type of swap is a plain Vanilla interest rate swap. It is the exchange of a fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15 years. The reason for this exchange is to take benefit from comparative advantage. Some companies may have comparative advantage in fixed rate markets while other companies have a comparative advantage in floating rate markets. When companies want to borrow they look for cheap borrowing i.e. from the market where they have comparative advantage. However this

may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa. Lets consider two US entities: a triple A rated commercial bank ABC Ltd and a triple B rated IT firm BAC Ltd. Each wanted to raise $100 million for 10 years. The Bank wanted to raise floating-rate funds, while IT firm wanted to raise fixed rate funds. The interest available to the two entities in the US bond market as follows for Bank Floating rate is 6month LIBOR + 30bp. For IT firm fixed rate is 12%. Assume that instead that both entities could issue securities in the Eurodollar bond market. Suppose that the following terms are available in the Eurodollars bond market for 10yr securities for these entities are as follows for bank Fixed rate is 10.5% and for IT firm is LIBOR+80bp. Notice that we indicate the terms that the bank could obtain on fixed rate-financing and that IT firm could obtain on floating rate securities. Now summarize the situation for the two entities in the U.S. domestic and Eurodollar bond market as show in below table Company ABC Ltd BAC Ltd A AA Floating Rate 6M LIBOR + 30bp(US Domestic) 6M LIBOR +80bp(Eurodollar) 50 bp Fixed Rate 10.50%(Eurodollar) 12.00%(US Domestics) 150 bp

Quality Spread

Notice that the quality spread for floating rate securities is 50bp is narrower than the quality spread for fixed rate securities is 150bp. This provide opportunity for both entities to reduce funds. Suppose each entity issued securities in the Eurodollar bond market, and the simultaneously entered into a 10yr interest rate swap with a $100 million notional principal amount offered by an intermediary (Sanjay Financial Services). The rates available to each entity in this swap are as follows:

Bank ABC Ltd- Pay Floating rate of 6-month LIBOR+70bp and receive fixed rate of 11.3%. IT firm BAC Ltd- Pay fixed rate @11.3% and receive floating rate 6 month LIBOR+45bp.

The cost of the issue for the bank ABC Ltd will be as follows: Interest Paid On fixed rate Eurodollar bond issued 10.50% On interest rate swap 6 m LIBOR + 70bp Total(A) 11.2% + 6M LIBOR

Interest Received On interest rate swap(B) 11.30%

Net Cost(A-B) 6M LIBOR - 10bp The cost of issue for the IT Firm BAC Ltd will be as follows: Interest Paid On floating rate Eurodollar bond issued On interest rate swap 11.30% Total(A) 12.1%+6M LIBOR 6M LIBOR + 80bp

Interest Received On interest rate swap(B) Net Cost(A-B) 11.65% 6M LIBOR + 45bp

The Transactions are shown in below table. By using securities in the Eurodollar bond market and using the interest rate swap, both entities are able to reduce their cost of issuing securities. The Bank ABC Ltd was able to issue floating rate securities for 6M LIBOR-10bp v/s floating rate securities in the US Bond @ 6M LIBOR+ 30bp and saved 40 bases point. The IT Firm BAC Ltd saved 35 bases point by issuing floating rate securities in the Eurodollar bond market (11.65% vs 12%) CURRENCY SWAP A currency swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. Just like interest rate swaps, the currency swaps are also motivated by comparative advantage. Currency swaps entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. It is also a very crucial uniform pattern in individuals and customers. Commodity swaps A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. The vast majority of commodity swaps involve crude oil. Credit default swaps A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if an instrument - typically a bond or loan - goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded. CDS contracts have been compared with insurance, because the buyer pays a premium and in return, receives a sum of money if one of the events specified in the contract occur. Unlike an actual insurance contract the buyer is allowed to profit from the contract and may also cover an asset to which the buyer has no direct exposure.

The benefits of derivatives Derivatives are priced by constructing a hypothetical replicating portfolio. So who needs them? If derivatives can be replicated perfectly, limiting their use would change nothing. Well, not quite. First, individuals and non-financial firms face much higher trading costs than financial institutions. Thus, replicating a derivative like a call option would be prohibitively expensive. Second, for derivatives that include option features, the replicating portfolio strategy typically requires trades to be made whenever the price of the underlying changes. Third, identifying the correct replicating strategy is often a problem. The main gain from derivatives is therefore to permit individuals and firms to achieve payoffs that they would not be able to achieve without derivatives, or could only achieve at information. For example, in a number of countries, the only reliable information about long-term interest rates is obtained from swaps, because the swap market is more liquid and more active than the bond market. Second, derivatives enable investors to trade on information that otherwise might be prohibitively expensive to use. For instance, selling stock short (that is, selling stock you dont own) is often difficult to do, because the shares must be borrowed from someone who does own them. This slows the speed at which adverse information is incorporated in stock prices, thereby making markets less efficient. With put options, a derivative that mimics the dynamics of selling short, investors can more easily take advantage of adverse information about stock prices. In theory, these cuts both ways; derivatives can also disrupt markets by making it easier to build speculative positions. But there isnt much evidence that derivatives trading have actually increased the volatility of the return of the underlying assets. Who uses derivatives and why The most comprehensive study of the use of derivatives by non-financial firms was made by Sohnke Bartram, Gregory Brown and Frank Fehle (all University of North Carolina), who examined some 7,300 non-financial firms from 48 countries, using corporate reports from 2000 and 2001. They found that 60 percent of these firms used derivatives. The most frequently used were foreign-exchange derivatives (44 percent of firms), followed by interest- rate derivatives

(33 percent of firms) and commodity derivatives (10 percent). Swaps and forwards are used more than options. Wayne Guay (University of Pennsylvania) found that when firms started using derivatives, on average their stock return volatility fell by 5 percent, their interest-rate exposure fell by 22 percent, and their foreign-exchange exposure fell by 11 percent. Clearly, firms do use derivatives for hedging, although if firms hedged systematically, the evidence suggests they would use derivatives much more than they actually do. Firms use derivatives for other reasons, too. Gordon Bodnar, Gregory Hayt, Richard Marston and Charles Smithson, writing in Financial Management in 1995, found 28 percent of the firms they surveyed used derivatives to minimize earnings volatility. There is also evidence that firms use derivatives to reduce tax liability. The way managers are paid affects the extent to which firms hedge. In general, firms for which options are a more important component of managerial compensation are less likely to hedge. That makes sense: in many situations, managers who hold options benefit t from increased volatility, since their options will be worth more if the stock price rises but the option will never be worth less than zero if the stock price falls. Finally, firms sometimes do use derivatives to speculate. Banks and investment banks make markets in derivatives, but they also take positions in derivatives to manage risk. In the third quarter of 2003, the banks with the 25 largest derivatives portfolios held 96.6 percent for trading purposes and 3.4 percent for risk-management needs. Little is known about derivatives use by individuals. What evidence there is, though, suggests that individuals fail to exploit them fully. For example, home mortgages in the United States typically contain an embedded option the borrower has the option to prepay the mortgage. Typically, though, mortgage holders exercise this option later than justified by models of option pricing. The Risks of Derivatives Different types of derivatives have different levels of risk for this effect. For example, standardized stock options by law require the party at risk to have a certain amount deposited with the exchange, showing that they can pay for any losses; Banks who help businesses swap

variable for fixed rates on loans may do credit checks on both parties. However in private agreements between two companies, for example, there may not be benchmarks for performing due diligence and risk analysis. Unsuitably high risk for small/inexperienced investors Derivatives pose unsuitably high amounts of risk for small or inexperienced investors. Because derivatives offer the possibility of large rewards, they offer an attraction even to individual investors. However, speculation in derivatives often assumes a great deal of risk, requiring commensurate experience and market knowledge, especially for the small investor, a reason why some financial planners advise against the use of these instruments. Derivatives are complex instruments devised as a form of insurance, to transfer risk among parties based on their willingness to assume additional risk, or hedge against it. Large notional value Derivatives typically has a large notional value. As such, there is the danger that their use could result in losses that the investor would be unable to compensate for. The possibility that this could lead to a chain reaction ensuing in an economic crisis, has been pointed out by famed investor Warren Buffett in Berkshire Hathaway's 2002 annual report. Buffett called them 'financial weapons of mass destruction.' The problem with derivatives is that they control an increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities markets. Investors begin to look at the derivatives markets to make a decision to buy or sell securities and so what was originally meant to be a market to transfer risk now becomes a leading indicator. Leverage of an economy's debt: Derivatives massively leverage the debt in an economy, making it ever more difficult for the underlying real economy to service its debt obligations, thereby curtailing real economic activity, which can cause a recession or even depression. What Would Happen if a Major Dealer or User Collapsed? Bankruptcy law contains an automatic-stay provision that prevents creditors from requiring immediate payment, making it possible for their claims to be resolved in an orderly fashion. Interest-rate swaps and some other derivatives are exempted from this automatic stay, however. Instead, the parties to a swap contract use a master agreement that specifies how termination payments are determined in the event of a default. Without this exemption from the automatic stay, defaults on derivatives contracts would present a considerable problem, since counterparties

would in some cases have to wait (sometimes for years) for their claims to be adjudicated, leaving them with mostly un-hedge-able risks. Consider a bank that experiences a default on a derivative contract. It chooses to ask for termination of the contract and is due a payment equal to the market value of its position at termination. If the position was hedged, the bank has only the hedge on its books after the default, without having the contract it was trying to hedge. The banks risk has increased, and it may not have received the cash payments that were promised. The bank may then lack the liquidity to make payments it owes, which leads to further problems. Under normal circumstances, markets are sufficiently liquid that the bank can quickly eliminate the risk created by default. But the situation may be direr if the default occurs in a period of economic turmoil. If all banks are trying to reduce risk, they may all get stuck, because there is only a limited market for the positions they are trying to sell. In such a situation, the Federal Reserve would have to step in to provide liquidity. Given the central role of Treasury securities in dynamic hedging, the Fed might also have to intervene to settle down the Treasury market. Derivatives allow firms and individuals to hedge risks or to bear risk at minimum cost. They can also create risk at the firm level, especially if a firm is inexperienced in their use. For the economy as a whole, the collapse of a large derivatives user or dealer may create systemic risks. On balance, derivatives plainly make the economy more efficient. However, neither users of derivatives nor their regulators can afford to be complacent. For their part, regulators need to monitor financial firms with large derivatives positions very carefully. Though regulators seem to be doing a good job in monitoring banks and brokerage houses, the risks taken by insurance companies, hedge funds and government- sponsored enterprises like Fannie Mae and Freddie Mac are not equally well understood and monitored. Should we fear derivatives? Most of us choose to fl y on airplanes even though they sometimes crash. But we also insist that planes are made as safe as it makes economic sense for them to be. The same logic should apply to derivatives.

REFRENCES http://www.cob.ohio-state.edu http://www.angelfire.com http://en.wikipedia.org/wiki/Derivative_(finance) http://www.investopedia.com Capital Markets Institutions & Instruments by Frank J. Fabozzi & Franco Modigliani