Financial Derivatives

A ‘derivative’ is a financial product the

value of which is derived from the value of
the underlying asset.
Derivatives are widely used in developed
financial markets to speculate on currencies
and financial assets.
Also used to hedge portfolio risk and
hedging exposures by corporate finance
managers.
Types of derivatives
a) Future contract
b) Option contracts
c) Swaps
d) Engineered products based on the
combination of futures, options, equity and
bonds
Swaps:
swap is an agreement between two or more
parties to exchange sets of cash flows over
a period in future.
Basic kinds of swaps:
3. Currency swaps
4. Interest rate swaps
An interest rate swap is an arrangement
whereby one party exchanges one set of
interest rate payment for another.
Types
1) Plain vanilla swaps
2) Forward swaps
3) Extendable swaps
4) Callable swap
5) Puttable swap
6) Zero coupon for floating swaps
7) Rate capped swaps
8) Equity swaps
Swap facilitators
economic agents who bring together counter-
parties and help consummate the swap contract.
Two types:
3. Broker- agents that identify and bring together
counter parties.
4. Swap dealers- themselves become counterparties
and assume risk.
Face two problems:
6. How to price swaps to provide for the services.
7. How to manage portfolios.
Swap market
The market where the counter parties
meet and arrange transactions for
exchanging the cash flow.
 Characteristics
 Limitations
Risks of interest rate swaps
 Basic risk
 Credit risk
 Sovereign risk

Price determination on swaps

Setting interest rate for a swap transaction is k/a
pricing a swap. Main determinant:
 Prevailing market interest rates
 Availability of counterparts
 Credit risk involved
 Expected sovereign risk
Mechanism
Nature of Fixed rate bond Variable rate
company bond
Quantity co. 9% LIBOR + 0.5%
Risky co. 10% LIBOR + 1%

Swap structure

Quantity co. Risky co.

LIBOR + 1%
9%

Investor
Investor
Currency swaps
Agreement whereby currencies are
exchanged at specified exchange rates at
specified intervals

currency swaps can be used to hedge the

payments which may have to be paid as a
result of debt as interest rate payment in
future.
Future market
A future contract is an arrangement for future
delivery of a specified quantity of an asset at a
specified price.
Principal features
 organized exchange
 Standardization
 Clearing house
 Margins
 Marking to market
 Actual delivery is rare
Options markets
Option means a ‘choice’ available to investors
regarding honoring the contract to buy or sell a
currency at some future date.
 Call option
 Put option
 Strike price/ exercise price
 Maturity date
 American option
 European option
 Premium (option price, option value)