Subject: Financial derivatives and Risk Management ( Finance)

Semester: VIII

College: Birgunj Public College ( BPC)

By Abdul Rahman Sir

Unit: 1 Introduction
CONCEPTS OF FINANCIAL DERIVATIVES
Definition: A derivative is a financial contract between two parties which derives its
value/price from an underlying asset.

Meanings: A financial derivative is a financial contract whose value is based on

something else. Specifically, the term financial derivative refers to a security whose
value is determined by, or derived from the value of another asset. The asset or
security from which a derivative gets its value is called an underlying asset.

An underlying asset might come in many forms but are most commonly stocks,
bonds, commodities, interest rate and currencies. The change in the value of a
derivative’s underlying asset causes a change in the value of the derivative itself.

Derivatives are traded at different market places. Derivatives are mostly traded on
Exchanges Market or over-the-counter (OTC). There are two types of derivative
markets or derivatives trading platform.

1. OTC (Over -the- Counter)

2. Exchange Market

The underlying asset’s value keeps changing according to market conditions. It is

extremely risky as the underlying value is exposed to various market sentiments
and other political, economical and social changes. To make the concept clearer,
here is a general example of a sugarcane farmer and a sugar manufacturer.

A decrease in the price of sugarcane is bad for the sugarcane farmer as he cannot
earn profits for his sugarcane. On the other hand, an increase in the price of
sugarcane is not good for sugarcane manufactures as they have to pay more to the
producers which will increase their cost.

The sugarcane farmer is worried about the constant fluctuation in sugarcane prices
in the market. He expects to sell his sugarcane produce quantity at the current
market price of NPR 2000 per quintal after 4 months. However, there is no
guarantee that the price of sugarcane might not decrease after 4 months.

To avoid this risk, the sugarcane farmer enters into a contract with the sugar
manufacturer (or a commodities broker) to sell his sugarcane produce quantity after
4 months at the current market price of NPR 2000. Incase if there are any changes
in the current market at certain point of time. (future)

Therefore, if after 4 months the price of sugarcane falls to NPR 1970 or rises up to
NPR 2020, the farmer will be bound to sell his sugarcane produce quantity at NPR
2000 per quintal and the broker or the sugar manufacturer will be bound to buy the
same.

In this way, this example simply explains how a derivatives contract works. In this
situation the underlying asset is the sugarcane produce (commodity) from which
the contract is deriving its value of sugar.

CHARACTERISTICS/ FEATURES OF FINANCIAL DERIVATIVES

1. It is a financial Derivative is a contract: Derivative is defined as the future

contract between two parties. It means there must be a contract-binding on the
underlying parties and the same to be fulfilled in future. The future period may
be short or long depending upon the nature of contract, for example, short term
interest rate futures and long-term interest rate futures contract.

2. Derives value from underlying asset: Normally, the derivative instruments have
the value which is derived from the values of other underlying assets, such as
agricultural commodities, metals, financial assets, intangible assets, etc. Value
of derivatives depends upon the value of underlying instrument and which
changes as per the changes in the underlying assets, and sometimes, it may be
nil or zero. Hence, they are closely related.

3. Specified obligation:( legally binding contracts) In general, the counter parties

have specified obligation under the derivative contract. Obviously, the nature of
the obligation would be different as per the type of the instrument of a
derivative. For example, the obligation of the counter parties, under the different
derivatives, such as forward contract, future contract, option contract and swap
contract would be different.
4. Direct or exchange traded: The derivatives contracts can be undertaken directly
between the two parties or through the particular exchange like financial futures
contracts. The exchange-traded derivatives are quite liquid and have low
transaction costs in comparison to tailor-made contracts. Example of exchange
traded derivatives are Dow Jons, S&P 500, Nikki 225, NIFTY option, S&P Junior
that are traded on New York Stock Exchange, Tokyo Stock Exchange, National
Stock Exchange, Bombay Stock Exchange and MEX, COMEN and NDEX in Nepal.

5. Predetermine life: Derivatives have a maturity or expiry date post which they
terminated automatically.

6. Involves forward transaction: Transaction between two parties in the derivatives

takes place or executed in the future specific dates.

7. Delivery of underlying asset not involved: Usually, in derivatives trading, the

taking or making of delivery of underlying assets is not involved, rather
underlying transactions are mostly settled by taking offsetting positions in the
derivatives themselves. There is, therefore, no effective limit on the quantity of
claims, which can be traded in respect of underlying assets.

8. Secondary market instruments: Derivatives are mostly secondary market

instruments and have little usefulness in mobilizing fresh capital by the
corporate world, however, warrants and convertibles are exception in this
respect.

9. Exposure to risk: In derivatives markets there are many risks associated such as
operational risk, counterparty risk and legal risk. Further, there may also be
uncertainty about the regulatory status of such derivatives. Both the parties
doing any kind of contract are most exposure about the risk associated.

10.Zero-sum game: Zero Sum game is the game in which one party’s gain always
equal to the loss of others party. Financial derivatives are the zero game as one
makes profits in the expense of others.

11.A derivative can be used as leverage Instruments.

12.There are no specific limits on the number of units that can be transacted in the
derivative market.

USES/IMPORTANCE OF FINANCIAL DERIVATIVES

1. To minimize risk (Hedging). Risk aversion is the tendency to avoid risk). averse
risks through various strategies like hedging, arbitraging, spreading etc. Derivatives
are used in highly volatile financial market conditions.
 2. To explore new investment opportunities:
3. To be aware of the risks and benefits associated with the derivatives.
4. To make riskless profit from market inefficiency.
5. To increase risk and return (speculation).
6. To be aware of effects of derivatives on the primary securities.

7. Financial Derivatives for prediction of future prices: Derivatives serve as a barometer

of future trends in prices for the security and hence help in discovery of new prices in
the spot and future market.

8. Financial derivatives enhance liquidity: Derivatives trading is basically based on

margin trading hence a large number of traders, speculators, arbitrageurs are
operating in the derivative market. Such trading enhance liquidity and reduce
transaction cost for underlying assets.

9. Derivative is an investing instrument hence assisting investors while making

investment decisions: Derivatives provide alternatives for the investors, traders and
fund managers for asset allocation.

10. Financial derivatives assist in financial market growth: OR Market efficiency:

Derivative market allows investing grounds to different market operators such as
speculators, hedgers, traders and arbitrageurs based on the preferred risks. This
leads to an increase in trading volume in the country.

FUNCTIONS/ROLE OF THE FINANCIAL DERIVATIVE MARKET

1. Risk management (hedging) for example, to reduce the risk investor choose to purchase
a spot item ad sell a futures contract.

2. Price Discovery: Derivatives assist in defining prices of underlying assets and future spot
rates for the commodity.

3. Transfer of risks: Derivative is a contractual investment tools hence, transfer the risk
from one party to another i.e., buyer to the seller.

4. Maintaining liquidity: Liquidity can b maintain from derivative association with the cash
market.

5. Check on Speculation: Derivative helps in hedging the risk against unfavorable price
movements of assets with the help of future and forward contracts.

6. Encourage young investors and entrepreneurs.

7. Motivates and increases savings and investments.

DANGER OF DERIVATIVES
Derivatives are very versatile instruments. They can be used for hedging, speculation, and
arbitrage. One of the risks faced by a company that trades derivatives is that an employee
who has a mandate to hedge or to look for arbitrage opportunities may become a
speculator.

Nice Leeson, an employee of Barings Bank in the Singapore office in 1995, had a mandate to
look for arbitrage opportunities between the Nikkei 225 futures prices on the Singapore
exchange and those on the Osaka exchange. Over time Leeson moved from being an
arbitrageur to being a speculator without anyone in the Barings -London head office fully
understanding that he had changed the way he was using derivatives. He began to make
losses, which he was able to hide. He then began to take bigger speculative positions in an
attempt to recover the losses, but only succeeded in making the losses worse.

By the time Leeson's activities were uncovered the total loss was close to 1 billion dollars. As
a results Barings -a bank that had been in existence for 200 years - was wiped out. One of
the lessons from Barings is that it is important to define unambiguous risk limits for traders
and then monitor carefully what they do to make sure that these limits are adhered to .

Source: John C.Hull

Further from above case: In general, the risks associated with derivatives can be
classified as

1. Credit Risk
2. Market Risk
3. Price Risk,
4. Liquidity Risk,
5. Operations Risk,
6. Legal Or Compliance Risk,
7. Foreign Exchange Rate Risk,
8. Interest Rate Risk, And Transaction Risk.