Derivatives Lecture Notes

Why Study Derivatives?

• CFA Context: Derivatives are asset classes in the CFA syllabus.
• Exam Weightage: 5–8%, the least weightage along with portfolio management and AI.
• Relevance: All topics are important despite weightage differences to score well overall.
• Practical Significance: Hedging, trading, speculation. Important for risk management and many job roles, especially in IB operations.

Employment and Practical Applicability

• Importance: Relevant in markets, hedging, and speculation. Significant in job roles related to IB finance and operations.
• Broad Scope: Derivatives have more job openings than equities in some cases.
• Practical Use: Essential for interviews and job roles, e.g., hedging experience even without personal trading experience.

Basics of Derivatives

• Definition: Financial instruments deriving value from underlying assets (e.g., equities, commodities, bonds).
• Uses: Hedging risks and speculation.
• Examples: Equity, Commodities, Bonds, Interest Rates, Gold, Silver, Credit Default Swaps, Indexes, Weather.
• History: Exists for thousands of years; became mainstream in financial markets from the 1970s-80s.
• Regulation: Became stringent post-2008 financial crisis.

Types of Derivatives

• Forward Contracts: Agreement between buyer and seller to buy/sell an asset at future date and a fixed price.
• Futures Contracts: Standardized forward contracts traded on an exchange with margin and mark-to-market requirements.
• Options: Contracts offering the right, but not the obligation, to buy/sell an asset.
• Swaps: Agreements to exchange financial instruments or cash flows between parties.

Forward Contracts

• Characteristics: Customizable, between two parties, agreed price and date, no intermediary.
• Key Points:
  • Agreed upon at present for future transaction.
  • Can be used for hedging and speculation.
  • Risk of counterparty default exists.
  • Value at the start is zero.

Example: Currency Hedge Using Forward Contracts

• Scenario: Importing projectors from Singapore.
• Exposure: Order value dependent on future SGD/INR exchange rate.
• Solution: Enter into a forward contract to fix exchange rate and hedge against currency risk.
• Result: Risk limited to agreed rate, reducing potential losses due to currency fluctuations.

Futures Contracts

• Characteristics: Exchange-traded, regulated, standardized, involves margins and daily mark to market.
• Key Points:
  • Agreement to buy/sell at future date at a fixed price.
  • Less counterparty risk due to exchange involvement.
  • Requires initial margin and maintenance.
  • Adjusted daily for market value changes.

Example: Hedging Equity Position Using Futures

• Scenario: Buying futures contract for equity.
• Mechanism:
  • Daily mark-to-market adjustments based on futures price changes.
  • Initial and maintenance margin requirements.
  • Close monitoring of daily margin calls and PnL impacts.

Practical Implications and Risk Management

• Importance of Hedging: Reduces risk exposure to market fluctuations.
• Mark-to-Market Process: Ensures current market value reflection in contracts.
• Risk in Extreme Scenarios: Rare, but exchanges may stop trades, causing issues.

Example: Settlement Process in Futures Contracts

• MTM: Daily gain/loss adjustments until contract maturity.
• Impact on Balance Sheets: Changes in PnL and margin adjustments.
• Operational Considerations: Continuous tracking of derivative positions and reporting to senior management.

Summary

• Forwards and Futures: Key tools for risk management and speculation, each with unique characteristics.
• Relevance in Finance: Essential for financial markets, trading, and risk management strategies.