Derivative Financial Instruments

Derivative financial instruments often termed as ‘derivatives’ are financial instruments that derive their value from the performance of underlying items which may be an asset, index, interest rate, or exchange rate. Basically it is an agreement between two parties which will result in a gain for one party and loss for the other based on changes in the value of a specified item.

Derivatives have the following special characteristics.

  1. It requires no net initial investment
  2. Its value change in response to changes in specified items (i.e. interest rate, commodity rate, currency exchange rate
  3. It is settled at a future date

Uses of derivatives

The primary uses of derivatives are:

  1. Hedging i.e. to mitigate risk related to stock prices, exchange rate, interest rates, etc. by entering into derivatives contracts whose value move in opposite direction to the underlying item such that loss in the underlying item is mitigated by again in derivative and vice versa
  2. Profit earning through speculation if the value of underlying item moves in line with the expectation of the owner

Forms of derivatives

Derivatives are of two types:

  1. Over the counter: (specific/ tailored arrangement between two parties)
  2. Exchange-traded (available through exchanges market dealing in derivatives)

Following are the common examples of derivatives:

1. Forwards Customized contract between two parties where payment is made at a future date at a pre-determined price.
2. Futures Contract to buy or sell an asset on a future date at a pre-agreed price. Future contracts are standardized and can be bought or sold through an Exchange.
3. Options Contract that give an option to the owner to buy or sell an asset till a certain maturity date at a strike price which is pre-agreed.

 

Option to buy an asset is called “call option” while option to sell an asset is called “put option”.

Like Futures, option contracts are also available in standardized form and can be bought or sold through Exchange.

4. Swaps Contract to exchange cash flow on or before a specified date based on underlying value of currencies exchange rates, interest rates, stocks etc.

 

Contract involving interest related cash flows are called “interest rate swaps” while those involving different currencies are called “currency swaps”.

Example: Currency futures as a risk management tool

Consider the following data:

  • Company P Inc. operates in the USA and imported goods on November 12, 2015worth £ 650,000 from Company Q Plc. in England payment for which is due on February 20, 2016
  • The current currency spot rate for $/£ is 1.4850/1
  • March futures are currently trading at 1.4960 with a contract size of £62,500 (Pound futures are available in standard sizes of 62,500. While maturity periods are also standard (March, June, September, and December. In our example our receipt in expected in February so we’ll have to use March futures.

In the above data, the paying company P Inc. has an exchange rate fluctuation risk. If Pound Sterling strengthens against the US Dollar then it will have to pay additional than now and vice versa.

If P Inc. wants to hedge this risk using currency future it needs to buy sterling futures now and sell those on February 20, 2016. To determine how many future contracts it would need, simply divide the amount to be hedged by the standard contract size.

= 650,000 = 10.4  round to 11 contracts
   62,500

Actual situation on February 20, 2016

Assume that on actual payment date i.e. February 20, 2016, pound strengthened against the dollar and is being traded at $/£ is 1.5030/1, and March futures are trading at 1.5120.

Gain / Loss on actual payment and future contracts

Loss on actual transaction:

Amount payable at November 10, 2015 (£625,000 x 1.4850) $965,250
Amount actually paid on February 20, 2016 (£625,000 x 1.5030) $ 976,950
Additional payment (loss) due to exchange rate fluctuation $ 11,700

Gain on future contract:

Future contract bought at Nov 10, 2015 (£62,500 x 10 x 1.4960) $1,028,500
Future contract sold at Feb 20, 2016 (£62,500 x 10 x 1.5120) $1,039,500
Gain on future contracts $ 11,000

In above example we have seen how future contract works as well how it can be used to hedge the exchange rate fluctuation risk. The loss/ additional payment of $ 11,700 has been largely offset by the gain in future contract.

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