Overview of Advanced

Market Products
Overview and Concept
Derivatives
November 5, 7 and 9, 2013

Derivative
Financial instrument that offers a return
based on the return of some other
underlying asset
Underlying asset classes are interest rate,
foreign exchange, equity and commodity

Derivatives Dealers
Commercial and
investments banks
that make markets in
derivatives
Also known as
market makers

Derivative Valuation
Value of a
derivative is the
amount of cash that
has to be paid or
received today in
exchange for that
derivative
instrument

Relationship Between Cash/Spot and

Derivative Market
Last to
develop

Options Markets

Buy Calls
Sell Puts

Pricing,
Hedging and
Valuation

Forward
Price and
Liquidity

Buy Puts
Sell Calls

Forward Markets
(Forwards, Futures and Swaps)

Forward
Purchases

Pricing,
Hedging and
Valuation

Underlying
Price and
Liquidity

Cash

Forward
Sales

Cash

Cash/Spot Markets

Buyers

Sellers

(Currencies and Interest Rate)

Assets

First to
develop

Assets

Cash/Spot Market
Cash/spot market instruments can be
exchanged directly into cash and typically
accrue income

Derivative Market
Offers alternative method of trading the
cash market, usually in the future, without
requiring legal ownership of the underlying
cash asset
Difference between cash/spot market and
derivative market is the time value of
money
Priced from the cash/spot market

Relationship Between Cash/Spot and

Derivative Market
Financial Markets

Derivative Financial Market

Supply/Demand for Capital

Supply/Demand for Hedging

Instruments for Money/Spot or
Capital Market Investments

o Capital Market
o Money Market
o Bank Deposit Market
o Bank Credit Market
o Other Investments

o Futures
o Forward Rate Agreements
o Swaps
o Options
o Warrants

Monetary Market

Derivative Financial Market

Derivative
Financial Market

Stock
Exchanges

Over the Counter (OTCF)

Forward Rate Agreements

Caps, Floors, Collars
Futures
Exchanges

Securities
Exchanges

Options, Futures

Warrants,
Structured Products

Treasury Trading Process Flow

Why Value Derivative?

Determine the cash
value or replacement
cost of a derivative
from given market
prices like foreign
exchange rates, bond
prices and security
yields

Price of Derivative
Current market quotation or rate of
exchange for a derivative instrument

Value of a Derivative
Amount of cash that would be paid or
received today in exchange for the
derivative instrument

Price of Derivative
Interest Rate Swap
Current price of IRS is fixed swap interest rate
Value of an existing swap is the present value
of difference between the future cash flows
created by the original traded fixed swap rate
and the current swap rate

Option
Value of an open option contract is the
difference between original traded premium
and the current market premium

Elements of Derivative Valuation

Financial Market Prices
Accessible prices in the cash/spot markets

Time Value of Money

Derivatives have potential of creating cash
flows in the future
Cash flows happening at different times have
different vales thus the need to account for
time value of money

Elements of Derivative Valuation

Law of Equivalent Value
All derivatives can be broken down into
combinations of physical instruments and/or
other derivatives
Value of a derivative should always equal the
sum of the value of its components

Uncertainty
Future cannot be predicted with certainty

Types of Derivative Positions

Forwards/Futures
Contracts

Options
Contracts

Long Position
Short Position
Calls

Long Position
Short Position

Puts

Long Position
Short Position

Developing Pricing and Valuation Models

Establish contract terms
ISDA contract used
Contract terms
Specify underlying instrument and future rights and
obligations the contract creates

Create synthetic replication

Refers to combination of cash and derivative financial
instruments to create another financial instrument
In valuation, identifies all the spot prices that combine
to determine the derivatives price or value

Developing Pricing and Valuation Models

Compute derivative price
Determine current market price of derivative using
concept of equivalent value
Equivalent value or value of a derivative should be
equal to its component parts

Compute derivative value

Determine current market price of derivative
Compare cash flows created by existing contracts to
cash flows created at current market price
Present value of their differences is the value of the
derivative