Derivatives

We view them as time bombs both for the

parties that deal in them and the economic system ...
In our view ... derivatives are financial weapons of
mass destruction, carrying dangers that, while now
latent, are potentially lethal
Warren Buffett
1. Before reading the text, try answering the following questions:
What are derivatives mainly used for?
Is there any Romanian derivatives Stock Exchange?
Do derivatives hedge the risk of owning things that are subject to price fluctuations? If
yes, what would be those things?
Do derivatives encourage fraudulent trading?
2. Match the following terms with their correspondent explanations: futures, forward,
option, swap, put option, call option, margin-equity ratio, exercise price (strike price)
The right, but not the obligation, to buy or sell a specific amount of a given stock,
commodity, currency, or debt, at a specified price during a specified period.
A contract obliging one party to buy and other party to sell equities, commodities or
currencies at a specific future date.
The price at which the holder of a call/put option may buy/sell the underlying security.
It is the exchange of one security for another one because investment objectives have
changed.
An option contract that gives the holder the right to sell a certain quantity of an
underlying asset to the writer of the option, at a specified price up to a specified date.
A standardized, exchange-traded contract that requires delivery of a commodity, bond,
currency, at a specified price, on a specified future date.
An option contract that gives the holder the right to buy a certain quantity of an
underlying asset from the writer of the option, at a specified price up to a specified
date.
It is a term used by speculators, representing the amount of their trading capital that is
being held as spread at any particular time.

The derivatives markets are the financial markets for derivatives.

Derivatives market

Exchange trade
derivatives

Future

Forwar

Over-the-counter
derivatives

Swap

Options

Over-the-counter (OTC) derivatives are contracts that are traded directly between two
parties, without going through an exchange or other intermediary.
Exchange-traded derivatives are those derivatives products that are traded by means of
derivatives exchanges. Derivatives exchanges act as intermediaries to all transactions.

FUTURES

FORWARDS

Types of
Derivative
s

OPTIONS

SWAPS
A derivative is a financial contract:
Trading assets (such as commodities, shares, bonds)
Taking into account the performance of interest rates, exchange rates, but according to
consumer price indexes, stock market indexes.
Futures contract
A futures contract is a standardized contract, traded on a futures exchange, to buy or sell
certain types of assets, at a certain date in the future, at a pre-set price.
The future date = the delivery date
The pre-set price = the futures price
The price of the underlying asset on the delivery date = the settlement price
The futures price converges towards the settlement price on the delivery date.

Futures contracts are highly standardized, to ensure that they are liquid. The
standardization usually involves specifying:
The type of settlement, e.g. cash
The amount or units of the underlying asset e.g. bonds, foreign currency, wheat, oil
The currency in which the futures contract is quoted.
The type of the deliverable (in case of e.g. bonds), quality and location of delivery
(e.g. in case of goods).
The delivery month
The last trading date
The value of a contract when traded could be zero, but its price continually fluctuates.
This creates a credit risk to the exchange. To minimize this risk, the exchange demands that
contract owners come up with a form of collateral commonly known as margin. There are two
kinds of margins: maintenance margin and initial margin.
3. Fill in using maintenance margin or initial margin:
..is paid by both buyer and seller. It represents the loss on that contract, as
determined by past price changes
Because a series of unfavorable price changes may wear out the., a further
margin, usually called., is necessary to the exchange. This is calculated by
agreeing a price at the end of each day, called the settlement price of the contract.
4. Read the short paragraph below and choose each time the best option out of two:
Traders would rarely hold 100% of their capital as margin. The probability of losing their
entire capital someday would be low/high. By contrast, if the margin-equity ratio is so
high/low as to make the traders capital equal to the value of the futures contract itself, then
they would not profit from the leverage contained in futures trading. A conservative trader
might hold a margin-equity ratio of 15%/40%, while a more aggressive trader might hold
15%/40%.
Forward contract
A forward contract is an agreement between two parties to buy or sell an asset at a pre-agreed
future point in time. Therefore, the trade date is not to be confused with delivery date. A
forward contract is used to control and hedge risk, e.g.:
Currency exposure risk (e.g. forward contracts on USD or EUR);
Or commodity prices (e.g. forward contracts on grains, oil).
5. Decide which option out of the two is the best one:
In a forward transaction, no cash changes hands. If the transaction is backed up by some sort
of collateral, exchange of margin/capital will take place according to an arranged/preagreed schedule. Otherwise, no asset of any kind actually changes hands, until the
maturity/deadline of the contract.

Futures vs. Forwards

6. Complete the gaps in the following text by using the terms futures and forward:
The main differences between futures contracts and forward contracts are:
..are always traded on an exchange, whereas ..always trade over-the-counter
...is unique, are highly standardized
The price at which the contract is finally settled is different:
are settled at the settlement price fixed on the last trading date of the contract
are settled at the price agreed on the trade date
The credit risk of futures is much lower than that of forwards:
The profit or loss on a..position is exchanged in cash every day. After this, there is
no credit exposure.
The profit or loss on a contract is only realized at the time of settlement, so the
credit exposure can keep increasing
Option
An option is a contract where the holder or buyer has the right but not the obligation to
buy securities, currencies, commodities on or before a future date (the exercise date). The
writer or seller has the obligation to honor the contract. Since the option gives the buyer a
right and the seller an obligation, the buyer has received something of value. The amount the
buyer pays the seller for the option is called the option premium.
The holder of the option has the right but not the obligation to buy (call option) or sell
(put option) a specified amount of a security within a specified period.
7. There are different types of options. Match each type with the proper explanation:
real option, exchange traded option, vanilla option, exotic option
It is a simple option; examples would be European options and American options on
stock and bonds.
It is a choice that an investor has when investing in the real economy. This option is
the opportunity to change production inputs. It is not very liquid.
It has a systematic pricing and is settled through a clearing house.
It is an option where the underlying instrument is more complex than simple equity or
debt; examples would be Asian options.
The option contract
For the option holder, the option:
Offers the right, but no obligation
to buy (call option) or sell (put option)
a specific quantity
of a given financial underlying (e.g. bonds)
at an agreed price (exercise or strike price)
on one or more call dates
in exchange for a premium (option price).

The option seller has an obligation to fulfill the contract if the option holder exercises
the option. In return, the option seller receives the option premium.
If you expect the value of a share that you own to fall below its current price, you can
buy a put option at the respective price or you could write a call option giving someone else
the right to buy the share at the current price: if the market price is below the respective price,
no one will take up the option and you earn the premium.
If you think a share will rise, you can buy a call option giving the right to buy at the
current price, hoping to resell the share at a profit. You can also write a put option giving
someone else the right to sell the shares at the current price: if the market price is above the
respective price, no one will take up the option and you earn the premium.
A call/put option has intrinsic value if its exercise price is below/above the current
market price of the underlying share. Call options with an exercise price below the underlying
shares current market price and put options with an exercise price above the shares market
price are describes as being in -the -money.
Call options with an exercise price above the underlying shares current market price
and put options with an exercise price below the underlying shares market price are out-ofthe-money.
8. Match the three statements with their respective halves:
Buyers and sellers of exchange-traded options do not usually interact directly..
The seller guarantees that he can fulfill his obligation
The risk for the option holder is limited.
the futures and options exchange acts as intermediary
he cannot lose more than the premium paid
if the buyer chooses to execute
Swap
Swaps are often used to hedge certain risks, for instance interest rate risk. Another use
is speculation.
Swaps are negotiated outside exchanges. They cannot be bought and sold like
securities or futures contracts, but are all unique. As each swap is a unique contract, the only
way to get out of it is by either mutually agreeing to tear it up, or by reassigning the swap to a
third party, obviously with the approval of the counterparty.
9. There are different types of swaps; match them with the explanations provided
below: total return swap, commodity swap, basis swap, interest rate swap, equity
swap
.is the most common type of swap. It exchanges fixed rate payments against
floating rate payments. Exceptions exist, such as floating-to-floating swaps, known
as.

is a swap, where one entity pays the total return of an asset, and a different entity
makes periodic interest payments. The entities involved have exposure to the return of
the underlying assets, without having to hold the underlying assets.
..is a contract in which entities agree to exchange payments related to indices, at
least one of which is a commodity index.
..has a stock, a basket of stocks, or a stock index as the underlying asset; in this
case you do not have to pay anything before, but you do not have any voting rights.

10. Establish whether the statements written below are true or false:
The price of forward contracts is determined the moment the contract is signed.
Swaps are used to exchange fixed with floating interest debts.
Futures contracts are non-standardized contracts.
A call option with an exercise price below the underlying shares current market price
is in in-the-money.
You could write a call option giving someone else the right to sell the share at the
current price.
Hedging also means speculating.
If you expect the value of a share that you hold to increase above its current price, you
can buy a put option.
Task
Work in pairs and establish which kind of investment you would choose to make and
what kind of contract you would conclude for each type of asset.