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FL09 - Derivatives
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Lecture notes of 10 pages for the course Law of Finance, Credit and Security at KCL (FL09 - Derivatives)
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FL09 – Derivatives 27/11/15 Prof. Michael ShilligDERIVATIVES
INTRODUCTION
How to reduce credit risk
o 1. Share among many – loan syndication and bond issue (week 5 &
6)
o 2. Get security (week 7 & 8)
Secured debt
Title based finance
o 3. Transfer to others (securitisation – week 10)
o 4. Hedge (derivatives – week 9)
The way to hedge risks is through derivatives
o 5. Monitoring/influencing borrower behaviour (covenants) – week 5
o 6. Better ranking than others: subordination – week 5
Overview of derivatives
o Types of derivative contracts
o Put-call parity and option pricing
o Main uses of derivatives
o Policy considerations
TYPES OF DERIVATIVES
Derivative = a financial asset whose value is driven by the value of some
other asset or assets (could be financial or otherwise)
Forwards and futures
o Forward contract = unconditional promise to buy/sell some
underlying asset at a specified price (forward price) on a specified
date (settlement/maturity date)
Financial asset or tangible asset
Foreign exchange markets
o Futures contract = similar to forward, except underlying asset is not
actually transferred but (cash) settled by offset and parties
positions are marked to market on a daily basis
Mutual compensation for marginal changes (margin calls)
Exchange traded
Petroleum futures
o Difference between forwards and futures
Forward contracts are OTC (over the counter) contracts –
negotiated between parties
Futures are standardised and can be tradable
Swaps = unconditional promise between two counterparties to exchange
cash flows calculated on a different basis from the other
o Interest rate swap – based on notional amount, fixed interest
payments are exchanged for floating interest payment
Used to hedge against risk of changing interest rates
o Currency swaps – payments in one currency are exchanged for
payments in different currency
Hedge against fluctuations in exchange rates
o Equity swap (contract for difference) – cash flows based on share
price movements (up or down) are exchanged for a fixed ‘premium’
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