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Derivatives Summary
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Detailed and well summarised study notes of the derivatives section taught in financial management at UCT (FTX2024S).
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DERIVATIVESINTRODUCTION
What is a derivative?
A financial instrument whose value / return is based on the value of some other underlying
asset.
- return derived from another instrument
- underlying asset: ordinary shares, bonds, maize, oil, gold & other minerals
- types: forwards, future, options & swaps
- 2 broad categories
buyer & seller locked into contract
&
allows buyer to walk away
Uses of derivatives
• Risk management – hedging:
- bear an economic risk & want to mitigate it
- want to lock in a certain price today
- protection against price changes
- hedgers deal with the commodity-they either own the commodity now or they are
interested in owning it in future
- exposure to possibility of loss BUT also leads to firm giving up possibility of gain
• Speculating
- not worried about risk ∵ take additional risk in the expectation of a gain
- betting on future price movements
- buying derivatives/ assets hoping to profit
allows the speculator to lock/fix a certain price
gain by locking a certain price and sell when prices change
- speculators have no interest in dealing with the commodity
use derivatives to profit from movements in future spot prices
,Market for derivatives
Exchange market Over-the counter market (OTC market)
Controlled by a stock exchange Informal market
Standardised terms Customised terms
FORWARD CONTRACTS
an agreement btw 2 parties (a buyer and a seller) to buy & sell an asset to be delivered at a
future date for a price agreed today (forward price, F 0).
- Delivery happens at a future specified date, but price is determined today
- Concern: subject to counterparty credit risk (other party fails to fulfil obligation)
- Allows buyer / seller to set price they will buy/sell an asset at a given date in future
- Contrasted with a spot contract, which is an agreement to buy/sell an asset today
Features of forward contract:
• Pre-agreed price, forward/contract price
- compare forward price to spot price
- forward price is the price to be paid in future & spot price is the market price now
- forward price generally not available in public domain.
- spot price is current price in the market at which a given asset can be bought/sold for
immediate delivery
• No exchange of cash and asset until delivery date
- on expiration date contract must be settled by delivery of asset & payment of cash
• Obligates seller to sell & buyer to buy (it’s a commitment)
• Traded between private parties, OTC markets, outside exchange markets
• Not regulated exposed to counter–party default risk
• Each contract is custom designed to meet specific needs
Parties of a forward contract:
Seller (e.g. wheat farmer) Buyer (e.g. bread manufacturer)
takes a short position/short forward position takes a long position/long forward position
hedger who already owns/intends to own the hedger who does not own the asset but require
underlying asset it for certain purposes.
, e.g. primary producer like a farmer or a miner e.g. manufacturer/refiner/miller
who produces wheat, maize, or gold
speculator speculator
Seller:
• sells underlying asset @ specified date in future @ a specified, pre-agreed price [lock/fix
selling price]
• Who is the seller?
- someone who has the asset & wants to sell it
• If you sell the contract, what is your risk exposure/concern/expectation?
- price below forward price
• By selling a forward contract you lock a selling price
- hedger protected against price fluctuations, you realise more especially if prices
decrease
- speculator positioned to buy at the decreased spot price & sell at the higher forward
price
Buyer:
• Commit to buy the underlying asset @ a specified date in future @ a specified, pre-
agreed price [lock/fix buying price]
• Who is the buyer
- someone who doesn’t have the asset but needs it in future like a miller, manufacturer
(hedger) OR it can be speculator
• What is your risk exposure/concern/expectation
- price increase above forward price
• By BUYING a forward contract you lock a buying price
- hedger protected against price fluctuations price increase
- speculator positioned to buy at the F0 and sell at increased spot price
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