4TH YEAR (FINANCIAL DERIVATIVES) INTRODUCTION

INTRODUCTION
What are Financial Derivatives?
Derivatives are financial contracts. The value of financial derivatives is dependent on the
underlying asset. Underlying assets include stocks, bonds, commodities, interest rates, market
indexes, and currencies. The value of the underlying asset changes with the market movements.
The key motives (reasons) of a derivative contract are to speculate on the underlying asset
prices in the future and to guard (protect) against the price volatility of an underlying asset or
commodity.
Taking another example, derivative contracts are used to fix the price of a commodity to
minimize losses. For instance, dealing in the commodities market doesn’t necessarily involve
the physical delivery of the commodity.
To elaborate, a futures contract for onions doesn’t involve buying and selling onions. The value
of the contract is derived from the cost of buying and selling onions.
Therefore, derivatives aim to create a balanced exchange rate for assets. Hence, they are
popular options to hedge against price volatility.
Derivatives are securities whose value is dependent on or derived from an underlying asset.
For example, an oil futures contract is a type of derivative whose value is based on the market
price of oil. Derivatives have become increasingly popular in recent decades, with the total
value of derivatives outstanding was estimated at $610 trillion at June 30, 2021.
How Does a Derivative Market Work?
Trading in the derivatives markets is more or less the same as dealing in the cash segment of
the stock market. You will require a trading account to deal in derivatives.
Trading in the derivatives market is through Exchanges and Over the Counter (OTC).
Exchange-Traded Derivatives: Contracts that take place through a broker are exchange-
traded derivatives. Futures and options are exchange-traded derivative contracts. When you
purchase a stock option, you will be purchasing the option instead of the security.
Over the Counter Derivatives: Contracts that take place directly between two parties are over
the counter derivative contracts. Forwards and swaps are over-the-counter contracts. As a
result, these contracts are customized (modified) to suit the requirements of both parties to the
contract.
Furthermore, financial derivative contracts are not risk-free. They come with an inherent
(natural) risk of market volatility. Therefore, it is risky to trade in the derivatives market
without proper hedging mechanisms.
Who are the Participants in a Derivative Market?
Derivatives trading requires a good understanding of the stock market. Knowledge and time
to track the stock market movements are primal for participating in the derivatives market.
Therefore, derivatives are not everyone’s ball game.
Following are the participants in the derivatives market:

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4TH YEAR (FINANCIAL DERIVATIVES) INTRODUCTION

Hedgers: The main focus for hedgers is protection. Often known as risk-averse traders.
Hedgers like to protect themselves from possible price fluctuations in the future. Hedgers are
active in the commodities market where price fluctuations are rapid. Futures and options
trading can offer them the much-needed price stability in such instances.
Speculators: Speculators are risk-takers who wish to earn good profits. They constantly
monitor the markets, the news, and any other information that could affect their trading. As a
result, speculators place an educated wager on the underlying asset’s price. In simple terms,
speculators seek to purchase an asset at a lower price in the short term while betting on bigger
returns in the long run.
Arbitrageurs: Arbitrageurs take advantage of the price difference of the same asset across
different exchanges. Arbitrageurs buy securities at a low cost in one market and sell them at a
higher price in a different market.
Margin Traders: Brokers in the derivatives market require a deposit/ margin amount from
investors. Margin amount is a minimum amount that investors have to deposit with the broker
to trade in the derivatives market. As a result, the trader can maintain a sizable outstanding
position.
Types of Financial Derivatives
The most popular types of Financial Derivatives are:
Futures
Futures are a type of derivatives contract where the buyer and seller enter into an agreement
to fix the quantity and price of the asset. The agreement has the quantity, price and date of the
transaction mentioned. Upon entering into the contract, the buyer and seller are obligated to
fulfil their duty regardless of the asset’s current market price. Futures contracts are popular
for hedging risk and speculation. However, the main purpose is to fix the price of the asset
against volatility.
Options
Options also derive their value from the underlying asset. The option holder is not obligated to
buy or sell the asset on expiry. Following are the two types of options:
Call Option: The buyer of a call option has the right, but not the obligation, to purchase the
asset at the stated price on the specified date.
Put Option: A put option holder has the right but not the obligation to sell the underlying asset
at a specific price on a specific date. Forwards
Forward contracts are similar to futures contracts. The contract holder is under the obligation
to fulfil the contract. However, these contracts are not standardized and do not trade on the
exchange. Forward contracts are over the counter contracts. As a result, these are customized
contracts to suit the requirements of the buyers and sellers (parties to the contract).

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4TH YEAR (FINANCIAL DERIVATIVES) INTRODUCTION

Swaps
Swaps are derivative contracts that help two parties to exchange their financial obligations.
Corporates use swap contracts to minimize and hedge their uncertainty risk of certain
projects. There are four types of swaps. Namely, interest rate swaps, currency swaps,
commodity swaps and credit default swaps.
The most popular type of swap is a credit default swap. A credit default swap provides
insurance from a debt default. The buyer of the swap gives the seller the premium payments.
In case of a default, the seller will pay the buyer the face value of the asset. At the same time,
the seller will get possession of the asset.
Why Do Investors Choose Financial Derivatives?
Following are the key reasons why investors choose financial derivatives:
To address market volatility: Financial assets are highly volatile. The price fluctuations can
often lead to heavy losses. You can leverage the financial derivatives to minimize your losses.
Suitable derivatives contracts can help shield you from price falls as well as price rise, as the
case may be.
Arbitrage opportunities: Derivative contracts have good arbitrage
opportunities. Arbitrage involves buying an asset at a low price in one market and selling it at
a high price in another market. The difference between the prices is the profit that you will
make.
Advantages and Disadvantages of Financial Derivatives
Advantages
Lock in Prices: With derivatives, investors can lock in the prices of the assets. If they expect
the asset prices to go down in the future, through derivative contracts, they can lock in the
present prices.
Hedging: Derivatives are popular for hedging. Individuals can enter into a derivative contract
where asset value moves in the opposite direction to the asset value they already own.
Leverage: Derivatives are leveraged products. Investors can get access to higher capital
through leverage, i.e., they can get access to more money than actual cash in hand.
Disadvantages
High Risk: Derivatives are high-risk investment options. Their high volatility may lead to huge
losses.
Leverage: (In finance, leverage is a strategy that companies use to increase assets, cash flows,
and returns, though it can also magnify losses.) Leverage can work as an advantage as well as
a disadvantage. If the asset prices move in the opposite direction than your anticipation, the
losses can be huge.
Counter-Party Risk: Some derivative contracts are over-the-counter contracts. For such
contracts, the counterparty default risk is high.

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4TH YEAR (FINANCIAL DERIVATIVES) INTRODUCTION

Authorized Derivative Dealers:

2. Deutsche Bank AG

3. Faysal Bank Limited

4. Habib Bank Limited

5. MCB Bank Limited

6. Standard Chartered Bank (Pakistan) Limited

7. United Bank Limited

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AMNA ASIM SHAIKH