TOPIC 3: FINANCIAL
INSTRUMENT
LEADER:
BEREBER,NATHALIE D
MEMBERS:
DIAZ, CHRISTIAN DAVE
DOLLETE, KATHLEEN
EBORDE,CHARLIE
FINANCIAL INSTRUMENT
Financial institutions do a huge volume of trading involving a wide
range of different financial instruments. There are a number of
reasons for this.
a. some trades are designed to satisfy the needs of their clients,
some are to manage their own risks,
b. some are to exploit arbitrage opportunities,
c. and some are to reflect their own views on the direction in which
market prices will move.
THE MARKETS
There are two markets for trading financial
instruments.
1. Exchange Trade Market
2. Over The Counter Market
1.Exchange Trade Market
Exchanges have been used to trade financial products for many years.
The role of the exchange is to define the contracts that trade and
organize trading so that market participants can be sure that the trades
they agree to will be honored.
Traditionally individuals have met at the exchange and agreed on the
prices for trades, often by using an elaborate system of hand signals.
Most exchanges have now moved wholly or partly to electronic trading.
Sometimes trading is facilitated with market makers. These are
individuals or companies who are always prepared to quote both a bid
price (price at which they are prepared to buy) and an offer price (price
at which they are prepared to sell).
2. Over The Counter Market
The OTC market is a telephone- and computer-linked network of
traders who work for financial institutions, large corporations, or
fund managers.
Most of the trading by banks is in the OTC market. Banks often act
as market makers for the more commonly traded instruments
A key advantage of the over-the-counter market is that the terms
of a contract do not have to be those specified by an exchange.
Market participants are free to negotiate any mutually attractive
deal. Phone conversations in the over-the-counter market are
usually taped.
CREDIT RISK
One difference between exchange-traded markets and OTC
markets concerns credit risk.
These exchanges have organized themselves so that credit risk
is almost completely eliminated. Steps are usually taken to
reduce credit risk in OTC trades, but some credit risk always
remains.
Regulators are concerned about what is known as systemic
risk. This is the risk that a default by one bank creates losses
by other banks that have traded with it. This, in turn, may lead
to more bankruptcies and severe problems for the financial
system.
CREDIT RISK
1. LONG AND SHORT POSITIONS IN ASSETS
The simplest type of trade is the purchase of an asset for cash or the sale of
an asset that is owned for cash.
2. SHORT SALE
In some markets it is possible to sell an asset that you do not own with the
intention of buying it back later. This is referred to as shorting the asset
1. Derivatives Market
A derivative is an instrument whose value depends on (or derives
from) other more basic market variables.
A stock option, for example, is a derivative whose value is
dependent on the price of a stock.
Derivatives trade in both the exchange-traded and OTC markets.
Both markets are huge. Although the statistics that are collected
for the two markets are not exactly comparable, it is clear that the
over-the-counter derivatives market is much larger than the
exchange-traded derivatives market.
>PLAIN VANILLA DERIVATIVES
These are the standard, or commonly traded, contracts in derivatives markets.
They are known as a plain vanilla derivatives products.
1.FORWARD MARKET
2.FUTURE MARKET
3.SWAP
4.OPTION
Forward Contracts
A forward contract is an agreement to buy an asset in the
future for a certain price.
Forward contracts trade in the over-the-counter market. One
of the parties to a forward contract assumes a long position
and agrees to buy the underlying asset on a certain specified
future date for a certain specified price. The other party
assumes a short position and agrees to sell the asset on the
same date for the same price.
Futures Contracts
Contracts, like forward contracts, are agreements to buy an asset
at a future time.
Unlike forward contracts, futures are traded on an exchange. This
means that the contracts that trade are standardized.
The exchange defines the amount of the asset underlying one
contract, when delivery can be made, exactly what can be
delivered, and so on. Contracts are referred to by their delivery
month.
It is the party with the short position that initiates the delivery
process and chooses between the alternatives.
SWAPS
A swap is an agreement between two companies to exchange
cash flows in the future.
The first swap contracts were negotiated in the early 1980s. Since
then the market has seen phenomenal growth. Swaps now
occupy a position of central importance in the over-the-counter
derivatives market.
The agreement defines the dates when the cash flows are to be
paid and the way in which they are to be calculated. Usually the
calculation of the cash flows involves the future values of interest
rates, exchange rates, or other market variables.
A forward contract can be viewed as a simple example of a swap.
OPTIONS
Options are traded both on exchanges and in the over-the-
counter market.
There are two basic types of option.
1. call option
gives the holder the right to buy the underlying asset by a certain date for
a certain price.
2. put option
gives the holder the right to sell the underlying asset by a certain date for
a certain price. The price in the contract is known as the exercise price or
strike price; the date in the contract is known as the expiration date or
maturity
MARGINS
Margin consists of cash or securities posted by a trader with a broker
or counterparty.
There are two main reasons for margins.
1. The trader is borrowing money to buy an asset. This is referred to a buying
on margin.
The margin is the amount provided by the trader toward the cost of the
assets.
2. The trader is entering into a contract that could lead to him or her owing
money in the future. In this case the margin can be regarded as collateral for
the trade.
2. NONTRADITIONAL DERIVATIVES
(Non-traditional derivatives, often called exotic derivatives, are
financial instruments that are more complex and customized than
standard, "vanilla" derivatives like futures and options)
Whenever there are risks in the economy, financial engineers have
attempted to develop derivatives to allow entities with exposures to
the risks to trade with either
(a) entities that have opposite exposures to the risks or
(b) speculators who are willing to assume the risks.
This section gives examples of derivatives that have been developed to meet
specific needs.
Weather Derivatives
Many companies are in the position where their performance is
liable to be adversely affected by the weather." It makes sense for
these companies to consider hedging their weather risk in much
the same way as they hedge foreign exchange or interest rate
risks.
The first over-the-counter weather derivatives were introduced in
1997.
Oil Derivatives
(Oil derivatives are financial instruments whose value is derived
from the price of crude oil. They allow traders and investors to
speculate on future movements in oil prices without physically
owning the commodity)
Natural Gas Derivatives
(Natural gas derivatives are financial instruments whose
value is derived from the price of natural gas. They are used
for hedging against price volatility and speculation on future
price movements)
Electricity Derivatives
(Electricity derivatives are financial instruments whose value
is derived from the price of electricity. They allow market
participants to manage price risk and speculate on future
price movements in the electricity market.)
Electricity is an unusual commodity because it cannot easily
be stored." The maximum supply of electricity in a region at
any moment is determined by the maximum capacity of all
the electricity-producing plants in the region.
Like natural gas, electricity has been going through a period
of deregulation and the elimination of government
monopolies.
EXOTIC OPTIONS AND STRUCTURED PRODUCTS
Many different types of exotic options and structured products
trade in the over-the-counter market. Although the amount of
trading in them is small compared with the trading in the plain
vanilla derivatives
they are important to a bank because the profit on trades in
exotic options and structured products tends to be much higher
than on plain vanilla options or swaps.
Here are a few examples of exotic options:
1. ASIAN OPTION
2. BARRIER OPTION
3. BASKET OPTION
4. BINARY OPTION
5. CAMPOUNT OPTION
6. LOOKBACK OPTION
1.Asian options
Whereas regular options provide a payoff based on the final price of the
underlying asset at the time of exercise, Asian options provide a payroll
based on the average of the price of the underlying asset over some
specified period.
2.Barrier options
These are options that come into existence or disappear when the price
of the underlying asset reaches a certain barrier.
For example a knock-out call option with a strike price of $30 and a
barrier of $20 is a regular call option that ceases to exist it the asset
price falls below $20.
3.Basket options
These are options on a portfolio of assets rather than options on a single
asset
4. Binary options
These are options that provide a fixed dollar payoff, or a certain amount
of the underlying asset, if some condition is satisfied.
An example is an option that provides a payoff in one year of $1,000 if a
stock price is greater than $20
5. Compound options:
These are options on options.
There are four types:
1. a call on a call,
2. a call on a put,
3. a put on a call,
4. and a put on a put.
An example of a compound option is an option to buy an option on a
stock currently worth $15.
The first option expires in one year and has a strike price of S1.
The second option expires in three years and has a strike price of $20.
6. Lookback options:
These are options that provide a payoff based on the maximum or
minimum price of the underlying asset over some period.
Exotic options are sometimes more appropriate for hedging than
plain vanilla options.
RISK MANAGEMENT CHALLENGES
Instruments such as futures, forwards, swaps, options, and structured
products are versatile. They can be used for hedging, for speculation, and
for arbitrage. (Hedging involves reducing risks; speculation involves taking
risks; and arbitrage involves.
To avoid the type of problem Barings encountered is an important risk
management challenge. Both financial and nonfinancial corporations must
set up controls to ensure that derivatives are being used for their intended
purpose.
Risk limits should be set and the activities of traders should be monitored
daily to ensure that the risk limits are adhered to.
THAT’S ALL
THANKYOU!!!
