Financial Derivatives embedded interest rates, or currency carry

trades, options, and some other sophisticated

credit structures. In the arbitrage trading
Economic and Market Assessment environment, carry trade refers to higher yield-risk
options funded by a lower-cost currency. At
Financial Derivatives present, the JpY and, most recently the US
Dollar, given the low central bank policy rates,
-​ its objective of is to create long-term value
have been considered as carry-trade funding
for the firm, be it used as a hedge, trading,
currencies.
or speculative position.
-​ the ability of derivatives specialists to Products and Applications
assess the economic value of this financial
instrument vis à vis the movements in Derivatives
financial market trends is considered the -​ a term once limited to investment banking
key determinant to value creation. circles, traders, risk specialists, or financial
institutions, suddenly became a by-word
Corporate treasury and finance officer for the general public when it was
perspective​ identified as the cause for large financial
The current corporation or financial institution losses during the 2007-2009 Global
officers (CFOs) are mostly concerned with cash Financial Crisis. Warren Buffet once called
flows, investment returns, hedging, and derivatives the financial weapons of mass
sustainability of their financial objectives. They destruction. Steve Kroft's special report on
also play a major role in long-term expansion and credit default swaps (CDS) simply called it
major acquisitions and relied-on issues regarding a side bet and a form of legalized
valuation, return analysis, and hedging gambling that allows one to wager on
alternatives during periods of uncertainty. financial outcomes without requiring one
Financial derivatives cannot be disregarded in to buy the underlying stocks, bonds, or
any of these issues, including their application in mortgages.
basic treasury concerns like cash flow Definition
management. An excess of Japanese Yen (JpY)
or Philippine Pesos (PhP) among banks would Derivatives
provide foreign exchange swaps as an efficient -​ financial instruments or securities or
alternative against interbank borrowings. The agreements whose value depends upon
basic liquidity swap derivatives among the price of some other (underlying)
multinationals have been proven to be the most commodity, security, and index.
efficient way to manage cash flows and gaps. The -​ a mere contract between two or more
interest rate gap exists when the maturities of the parties and the value is determined by the
total interest-rate sensitive assets and liabilities fluctuations in the underlying mentioned
within a particular period are not equal. These assets.
mismatches in interest rates are viewed as
another basic need among corporations in International Accounting Standards (IAS)
managing interest rate exposures. An import or -​ defines a derivative as a financial
export requirement of a company would definitely instrument or a contract with all three of
require some form of foreign exchange risk the following characteristics:
management to ensure that pricing and profits will
(a) Its value changes in response to the change in
not be totally unpredictable.
a specified interest rate, financial instrument
Global investors in bonds, equities, commodities, price, commodity price, foreign exchange rate,
and other financial products will always look for index of prices or rates, credit rating or credit
alternatives to hedge or immunize their portfolios index, or some other variable (sometimes called
through the application of derivatives. At times, the 'underlying');
users of derivatives combine positions in various
markets through hybrid structured notes with
(b) It requires no initial net investment or an initial -​ forward contracts are written by the parties
net investment that is smaller than what would be themselves.
required for other types of contracts that would be -​ types of forward contracts are enumerated
expected to have a similar response to changes and discussed below:
in market factors; and
A. Currency forwards
(c) It is settled at a future date. -​ a contract that locks in the price at which
an entity can buy or sell a currency on a
future date.
Uses of derivatives
-​ also known as "outright forward currency
(a) Hedging transaction", "forward outright", or "FX
-​ derivatives are used to mitigate the risk of forward".
economic loss arising from changes in the
B. Interest rate forwards or forward rate
value of the underlying asset.
agreements (FRA)
-​ allows risk on the price of the underlying
-​ an over-the-counter contract between
asset to be transferred from one party to
parties that determines the rate of interest
another.
to be paid or received on an obligation
-​ objective is to reduce the risk of having the
beginning at a future start date.
future selling price deviating unexpectedly
-​ the contract determines the rates,
from the current market value of the asset.
termination date, and notional value.
(b) Speculation -​ usually an exchange of a fixed rate for a
-​ Derivatives are used to increase profit variable rate, paying only the differential
through a bet in future movements in the on the notional amount of the contract.
value of an underlying asset. -​ two parties:
1.​ Borrower - paying the fixed rate
(c) Arbitrage 2.​ Lender - receiving the fixed rate
-​ Derivatives are used to exploit the
discrepancy between prices of the same Application of forward contracts (FRA)
product across different markets. Arbitrage
Bank A enters into an FRA with Company B, in
occurs when the current buying price of an
which Bank A will receive a fixed rate of 5%
asset falls below the price specified in a
yearly on a principal of USD 1 million over three
futures contract, or when a simultaneous
years. In return, Company B will receive the
buy-and-sell transaction occurs in two
one-year London Interbank Offered Rate
different markets, resulting in a price
(LIBOR), determined in three year's time, on the
difference between these markets.
principal amount. The agreement will be settled in
Types of derivatives cash in three years.

If, after three years, the LIBOR is at 5.5%, Bank A

is required to pay Company B because the
LIBOR is higher than the fixed rate.

Bank A (Receive) = USD 1 million x 5% = USD

50,000​
Company B (Receive) = USD 1 million x 5.5% =
USD 55,000​
Net Received by Company B (Bank A to pay) =
USD 5,000

2. Futures contracts
1. Forward contracts
-​ written by a clearing house and traded
-​ an agreement between two parties to buy
over an exchange
or sell an asset at a specified point in time
-​ an agreement between two parties that is
in the future at a price identified
initiated at one point in time but requires
beforehand
 that parties to the agreement to perform depend on subsequent price movement. If
some act (usually the trading of assets for expectations are wrong, the profit can be
cash), in accordance with the terms (or higher, lower, or turn into a loss.
some clearly defined rule) of the
(b) Arbitrage
agreement, at some point future in time.
-​ are highly standardized contracts that are -​ An arbitrage is made when the futures
written by a clearing house that operates market is misvalued from its fair value
in an exchange where the contract can be according to the cost of carry model.
bought and sold.
(c) Hedging
Some important terms associated with futures
contracts are: -​ Whenever a derivative is bought or sold
with the intent that subsequent gains or
(a) The seller of the contract losses on the derivative position will offset
-​ also called the holder of the short position, existing risk (gain or loss exposure) for the
is the party that is obliged to deliver the user, the transaction is a hedge.
stated asset.
There are two types of hedges: a long hedge,
(b) The buyer of the contract which means that the hedger takes a long
-​ also called the holder of the long position, position in a forward or future contract, and a
is the party that is obliged to pay for the short hedge, which means that the hedger
asset upon delivery. takes a short position in a forward or futures
contract.
(c) The underlying
-​ also called the deliverable item, is the (a) Long hedge
asset that is to be traded under the terms
of the contract. -​ used when one is expecting to acquire an
asset in the future, but there is concern
(d) Settlement, maturity, or expiration that its price might rise before the intended
-​ the time at which the contract is to be acquisition. To manage this price risk, the
fulfilled. hedger takes a long position in a futures
contract in the underlying asset. Then, if
(e) Contract size
the price does rise, the profit from the
-​ the quantity of the underlying asset that is
contract offsets the higher cost of the
to be traded at the time that the contract
ultimate purchase of the underlying. If the
settles.
price falls, on the other hand, the loss on
(f) The invoice amount or the forward contract the contract will be offset by the fact that
price the underlying can be bought at a lower
-​ the amount that must be paid for the price when the future purchase takes
contract size of the underlying asset by place.
the holder of the long position at the time
(b) Short hedge
of settlement of the agreement.
-​ generally used to reduce the risk
Uses of futures contracts
associated with possible changes in the
(a) Speculation price of owned assets. To hedge this price
risk, the hedger can take a short position
-​ An investor can take a position in futures
in futures contracts. Then if asset prices
contracts hoping to benefit from
fall, the resulting loss on the owned asset
subsequent price movements. If the price
will be offset by the profit on the short
is expected to rise, contracts are
futures position. If asset prices rise, the
purchased. If prices are anticipated to fall,
resulting loss on the contract will be offset
contracts are sold. The actual gain or loss
by the increase in the value of the asset
realized on the trade will only be known
being hedged. Thus, the value of the
when the position is closed out and will
 asset owned can be hedged against future features. However, these various types of
price fluctuations. contracts also have their own special
provisions based on the characteristics of
In either case, the goal of hedging is to
the underlying assets.
eliminate or reduce overall risk, both upside
and downside. (a) Interest-rate futures contracts

-​ are contracts with interest-bearing

Futures contract valuation
instruments as the underlying asset.
Future contracts Interest-rate futures are available on both
money market instruments (Treasury bills
-​ are simply agreements to buy or sell
and Eurodollar contracts) and bond
something at a future date.
instruments (Treasury bonds and Treasury
-​ have no inherent cash flows to value
note accounts, Municipal bonds).
(unlike a stock or bond) and cannot be
-​ are traded on a number of major
valued as the simple present value of their
exchanges including the Chicago Board of
future cash flows.
Trade (CBT), the International Money
-​ are valued using an arbitrage pricing
Market of the Chicago Mercantile
model called the cost-of-carry model,
Exchange, and the New York Futures
which means that the value of the futures
Exchange.
is equal to a time value of money and the
-​ primarily used to hedge against
cost of holding the position.
fluctuations in interest rates.
-​ there must be a mathematical relationship
between the price of a futures contract Application of futures contract (interest rate
and the spot price of the underlying asset futures)
on which the contract is based, where:
A pension fund manager has been receiving a
(a) Spot price steady return of 6% on his short-term portfolio in
-​ is the price of the asset that underlies the 90-day treasury bills:
futures contract. Sometimes the spot price
If it is projected that the interest rate will go down,
is called the cash price or current price.
he will buy and go long on a T-bill futures
(b) Futures price contract. If the interest rate goes down, he will
-​ the price of the asset if bought or sold for make a profit on his futures contract that would
future delivery in the futures (or forward) partially or fully offset his decline in interest
market. income for one period.

(c) Cost-of-carry If it is projected that the interest rate will go up

-​ the model states that there is a and the manager has invested in long-term
relationship between the price of a futures securities, a sell or short position is advised. If the
contract today, and the current price of interest rate goes up, it would provide profits
the asset on which the futures contract is which would offset part of the loss in the portfolio
based. value.
-​ may also be referred to as the spot-futures
(b) Stock index futures contracts
pricing model or the spot-futures parity
theorem. -​ are agreements to buy or sell a
standardized value of stock index on a
Basic types of futures contract future date at a specified price. The idea is
that the investor will have an opportunity
Futures contracts
to participate in the movement of an entire
-​ are traded on a wide variety of assets
stock index rather than buying or selling
including commodities, stock indices,
individual security. Stock index futures
fixed-income financial instruments, and
contracts are available on many of the
currencies. All of these contracts operate
world's stock indexes. Currently, futures
in the same way and share common
and options relate to such indexes as the
 Dow Jones Industrial Average (DJIA), the futures contracts are closed out or
Standard & Poor's 500 (S&P500) Stock reversed before the actual delivery date
Index, and the NASDAQ 100 Stock Index. occurs. The Chicago Mercantile Exchange
(CME) group corners the bulk of
The stock index futures market, unlike the
commodity futures trades generating USD
traditional commodity futures market, is a purely
1 quadrillion transactions annually.
cash settlement market. There is never implied
potential for future delivery of, for example, the Oil Futures
S&P500 Stock Index. An investor simply closes -​ are considered as one of the most closely
out (or reverses) his position before the watched futures market because of the
settlement date. If he does not, his account is recent volatility in crude prices driven both
automatically credited with his gains or debited by real demand and speculative positions.
with his losses, and the transaction is completed. -​ provides the ability to hedge the
Unlike, the T-bill contract, but similar to the short-term or long-term requirements of
Eurodollar contract, the stock index contract can the buyers or sellers. A bullish outlook on
only be settled for cash if held until the contract crude as a result of a cooler winter will
expiration. allow airline companies to manage their
exposures through the oil futures market.
Uses of stock index futures​
Subject to their requirements, companies
There are a number of actual and potential uses
may trade the oil futures for the specific oil
for stock index futures similar to other types of
index.
futures contracts, which include:
Other commodities​
■​ Speculation
Agricultural commodities, dairy, food, metals, and
-​ the speculator may attempt to
livestock are also traded in the futures market.
profit from major movements in the
market wherein he or she may
have developed a conviction about
the next move through
fundamental or technical analysis.
■​ Hedging
-​ used to minimize or manage
market risks of an existing, large,
diversified portfolio. This is
sometimes known as portfolio
insurance.
■​ Arbitraging
-​ the simultaneous buy-or-sell
Application of futures contract (corn)
program trading when there is a
profitable difference between index On May 22, 2018, a corn farmer entered into a
futures and stocks represented in commodities futures contract to purchase corn to
the underlying index. be delivered on December 15, 2018. Price per
bushel as of May 22 is Php 5.50 and total
(c) Commodities futures
contract price is Php 27,500 (Php 5.50 x
Commodity futures contracts 5,000/bushel).
-​ agreements that provide for the delivery of
Since commodity trading is based on the use of
a specific amount of a commodity at a
margin rather than actual cash, a margin
designated time in the future and at a
requirement ranging from two to ten percent of
given price.
the value of the contract is required. For this
-​ buyers try to avoid risks associated with
example, let's assume a Php 1,000 margin
raw material prices, while sellers try to
requirement on the Php 27,500 contract which
lock in guaranteed prices for their
represents 3.6% of the value. The margin
produce. However, almost all commodity
payment is considered a payment in good faith
against losses and there is no actual borrowing or Loss​
interest to be paid. If the initial margin is reduced, (USD 43,500)
for example, Php 300 due to losses on the
Futures Market
contract, the farmer will have to pay an additional
Php 300 to maintain the margin requirement. If he Sale of eight EUR futures contracts​
is not able to do so, the position will be closed out 8 x EUR 125,000 x USD 1.1720 per EUR 1.00 =
and the Php 300 loss will be realized. USD 1,172,000
On December 15th (maturity date), the price goes Purchase price of EUR contracts​
up to Php 5.70 per bushel resulting in a gain of USD 1,200,000
Php 1,000 (0.20 x 5,000 bushels) on the contract.
With an initial margin requirement of Php 1,000, Gain (to offset above loss)​
the corn farmer made a 100% profit as indicated USD 28,000
in the following computation:

Peso Gain = 1,000 x 100 = 100%​

Amount of margin deposit = 1,0000

Currency futures​
Forex futures are used by companies to remove
the exchange-rate risk inherent in cross-border
transactions. They can be used by investors to
speculate and profit from currency exchange
fluctuations. Futures are available in the following
currencies: Euro, Japanese Yen, Australian,
Dollar, Mexican Peso, Canadian Dollar, and
Russian Ruble.

Application of futures contract (currency)

A U.S. businessman orders equipment for

delivery and payment in 3 months from July 2018.
Equipment will cost EUR 1 million. Spot rate is
USD 1.1565 per EUR 1.00. The September 2018
futures contract is selling at USD 1.1720 per EUR
1.00, the 3-month implied forward rate. The
businessman purchases eight contracts to cover
the future foreign currency needs. Spot rate after
3 months is USD 1.2000 per EUR.

8 contracts x 125,000 EUR per contract = EUR

1,000,000​
EUR
1,000,000 x USD 1.1720 = USD 1,172,000

Spot Market

Original estimate of equipment cost​

EUR 1,000,000 x USD 1.1562 per EUR 1.00 =
USD 1,156,500

Actual Cost​
EUR 1,000,000 x USD 1.2000 per EUR 1.00 =
USD 1,200,000