Lecture 6

Derivatives are financial contracts whose value is derived from the performance of an underlying
entity. This underlying entity can be an asset, index, or interest rate, and can include a wide array of
financial products. Derivatives are primarily used for hedging risk or speculating on the future price
of an asset. They come in several forms, including forwards, futures, options, and swaps.

Types of Derivatives and Examples

1. Forwards and Futures:
 Forward Contracts: These are customized contracts between two parties to buy or
sell an asset at a specified price on a future date. For example, a wheat farmer might
enter into a forward contract to sell his crop at a future date at a guaranteed price,
mitigating the risk of price fluctuations.
 Futures Contracts: Similar to forward contracts but standardized and traded on
exchanges. For instance, an investor might buy a futures contract on crude oil if they
believe the price will go up. Futures are marked to market daily, meaning the gains
and losses are settled each day of trading.
2. Options:
 Call Option: Gives the holder the right, but not the obligation, to buy an asset at a
specified strike price before the option expires. For example, if a stock is trading at
$100 and an investor buys a call option with a strike price of $110, the investor
profits if the stock price exceeds $110 before the option expires.
 Put Option: Gives the holder the right, but not the obligation, to sell an asset at a
specified strike price before the option expires. This is useful if the holder expects the
asset's price to decline. For example, if an investor holds shares that they believe
might drop in price, buying a put option allows them to sell at the strike price even if
the market price falls below it.
3. Swaps:
 Interest Rate Swaps: These involve exchanging one set of cash flows (interest
payments) for another, based on a specified principal amount. Typically, one set of
cash flows will be fixed, while the other will be variable (often tied to a floating rate
like LIBOR). For instance, a company with a variable rate loan might swap payments
with another company that has a fixed rate loan to gain certainty about their future
liabilities.
 Currency Swaps: Parties exchange principal and interest payments in different
currencies. For example, a U.S. company might enter into a currency swap to get
euros for business operations in Europe, exchanging fixed-rate dollar payments for
fixed-rate euro payments.
How Derivatives Work
The primary functions of derivatives are to hedge risk and to speculate:
 Hedging: Companies and investors use derivatives to reduce the risk associated with price
fluctuations of an underlying asset. By locking in prices or rates, they can manage their
 exposure to financial risks. For example, an airline might use fuel derivatives to lock in fuel
prices, reducing the risk of rising costs.
 Speculation: Traders and investors use derivatives to profit from changes in the price of an
underlying asset. This involves higher risk but offers potentially high rewards. For instance,
speculating on stock prices using options can lead to significant gains if predictions about
market movements are correct.
Risks and Considerations
While derivatives are valuable for risk management and financial optimization, they also come with
risks:
 Market Risk: The value of derivatives can be highly volatile, influenced by changes in the
underlying asset's price.
 Liquidity Risk: Some derivatives, especially complex or customized ones like certain swaps
or forwards, might be difficult to sell before expiration.
 Counterparty Risk: The risk that the other party in the derivative contract will not fulfill
their obligations, especially prevalent in non-exchange traded derivatives.

Uses of Derivatives:
Risk Management (Hedging)
The most common use of derivatives is to hedge or mitigate risks associated with price fluctuations of
the underlying assets. By locking in prices or rates, individuals and organizations can manage
exposure to various risks:
 Commodity Price Risk: Agricultural producers, mining companies, and manufacturers use
futures and options to secure stable prices for their outputs or inputs. For instance, a farmer
might use futures contracts to lock in the price of crops ahead of the harvest to hedge against
the risk of price declines.
 Currency Risk: Businesses operating in multiple countries use currency swaps and options to
hedge against fluctuations in exchange rates, which can affect their earnings and expenses
when converted to their home currency.
 Interest Rate Risk: Financial institutions and investors use interest rate derivatives like
swaps and futures to manage their exposure to changes in interest rates, which can affect the
cost of borrowing or the returns on assets.
Speculation
Traders use derivatives to speculate on the future direction of market prices without the need to hold
the underlying assets. This is done by leveraging small amounts of capital to potentially yield high
returns:
 Market Predictions: Speculators might buy options or futures to profit from anticipated
movements in stock prices, interest rates, or commodity prices. For example, if a speculator
believes that oil prices will rise, they might buy oil futures contracts. If their prediction is
correct, they stand to make a significant profit.
  Leverage: Since derivatives often require a relatively small upfront investment (known as
margin), they provide a means to gain significant market exposure (leverage). This can
amplify both gains and losses.
Arbitrage
Arbitrage involves taking advantage of a price difference between two or more markets, striking a
combination of matching deals that capitalize upon the imbalance. Derivatives are ideal for arbitrage
because they allow traders to quickly and easily enter and exit positions:
 Cross-Market Arbitrage: Traders might exploit pricing inefficiencies between futures and
the underlying physical goods or discrepancies between similar instruments in different
markets. For example, an arbitrageur might notice that gold is priced differently in two
markets and use derivatives to profit from the difference.
Market Efficiency
Derivatives help in discovering prices and spreading information about future expectations in the
market, which can lead to more efficient pricing of assets:
 Price Discovery: Futures and options markets provide data on future price expectations,
which helps in the price discovery process of the underlying asset. This can be especially
important in markets for commodities and currencies.
Access to Unavailable Assets or Markets
Derivatives can provide exposure to assets or markets that may be otherwise inaccessible to certain
investors:
 Synthetic Positions: Through combinations of various derivatives, investors can create
synthetic positions that mimic the returns of a particular asset, sector, or index without
owning the actual asset. For instance, using options to simulate the economic effect of owning
a stock.
Regulatory and Tax Advantages
Some derivatives transactions may offer benefits such as lower transaction costs or advantageous tax
treatment compared to direct transactions in the underlying assets:
 Regulatory Arbitrage: Corporations might use derivatives to navigate or optimize regulatory
requirements, such as capital adequacy ratios for banks.
Settlement in finance refers to the process through which a derivatives contract is resolved according
to its terms at the end of the contract period. This involves fulfilling all contractual obligations, such
as the transfer of the underlying asset or the exchange of monetary values based on the agreed terms.
Explanation in Simple Terms
Imagine you and a friend bet $10 on the outcome of a sports game. At the end of the game, whoever
loses pays the winner $10. In this scenario, the act of paying the $10 is similar to the settlement
process in derivatives.
In the context of financial derivatives like futures or options:
 If you're supposed to deliver something (like a quantity of oil), settlement means actually
delivering that oil to the person who bought the futures contract from you.
 If the contract is about paying money (like in stock index futures), settlement means paying or
receiving the difference in price based on the agreed terms of the contract.
Simply put, settlement is making sure everything that was supposed to happen according to the
contract does happen when the contract ends.
Settlement by delivery involves the actual physical exchange of a commodity or financial instrument
from the seller to the buyer at the end of a contract.
Cash settlement is a method where financial obligations in a derivative contract are settled by paying
the difference in cash, rather than exchanging physical goods.
Cash settlement:
If spot price of wheat > $6.00 per bushel (e.g., $6.50):
• Andreas sells 100K bushels in the market for $650K.
• Pays US Mills $50K.
• US Mills buy 100K in the market.
• Receive $50K from Andreas.
If spot price of wheat < $6.00 per bushel (e.g., $5.50):
• Andreas sells 100K bushels in the market for $550K.
• Receives from US Mills $50K.
• US Mills buy 100K in the market.
• Pay $50K to Andreas.

Payoff Structure
Terms:
  T (Maturity): The time when the contract expires.
 ST (Spot Price at Maturity): The market price at maturity.
 F (Forward Price): The agreed price for future purchase/sale.
Payoff Calculation:
 Seller: ST−F
 Buyer: F−ST
Graphical Representation:
 Seller’s Payoff: Profit if ST<F, loss if ST>F.
 Buyer’s Payoff: Profit if ST>F, loss if ST<F.

Margin
Definition: The collateral required to cover the credit risk in trading.
Components:
 Initial Margin: The upfront payment required to open a position.
 Maintenance Margin: The minimum balance needed to keep a position open.
 Margin Call: A demand to add more funds if the account falls below the maintenance
margin.
 Leverage: Using borrowed funds to increase the potential return on investment.

Simplified Example
Imagine you want to buy shares of a company using margin trading.
1. Initial Investment:
 You want to buy $10,000 worth of shares.
 The broker requires an initial margin of 50%.
2. Borrowing from Broker:
 You need to pay 50% of the purchase price with your own money, which is $5,000.
 The broker lends you the remaining 50%, which is $5,000.
3. Purchase Shares:
 You use the combined $10,000 to buy shares.
Scenario 1: Share Price Increases
 Initial Share Price: $10 per share
 Number of Shares Purchased: 1,000 shares (since $10,000 / $10 = 1,000 shares)
If the share price rises to $12 per share:
 New Value of Shares: 1,000 shares * $12 = $12,000
 Loan from Broker: $5,000
 Your Equity: New value of shares - Loan = $12,000 - $5,000 = $7,000
You initially invested $5,000 of your own money, and now your equity is $7,000. You made a profit
of $2,000 ($7,000 - $5,000).
Scenario 2: Share Price Decreases
 Initial Share Price: $10 per share
 Number of Shares Purchased: 1,000 shares
If the share price falls to $8 per share:
 New Value of Shares: 1,000 shares * $8 = $8,000
 Loan from Broker: $5,000
 Your Equity: New value of shares - Loan = $8,000 - $5,000 = $3,000
You initially invested $5,000 of your own money, and now your equity is $3,000. You have a loss of
$2,000 ($5,000 - $3,000).
Maintenance Margin and Margin Call
Suppose the broker requires a maintenance margin of 30%. This means your equity must always be at
least 30% of the total value of the shares.
Calculating Maintenance Margin:
 Total Value of Shares at $8 Each: $8,000
 Required Equity (30% of $8,000): $2,400
Your equity is $3,000, which is above the required maintenance margin of $2,400, so you don't get a
margin call.
If the share price drops further to $6 per share:
 New Value of Shares: 1,000 shares * $6 = $6,000
 Loan from Broker: $5,000
 Your Equity: $6,000 - $5,000 = $1,000
Now, your equity is $1,000, which is below the required maintenance margin of $1,800 (30% of
$6,000). You will receive a margin call, and you need to deposit more money or sell some shares to
cover the shortfall.

Interest Rate Swaps

Definition: A contract where two parties exchange interest payments on a principal amount.
Types:
 Fixed-for-Floating (Vanilla Swap): One party pays fixed, the other pays floating.
 Floating-for-Floating (Basis Swap): Both parties pay floating rates based on different
benchmarks.
Uses:
 Managing Risk: Hedge against interest rate changes.
 Reducing Costs: Lower overall borrowing costs.
 Aligning Cash Flows: Match asset and liability rates.
 Speculating: Bet on future interest rate movements.
 Arbitrage: Exploit interest rate differences.
 Corporate Restructuring: Adjust debt profiles in mergers.
 International Business: Manage interest rate and currency risks.
Simplified Example
Let's assume two companies, Company A and Company B, enter into an interest rate swap agreement:
  Company A has a loan with a fixed interest rate of 5%.
 Company B has a loan with a floating interest rate of LIBOR + 1%.
 Notional Principal: $1,000,000
 Duration: 1 year
 LIBOR Rate at the Start: 3%
Purpose of the Swap:
 Company A wants to take advantage of potentially lower floating rates.
 Company B prefers the predictability of fixed payments.
Swap Agreement
 Company A agrees to pay Company B a floating rate of LIBOR + 1%.
 Company B agrees to pay Company A a fixed rate of 5%.
Payment Calculations
1. Determine Payments Without Swap:
 Company A pays 5% on $1,000,000:
 Annual payment = $1,000,000 * 0.05 = $50,000
 Company B pays LIBOR + 1% on $1,000,000:
 Assuming LIBOR is 3% at the start, annual payment = $1,000,000 * (0.03 +
0.01) = $40,000
2. Determine Payments With Swap:
 Company A pays floating rate (LIBOR + 1%) to Company B:
 Assuming LIBOR remains 3%, annual payment = $1,000,000 * (0.03 + 0.01)
= $40,000
 Company B pays fixed rate (5%) to Company A:
 Annual payment = $1,000,000 * 0.05 = $50,000
3. Net Payments:
 Company A pays $40,000 to Company B.
 Company B pays $50,000 to Company A.
 The net payment is the difference between the two amounts. Since Company B's
payment is higher, Company B pays the net difference to Company A.
 Net Payment from Company B to Company A: $50,000 - $40,000 = $10,000
Scenario Analysis
1. If LIBOR Rises to 4%:
 Company A's floating rate payment: $1,000,000 * (0.04 + 0.01) = $50,000
  Company B's fixed rate payment: $50,000
 Net Payment: $50,000 (floating) - $50,000 (fixed) = $0
 Neither company owes anything extra to the other because the payments equal out.
2. If LIBOR Falls to 2%:
 Company A's floating rate payment: $1,000,000 * (0.02 + 0.01) = $30,000
 Company B's fixed rate payment: $50,000
 Net Payment from Company B to Company A: $50,000 - $30,000 = $20,000
Benefits to Both Companies
 Company A:
 If LIBOR decreases, Company A benefits from lower floating payments compared to
the fixed rate it would otherwise pay.
 When LIBOR is 2%, Company A effectively pays $30,000 in interest instead of
$50,000.
 Company B:
 Company B gains the predictability of fixed payments, which helps with budgeting
and financial planning.
 Company B always pays $50,000, regardless of LIBOR fluctuations.

Balloon Repayment
Definition: A large payment due at the end of a loan term, larger than the regular payments. Balloon
payments are common in loans where the regular payments are not sufficient to pay off the entire loan
amount by the end of the term.
Structure:
 Regular Payments: Smaller, periodic payments over the loan term.
 Balloon Payment: Significant final payment covering the remaining loan balance.
Calculation:
1. Monthly Payment: PMT= P ×r / 1−(1+r)^(−n)
2. Balloon Payment: B=P×(1+r)^n−PMT× ((1+r)^n−1 / r)
Example:
 Borrow $100,000 with a 5-year term and 6% annual interest.
 Calculate monthly payments and the balloon payment at the end of 5 years.
Detailed Example
Loan Details:
 Principal (Loan Amount): $100,000
  Annual Interest Rate: 6% (0.06)
 Loan Term: 5 years (60 months)
 Balloon Payment: At the end of 5 years
Step 1: Calculate Monthly Interest Payment Assuming an interest-only loan (for simplicity), the
monthly interest payment is calculated as follows:
Monthly Interest Payment=Annual Interest Rate12×PrincipalMonthly Interest Payment=12Annual Int
erest Rate×Principal
Monthly Interest Payment=0.0612×100,000Monthly Interest Payment=120.06×100,000
Monthly Interest Payment=0.005×100,000Monthly Interest Payment=0.005×100,000
Monthly Interest Payment=500Monthly Interest Payment=500
So, you pay $500 each month as interest.
Step 2: Calculate Total Payments Made During the Term
Total Interest Payments=Monthly Interest Payment×Number of MonthsTotal Interest Payments=Mont
hly Interest Payment×Number of Months
Total Interest Payments=500×60Total Interest Payments=500×60
Total Interest Payments=30,000Total Interest Payments=30,000
Over the 5 years, you will have paid $30,000 in interest.
Step 3: Calculate Balloon Payment
At the end of the 5 years, the balloon payment is the remaining principal since the regular payments
only covered interest:
Balloon Payment=PrincipalBalloon Payment=Principal
Balloon Payment=100,000Balloon Payment=100,000
So, you need to make a $100,000 balloon payment at the end of the loan term.
Summary of Payments
 Monthly Payment (Interest-Only): $500
 Total Interest Payments Over 5 Years: $30,000
 Balloon Payment at End of Term: $100,000
Practical Example Scenario
Let’s say you took out this $100,000 loan to buy a piece of equipment for your business. You expect
your business to generate significant revenue over the next five years, allowing you to either save up
for the balloon payment or refinance the loan.
 Yearly Breakdown:
 Each month, you pay $500, which only covers the interest.
 After 5 years, you still owe the full $100,000 principal.
Decision Point at End of Term:
 Option 1: Pay the $100,000 balloon payment using saved-up funds or profits from your
business.
 Option 2: Refinance the $100,000 into a new loan, potentially with different terms.
 Option 3: Sell the equipment (if applicable) and use the proceeds to pay off the balloon
payment.