79. Classification and comparative characteristics of derivatives: options, swaps, futures, forwards. Классификация и сравнительные характеристики деривативов: опционы, свопы, фьючерсы, форварды

Derivative is a financial instrument, traded on or off an exchange, the price of which is directly dependent upon (derived from) the value of one or more underlying: securities, equity indices, debt instruments, commodities, other derivative instruments, or any agreed upon pricing index or arrangement.

Uses of Derivatives: 1) To hedge or insure risks; i.e., shift risk. 2) To reflect a view on the future direction of the market, i.e., to speculate. 3) To lock in an arbitrage profit. 4) To change the nature of an asset or liability. 5) To change the nature of an investment without incurring the costs of selling one portfolio and buying another.

Basic Derivatives: 1) Forward Contracts; 2) Futures Contracts; 3) Swaps; 4) Options.

Derivative markets: 1) Exchange-traded futures and options; 2) Over-the-Counter forwards, options, & swaps.

A forward contract is a non-standardized agreement to transact involving the future exchange of a set amount of assets at a set price. A futures contract is a standardized exchange traded agreement to transact involving the future exchange of a set amount of assets for a price that is settled daily. If your position has value, you face the risk that your counterparty will default. A long position is the purchase of a futures contract. A short position is the sale of a futures contract. Futures trades are leveraged investments as traders post and maintain only a small portion of the value of their futures position and “borrow” the rest from brokers.

Futures are similar to forwards, except: 1) Futures trade on futures exchanges (CME, CBOT, etc.). 2) Futures are standardized contracts => this increases their liquidity.

Default risk for futures is lower because: 1) the clearinghouse of the exchange guarantees payments. 2) an initial margin is required. 3) Futures contracts are “marked to market” daily.

An option is a contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset at a specified price within a specified period of time. A call option is an option that gives the purchaser the right, but not the obligation, to buy the underlying security from the writer of the option at a specified exercise price on (or up to) a specified date. A put option is an option that gives the purchaser the right, but not the obligation, to sell the underlying security to the writer of the option at a specified exercise price on (or up to) a specified date. The Black-Scholes option pricing model is the model most commonly used to price and value options. An American option can be exercised at any time before (and on) the expiration date. A European option can be exercised only on the expiration date.

Types: 1) At-the-money (ATM): exercise price = spot rate. 2) In-the-money (ITM) options profitable, excluding premium, if exercised immediately. 3) Out-of-the-money (OTM) options not profitable, excluding premium, if exercised immediately.

A swap is an agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a specified interval. An interest rate swap is an exchange of fixed-interest payments for floating-interest payments by two counterparties: 1) the swap buyer makes the fixed-rate payments; 2) the swap seller makes the floating-rate payments; 3) the principal amount involved in a swap is called the notional principal. A currency swap is a swap used to hedge against exchange rate risk from mismatched currencies on assets and liabilities. Credit swaps allow financial institutions to hedge credit risk. Swaps are not standardized contracts. Swap dealers (usually financial institutions) keep markets liquid by matching counterparties or by taking positions themselves.

79. Currency Derivatives: Currency Forward Contracts, Currency Futures, Currency Put Options, Currency Call Options, Currency Swaps. Валютные деривативы: форвардные валютные контракты, валютные фьючерсы, валютные опционы колл и пут, валютные свопы.

A foreign exchange derivative is a financial derivative whose payoff depends on the foreign exchange rate(s) of two (or more) currencies. These instruments are commonly used for currency speculation and arbitrage or for hedging foreign exchange risk.

The most commonly used instruments for hedging are forward exchange rates agreements, futures contracts and currency options.

A forward contract is an agreement to buy or sell a certain asset at a designated price at some designated time in the future. Forwards are traded over-the-counter and are a very simple instrument to use. By entering into a forward agreement, the agent is in fact locking the foreign exchange rate to be applied in the future. In this way the downside risk is completely eliminated, but at the same time all benefits from an increase in the exchange rate are foregone.

Futures contracts work in quite a similar way to forwards, but are a standardized instrument, available only for specific currencies, at specific prices and delivery dates. This may not be however the most advantageous instrument to hedge the currency risk. Not only the contract size may not be the most adequate size for the investor needs (therefore not allowing a complete hedge), but also the margin accounting may prove to be difficult to maintain. It is shown in fact that in certain circumstances, the use of forwards or futures contracts is equivalent in terms of end result.

Another financial instrument is a foreign exchange option. An option is basically a standardized contract that gives the buyer the right (while no obligation) to buy or sell a given currency at a given exchange rate (strike price) by a certain date. Options that give you the right to buy a currency are called call options, while those that allow you to sell it are named put options. (48)

Foreign exchange swap, forex swap, or FX swap is a simultaneous purchase and sale of identical amounts of one currency for another with two different value dates (normally spot to forward).

A currency swap is a swap that involves the exchange of principal and interest in one currency for the same in another currency. There are four types of basic currency swaps: 1) fixed IR for fixed IR. 2) fixed IR for floating IR. 3) floating for fixed IR. 4) floating for floating IR.

Cross-Currency Swap is an agreement between two parties to exchange interest payments and principal on loans denominated in two different currencies. In a cross currency swap, a loan's interest payments and principal in one currency would be exchanged for an equally valued loan and interest payments in a different currency. The reason companies use cross-currency swaps is to take advantage of comparative advantages. For example, if a U.S. company is looking to acquire some yen, and a Japanese company is looking to acquire U.S. dollars, these two companies could perform a swap. The Japanese company likely has better access to Japanese debt markets and could get more favorable terms on a yen loan than if the U.S. company went in directly to the Japanese debt market itself, and vice versa in the U.S. for the Japanese company.

Currency Carry Trade is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used. The big risk in a carry trade is the uncertainty of exchange rates. Also, these transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless the position is hedged appropriately.