Moscow State University of Economics, Statistics and Informatics (MESI) Tver branch.

Course paper

Subject: «International financial markets and institutes»

«Trends in the development of the Russian market of credit derivatives»

Made by: student group ДЭЭ-101М

Chirkov A.V.

Checked:

Sokolova A.U.

Tver 2014

Table of contents

Introduction 3

1. Derivatives 4

1.1 Basic information 4

1.2 Common derivative contract types 7

1.3 History of derivatives market 9

1.4 Types of derivatives 14

2. The Russian market of derivatives 16

Conclusion 21

Literature 22

Introduction

What is a financial derivative? In the business world, the term is bandied about daily and is or is not defined as "a financial instrument that derives its value from some other instrument or index." This description is rarely enlightening and does not adequately explain its meaning. Further, a generally agreed upon or authoritative definition of a derivative instrument does not exist. Recent documents by the Financial Accounting Standards Board (FASB) describe derivatives as "forwards, futures, swaps, options, or financial instruments with similar characteristics." Still, what does this mean?

Given their reputation as exotic, highly complex and specialized financial instruments, derivatives may be a somewhat intimidating topic. In reality, they have been in existence in simple forms for decades and the concept behind them is not difficult to understand.

Now I’d like to tell you a few words about derivatives, their history and the Russian market of credit derivatives.

1. Derivatives

1. Basic information

In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often called the "underlying". Derivatives can be used for a number of purposes - including insuring against price movements (hedging), increasing exposure to price movements for speculation or getting access to otherwise hard to trade assets or markets.¹

Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as collateralized debt obligations, credit default swaps, and mortgage backed securities. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the Chicago Mercantile Exchange, while most insurance contracts have developed into a separate industry. Derivatives are one of the three main categories of financial instruments, the other two being equities (i.e. stocks or shares) and debt (i.e. bonds and mortgages).

Derivatives are contracts between two parties that specify conditions (especially the dates, resulting values and definitions of the underlying variables, the parties' contractual obligations, and the notional amount) under which payments are to be made between the parties.² The most common underlying assets include commodities, stocks, bonds, interest rates and currencies, but they can also be other derivatives, which adds another layer of complexity to proper valuation. The components of a firm's capital structure, e.g. bonds and stock, can also be considered derivatives, more precisely options, with the underlying being the firm's assets, but this is unusual outside of technical contexts.

From the economic point of view, financial derivatives are cash flows, that are conditionally stochastically and discounted to present value. The market risk inherent in the underlying asset is attached to the financial derivative through contractual agreements and hence can be traded separately. The underlying asset does not have to be acquired. Derivatives therefore allow the breakup of ownership and participation in the market value of an asset. This also provides a considerable amount of freedom regarding the contract design. That contractual freedom allows to modify the participation in the performance of the underlying asset almost arbitrarily. Thus, the participation in the market value of the underlying can be effectively weaker, stronger (leverage effect), or implemented as inverse. Hence, specifically the market price risk of the underlying asset can be controlled in almost every situation.³

There are two groups of derivative contracts: the privately traded over-the-counter (OTC) derivatives such as swaps that do not go through an exchange or other intermediary, and exchange-traded derivatives (ETD) that are traded through specialized derivatives exchanges or other exchanges.

Derivatives are more common in the modern era, but their origins trace back several centuries. One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century. Derivatives are broadly categorized by the relationship between the underlying asset and the derivative (such as forward, option, swap); the type of underlying asset (such as equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives, or credit derivatives); the market in which they trade (such as exchange-traded or over-the-counter); and their pay-off profile.

Derivatives may broadly be categorized as "lock" or "option" products. Lock products (such as swaps, futures, or forwards) obligate the contractual parties to the terms over the life of the contract. Option products (such as interest rate caps) provide the buyer the right, but not the obligation to enter the contract under the terms specified.

Derivatives can be used either for risk management (i.e. to "hedge" by providing offsetting compensation in case of an undesired event, a kind of "insurance") or for speculation (i.e. making a financial "bet"). This distinction is important because the former is a prudent aspect of operations and financial management for many firms across many industries; the latter offers managers and investors a risky opportunity to increase profit, which may not be properly disclosed to stakeholders.

Derivatives are used for the following:

• Hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out ⁴

• Create option ability where the value of the derivative is linked to a specific condition or event (e.g. the underlying reaching a specific price level)

• Obtain exposure to the underlying where it is not possible to trade in the underlying (e.g. weather derivatives)

• Provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative

• Speculate and make a profit if the value of the underlying asset moves the way they expect (e.g. moves in a given direction, stays in or out of a specified range, reaches a certain level)

• Switch asset allocations between different asset classes without disturbing the underlying assets, as part of transition management

• Avoid paying taxes. For example, an equity swap allows an investor to receive steady payments, e.g. based on LIBOR rate, while avoiding paying capital gains tax and keeping the stock.