Financial Markets (Session Three)

Session Three


Are type of securities that their value is abstracted from other financial instruments; these types of derivates are used as a hedging bargain to stop any losses from any reversal movement in the market, so the main use is to "Control Risk"; it is mainly used with currency and interest rates.

The derivative is used by the three types of investors:

Hedgers: the Hedger uses the derivates in order to minimize the losses by taking a position opposite to the transaction that he/she is having, so if the market reverse no major losses will occur.

Speculators: the speculator will get in market just looking for abnormal profits, with accepting higher risk, by taking an open position.

Arbitragers: the arbitrager try's to look for low risk profit, by taking advantage of difference in prices.

A derivative includes different types of instruments:

Forward Contracts: are negotiated between two parties, to buy a long position and sell a short position of a specified amount of a commodity, as the buyer hold the right to undertake the action but not obligated, and setting the price (known by the spot price) of the commodity at a specified date.

Future Contracts: are standardized contracts that are traded on a regulated floors, obligating the delivery of the agreed amount of commodity or a currency or an instrument for example treasury bonds, foreign currency. These types of contracts are considered to have low risk.

Options: is a contract that designed to specify in it the quantity of a certain commodity with the specified date of transaction, were options have the right to buy or sell but not the obligation.

There are two types of option contracts:

Call option: gives the buyer the right to buy (but not the obligation) a specified amount of securities at a certain price at a set date.

Put option: gives the buyer the right to sell (but not the obligation) to the writer of the option by a certain prices and a specified date.

Swaps: “is a flexible, private, forward-based contract or agreement, which is used to hedge against exchange risk from mismatched currencies on assets and liabilities”.

There are different types risk associated with derivatives:

Basis risk: it is the price of the hedged asset subtracted from it the price of the derivative contract.

Credit risk: it's the risk of the chance of one party offsetting the financial obligation under the contract.

Market risk: it's the loss due to changes in the value of the derivative, including different types of risks control, accounting and legal risks.

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