Financial Markets (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.