Advanced Modelling and Strategies in Derivatives Markets
A derivative is an instrument that derives its value from another underlying asset or a group of assets. Derivatives can be either exchange-traded or an OTC product. Derivatives include futures, options, forwards, swaps, and credit default swaps. Derivative pricing derives its values from the underlying asset. Underlying assets could be stocks, bonds, indices, exchange rates, commodities, and interest rates, to name a few.
Derivatives are commonly used to speculate or as a hedging instrument to diversify portfolio risk. Learning about derivatives is an integral part of investment banking. Our Investment banking course is specially designed to understand derivatives markets, learn about investment banking, and hone your investment banking skills.
- As explained before, derivatives values are derived from the financial security or instrument to which they are linked.
- The pricing depends on the type of the derivative contract. There are also many different permutations and combinations of each derivative contract. Long and short calls, put strategies, or even a combination of different types of options, etc. are some examples.
- Futures are standardized contracts created by exchanges and include a certain quantity and quality of the underlying commodity. Futures values are based on the spot price along with the basis amount. Basis amount refers to the difference between the spot prices of the future contact and the future price. This also affects the values used in hedging. Future traders use this to determine the profitability between cash or actual delivery of the product.
- Option prices depend on the underlying instrument price, time to expiration of the option, the volatility of the option, interest rate, and the strike or the exercise price of the option. Options can be both in-the-money or out-of-the-money depending on time to expiration. Models like the Black and Scholes model, Binomial tree and trinomial tree, etc., are commonly used to determine option pricing.
- In swaps, there are two streams of fixed and variable cash flows over the maturity of the swap contract. The pricing is determined by equating the present value of the two streams. Interest rate, commodity, and currency swaps are the most common derivative instruments.
- Forwards are non-standardized, OTC contracts used for currencies arranged between two counterparties (one being the bank) with flexible terms. Forward pricing depends on the relative interest differential between the two currencies.
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Risk Management Using Derivative Strategies
Derivatives, as mentioned previously, are used for both speculations and hedging or risk management to protect your portfolio of underlying assets.
Hedging or protecting against risk using derivatives is commonly used so that if the prices of your underlying portfolio assets depreciate, your derivative position appreciates to offset the portfolio loss. Hedging helps eliminate uncertainty and avoid losses that occur due to price volatility.
- A put option is an example of an instrument used to hedge a stock portfolio. A protective put strategy is owning a stock portfolio and buying a put option to protect stock price losses below the strike price.
- Forward and swap contracts in currencies are used to protect against the effect that exchange appreciation or depreciation has on the portfolio. The currency conversion is fixed at the forward rate, and you are protected against both appreciation and depreciation of the currency. You can convert your foreign exchange earnings at the forward strike rate. Currency swaps can also be used for similar purposes.
- In low-interest rate environments, interest rate swaps from fixed to floating rates can be used to minimize the interest outgo, especially on medium-term foreign exchange loans. This enables your company to benefit in a low market interest rate environment to reduce your interest liability.
Risks of Trading in Derivatives
Derivatives are risky instruments when traded uncovered (i.e., without ownership of the underlying instrument). This is because they have gearing or leverage. If the underlying asset price increases 10%, the price of the derivative linked to that asset is likely to move 50%. As this movement is on both the upside and the downside, the risk in a derivative increases exponentially.
Also, for investing a small sum (a fraction of the underlying asset's value) in the form of option premium, or initial margin on a futures contract, you get exposure to a potentially large payoff. There is the counterparty risk of default in derivative contracts like futures or swaps. Interest rate risk is yet another factor. Derivative contracts are also sensitive to supply and demand pressures.
Given the complexity of derivatives, it is essential to get a thorough understanding of the derivatives market. If you are desirous of becoming an investment banker, you have to learn investment banking and cultivate investment banking skills.