Page 224 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 8: Derivatives

According to the author, derivatives can be defined as: Notes
Derivatives are those assets whose value is determined from the value of some underlying
assets. The underlying asset may be equity, commodity or currency. The list of derivative assets
is long.
Derivatives are the most modern financial instruments in hedging risk. The individuals and
firms who wish to avoid or reduce risk can deal with the others who are willing to accept the risk
for a price. A common place where such transactions take place is called the 'derivative market'.
As the financial products commonly traded in the derivatives market are themselves not primary
loans or securities, but can be used to change the risk characteristics of underlying asset or
liability position, they are referred to as 'derivative financial instruments' or simply 'derivatives.'
These instruments are so called because they derive their value from some underlying instrument
and have no intrinsic value of their own. Forwards, futures, options, swaps, caps floor collar etc.
are some of more commonly used derivatives. The world over, derivatives are a key part of the
financial system.

8.1 Characteristics of Derivatives

The important characteristics of derivatives are as follows:
1. Derivatives possess a combination of novel characteristics not found in any form of assets.

2. It is comfortable to take a short position in derivatives than in other assets. An investor is
said to have a short position in a derivatives product if he is obliged to deliver the
underlying asset in specified future date.

3. Derivatives traded on exchanges are liquid and involves the lowest possible transaction
costs.
4. Derivatives can be closely matched with specific portfolio requirements.

5. The margin requirements for exchange-traded derivatives are relatively low, reflecting
the relatively low level of credit-risk associated with the derivatives.
6. Derivatives are traded globally having strong popularity in financial markets.

7. Derivatives maintain a close relationship between their values and the values of underlying
assets; the change in values of underlying assets will have effect on values of derivatives
based on them.
8. In a Treasury bond futures contract, the derivatives are straightforward.

8.2 Hedging

The term 'hedging' is fairly clear. It would cover derivative market positions that are designed
to offset the potential losses from existing cash market positions. Some examples of this are as
follows:

1. An income fund has a large portfolio of bonds. This portfolio stands to make losses when
interest rates go up. Hence, the fund may choose to short an interest rate futures product
in order to offset this loss.

2. An income fund has a large portfolio of corporate bonds. This portfolio stands to make
losses when credit spreads of these bonds degrade or when defaults take place. Hence, the
fund may choose to buy credit derivatives, which pay when these events happen.

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