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Unit 11: Introduction to Derivatives

While the contracts have yet to materialize, the market is bracing itself, with one airline Notes
executive concluding that the market is “far more concerned with risk management than
ever before”.
Question
Discuss the solution for derivatives.

Source: http://www.fow.com/article/1973031/issue/26557/case-study-airline-fuel-costs-airlines-
hedge-oil-exposures.html

11.5 Summary

A derivative security is a financial contract whose value is derived from the value of
something else, such as a stock price, a commodity price, an exchange rate, an interest rate,
or even an index of prices.

Derivatives may be traded for a variety of reasons. A derivative enables a trader to hedge
some pre-existing risk by taking positions in derivatives markets that offset potential
losses in the underlying or spot market.
In India, most derivatives users describe themselves as hedgers (Fitch Ratings, 2004) and
Indian laws generally require that derivatives be used for hedging purposes only.

Another motive for derivatives trading is speculation (i.e. taking positions to profit from
anticipated price movements). In practice, it may be difficult to distinguish whether a
particular trade was for hedging or speculation, and active markets require the participation
of both hedgers and speculators.

A third type of trader, called arbitrageurs, profit from discrepancies in the relationship of
spot and derivatives prices, and thereby help to keep markets efficient.
Jogani and Fernandes (2003) describe India’s long history in arbitrage trading, with line
operators and traders arbitraging prices between exchanges located in different cities, and
between two exchanges in the same city.

11.6 Keywords

Arbitrageurs: Operators who operate in the different markets simultaneously, in pursuit of
profit and eliminate mispricing.
Derivative: Derivative is a product/contract that does not have any value on its own i.e. it
derives its value from some underlying.
Forward Contract: A forward contract is one to one bi-partite contract, to be performed in the
future, at the terms decided today.

Hedgers: Operators, who want to transfer a risk component of their portfolio.
Hedging: ‘Hedging’ an investment in a stock with a short position in another stocks’ futures is
not an acceptable hedge because of effectiveness concerns.

OTC: OTC (over-the-counter) contracts, such as forwards and swaps, are bilaterally negotiated
between two parties.
Portfolio Rebalancing: The use of derivatives for portfolio rebalancing covers situations where
a particular desired portfolio position can be achieved more efficiently or a lower cost using
derivatives rather than cash market transactions.

Speculators: Operators, who intentionally take the risk from hedgers in pursuit of profit.

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