Page 11 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes 1.2.3 Commodity Derivatives

The earliest derivatives markets have been associated with commodities, driven by the problems
about storage, delivery and seasonal patterns. But modern day commodity derivatives markets
only began to develop rapidly in the 1970s. During that time, the break-up of the market
dominance of a few large commodity producers allowed price movements to better reflect the
market supply and demand conditions. The resulting price volatility in the spot markets gave
rise to demand of commodity traders for derivatives trading to hedge the associated price risks.

Example: Forwards contracts on Brent and other grades of crude became popular in the
1970s following the emergence of the Organisation of Petroleum Exporting Countries.
Deregulations of the energy sector in the United States since the 1980s also stimulated the
trading of natural gas and electrical power futures on the New York Mercantile Exchange (NYMEX)
in the 1990s.

1.2.4 Foreign Exchange Derivatives

The increasing financial and trade integration across countries have led to a strong rise in
demand for protection against exchange rate movements over the past few decades. A very
popular hedging tool is forward exchange contract. It is a binding obligation to buy or sell a
certain amount of foreign currency at a pre-agreed rate of exchange on a certain future date.
Consider a Korean shipbuilder who expects to receive a $1 million payment from a US cruise
company for a boat in 12 months. Suppose the spot exchange rate is 1,200 won per dollar today.
Should the won appreciate by 10 per cent against the dollar over the next year, the Korean
shipbuilder will receive only 1,090 million of won (some 109 million of won less than he would
have received today). But if the shipbuilder can hedge against the exchange risk by locking in
buying dollars forwards at the rate of say 1,100 won per dollar.
For thinly trade currencies or currencies of those countries with restrictions on capital account
transactions, the profit or loss resulting from the forwards transaction can be settled in an
international currency. This is the so-called non-deliverable forwards contract, and very often
they are traded offshore.
Another type of foreign exchange derivatives are cross-currency swaps. This involves two parties
exchanging payments of principal (based on the spot rate at inception) and interest in different
currencies. According to many market participants, having a liquid cross-currency swap market
is an important for local currency bond market developments. This is because such instruments
allow foreign borrowers in local bond markets to swap back their proceeds to their own currencies
while hedging against the interest rate risk.

1.2.5 Credit Derivatives

A credit derivative is a contract in which a party (the credit protection seller) promises a payment
to another (the credit protection buyer) contingent upon the occurrence of a credit event with
respect to a particular entity (the reference entity). A credit event in general refers to an incident
that affects the cash flows of a financial instrument (the reference obligation). There is no precise
definition, but in practice, it could be filing for bankruptcy, failing to pay, debt repudiation or
moratorium.

The fastest growing type of credit derivatives over the past decade is credit default swap (CDS).
In essence, it is an insurance policy that protects the buyer against the loss of principal on a bond
in case of a default by the issuer. The buyer of CDS pays a periodic premium to the seller over the
life of the contract. The premium reflects the buyer’s assessment of the probability of default and
the expected loss given default.

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