Page 9 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes Self Assessment

Fill in the blanks:
1. Derivatives are ………………. whose value/price is dependent on the behaviour of the
price of one or more basic underlying assets.

2. A derivative by itself does not constitute …………..... .
3. A ………… is merely an agreement between two parties.

1.2 Products of Derivatives

In this section, we discuss a range of derivatives products that derive their values from the
performance of five underlying asset classes: equity, fixed-income instrument, commodity,
foreign currency and credit event. However, given the speed of financial innovation over the
past two decades, the variety of derivatives products have grown substantially. Thus, a few key
examples will be discussed below:

1.2.1 Equity Derivatives

Equity futures and options on broad equity indices are perhaps the most commonly cited equity
derivatives securities. Way back in 1982, trading of futures based on S&P’s composite index of
500 stocks began on the Chicago Mercantile Exchange (CME). Options on the S&P 500 futures
began trading on the CME in the following year. Today, investors can buy futures based on
benchmark stock indices in most international financial centres.
Index futures contract enable an investor to buy a stock index at a specified date for a certain
price. It can be an extremely useful hedging tool.

Example: An investor with a stock portfolio that broadly matches the composition of the
Hang Seng index (HSI), he will suffer losses should the HSI record a fall in market value in the
near future. Since he means to hold the portfolio as a long term strategy, he is unwilling to
liquidate the portfolio. Under such circumstances, he can protect his portfolio by selling HSI
futures contracts so as to profit from any fall in price. Of course, if his expectations turned out to
be wrong and the HSI rose instead, the loss on the hedge would have been compensated by the
profit made on the portfolio.
Some investors prefer to purchase options on futures (or “futures options”) instead of straight
futures contracts. The option strike price is the specified futures price at which the future is
traded if the option is exercised. For some market participants, the pricing of an option reveal
valuable information about the likely future volatility of the returns of the underlying asset.
One commonly cited example is the Chicago Board Options Exchange Market Volatility Index
(VIX index), which is calculated based on a range of options on the S&P 500 index. When
investors are concerned about a potential drop in the US stock market, they buy the VIX index as
an insurance against losses in the value of their portfolio. The more investors demand, the
higher the price of the VIX. As such, the VIX can be viewed as an “investor fear gauge”.
Other commonly traded equity derivatives are equity swaps. Under an equity swap contract, an
investor pays the total return on a stock to his counterparty and receives in return a floating rate
of interest. With this equity swap, the investor can hedge his equity position without giving up
ownership of his share. At the same time, the party receiving equity return enjoys exposure
without actually taking ownerships of shares.

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