International Finance

Introduction to Derivatives Financial

Instruments
By Miguel Escalona
Definition

Derivatives are financial instruments, whose
prices are derived from the value of
something else (known as the underlying).

The underlying on which a derivative is
based can be the price of an asset, the
value of an index, or other items.

There must be an independent way to
observe this value to avoid conflicts of
interest.

The main types of derivatives are Futures,
Forwards, Options and Swaps.
Underlying Items

Based on the price of an asset can be:

Commodities

Equities (stocks)

Residential Mortgages

Commercial Real Estate

Loans

Bonds
Underlying Items

Based on the Value of an Index can be:

Interested rates

Exchanges rates

Stock market indexes

Consumer price index CPI-inflation derivatives

Loans

Bonds
Underlying Items

Based on Credit operations can be:

Loans

Bonds

Other forms of credit
Derivative Markets

The market can be divided into two, that
for exchange traded derivatives and that
for over-the-counter derivatives. The
legal nature of these products is very
different as well as the way they are
traded, though many market participants
are active in both.
OTC Derivatives

Over-the-counter (OTC) derivatives are
contracts that are traded (and privately
negotiated) directly between two parties,
without going through an exchange or other
intermediary.

Products such as swaps, forward rate
agreements, and exotic options are always
traded in this way.

The OTC derivatives market is huge.
According to BIS (Bank for International
Settlements), the total outstanding notional
amount is USD 248 trillion at the end of
December 2004.
ETD Derivatives

Exchange-traded derivatives (ETD) are
those derivatives products that are
traded via specialized derivatives
exchanges or other exchanges.

A derivatives exchange acts as an
intermediary to all related transactions,
and takes Initial margin from both sides
of the trade to act as a guarantee.

According to BIS (Bank for International
Settlements), the combined turnover in
the world's derivatives exchanges totaled
USD 344 trillion during 2005.
Derivatives traders at the
Chicago Board of Trade.
Types of Derivatives Contracts

Futures / Forwards are contracts to buy or
sell an asset on or before a future date at
a price specified today.

Futures contract is a standardized
contract written by a clearing house that
operates an exchange where the contract
can be bought and sold, while a Forward
contract is a non-standardized contract
written by the parties themselves.
Types of Derivatives Contracts

Options are contracts that give the owner the
right, but not the obligation, to buy (in the
case of a call option) or sell (in the case of a
put option) an asset.

The price at which the sale takes place is
known as the strike price, and is specified at
the time the parties enter into the option.

The option contract also specifies a maturity
date.
Types of Derivatives Contracts

Swaps are contracts to exchange cash
(flows) on or before a specified future
date based on the underlying value of
currencies/exchange rates, bonds/interest
rates, commodities, stocks or other
assets.
Finance terms to review

Assets

Derivatives

Underlying

Commodities

OTC (Over the counter) Market

ETD (Exchange Traded Derivatives) Market

Futures/ Forwards

Options

Clearing house

Strike price

Call option

Put option

Swaps

Bank for International Settlements