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18/11/2013 03:56:55 PM

DERIVATIVE INSTRUMENT

DERIVATIVE  INSTRUMENT

 PSU Division

                                                                                                        Le Thi Bich Ngoc

 

Risk Business

Financial managers work in a cozy, if constant change caused by volatile market and new technology. For example, in 1971 currencies were  allowed to float freely, oil price shock, high inflation, and wide swings in interest rate, a product – “derivative” was developed to manage the risk due to change in market price.

 

Derivative

Derivative is a tool which is created from available tools such as shares, bonds to warranty different targets ( reduce the risk, make and protect profit). Derivative will be a lever, make increasing more the value of investment, or guarantee if stock and  bond price change, the derivative price still preserve.

Deriavtive market is used to buy and sell back financial contract. Derivative instrument is very abundant and diversified but there are four main instruments:

-         Forward

-         Future

-         Option

-         Swap

Forwards is the agreement to buy or sell an asset at a specified future time at a price agreed upon today.

Futures is the agreement to buy or sell an asset at a specifiec future time without fair value at the time. For example, at the beginning of 2002, A Co. signed the contact with B Co. to buy 10 tons of  rice, $2/kg at the end of 2003.

That means B Co. have to sell 100 tons of rice with $2/kg to A Co. even if market price can change.

The difference between Forward and Future is that the price is reached an agreement based on estimation of each party. Besides, this price can change increasingly or decreasingly compared with the price in the contact.

Options is the right ‘s investors to buy or sell shares with a specified price; however, this price is lower than the current price. Ther are 2 options: call options and put options.

               Call options permit the buyer has the right, but not obligation to buy an agreed quantity for a certain price. For example: the price of IBM stock at the current time is $80 per share, after analyzing, investors forcast that the stock price will increase in the next time. So, if investors want to buy 1,000 shares, they have to spend $80,000. Assumed that if the stock price is $40/share in the next time, investors will have a net loss $40,000. To reduce the risk, investors can buy call options with strike price $80/share within 2 months, plus option premium $2/share. In this time, if the stock price increases above $80/share, investors can use call options with strike price $80/share, and then sell $100/share in the stock market. Investors will have the profit $20,000, minus $2,000 for call options, so net income is $18,000. However, if the stock price constantly decreases, investors can use call options not to buy shares, and just pay $2,000 option premium. In summary, the buyers buy call options just has a restricted loss but the profit is very large. The sellers also have profit from selling call options.

               Put options permit the buyer has the right, but not obligation to sell an agreed quantity for a certain price. For example: there are 100 IBM shares, $80/share, investors can buy put options to warranty that in the following 3 months, they can sell stock with $80/stock at any time.

Swaps is that 2 parties exchange the right of this cash flow to get that one. The swap contact is used to prevent the financial risk such as the risk about changing interest, the risk about exchange rate, the risk about stock price. For example: A has the deposit $100,000 with fixed rate 5%/year. B has also amount from investing $100,000 with average rate 5%/year. If A and B sign the swap contact, B will pay dividends from investing for A, and A will pay interest revenue $5,000/year for B.