Financial Derivatives: Definitions, Uses, and Risks

TAKEAWAYS:

• Financial derivatives are contracts whose value depends on an underlying asset (stocks, commodities, interest rates).
• They are used for hedging, speculation, and arbitrage, but misuse can lead to systemic risks.
• Derivatives are leveraged (high risk/reward) and zero-sum (gains/losses offset between parties).
• Misuse includes excessive speculation, market manipulation, and misaligned incentives (e.g., 2008 financial crisis).
• Key players: brokers, exchanges, and clearinghouses ensure contracts are honored.
• Nepal’s NEPSE and NMB Bank use derivatives for currency hedging and interest rate swaps.

1. What Are Financial Derivatives?

Financial derivatives are contracts whose value is derived from an underlying asset (e.g., stocks, bonds, commodities, interest rates, or market indices). They allow parties to transfer risk, speculate, or lock in prices without owning the asset.

Key Characteristics

classDiagram
    class Derivative {
        +Contract between two parties
        +Value depends on underlying asset
        +No initial ownership of asset
        +Leveraged (small margin controls large position)
        +Zero-sum (gains/losses offset)
    }
    class UnderlyingAsset {
        <<abstract>>
        +Stocks
        +Commodities (gold, oil)
        +Interest Rates
        +Indices (NEPSE All Share Index)
    }
    Derivative --> UnderlyingAsset : "Derives value from"

Why Are They Called "Derivatives"?

• Derive: Their price is derived from the underlying asset’s price.
• Example: A futures contract on gold derives its value from the spot price of gold.
• No intrinsic value: Unlike stocks (which represent ownership), derivatives are pure contracts.

2. Types of Financial Derivatives

Derivatives are classified based on their underlying asset and contract type. The four primary types are:

3. How Derivatives Work: A Real-World Example

Case Study: NMB Bank Hedging Currency Risk

NMB Bank uses forward contracts to hedge against NPR depreciation when importing machinery from China.

• Scenario: NMB expects to pay $100,000 in 6 months for equipment.
• Risk: If NPR weakens, the cost in NPR will rise.
• Solution: NMB enters a forward contract to buy $100,000atRs.130/$ today (locked rate).
• Outcome:
  • If spot rate in 6 months = Rs. 140/$, NMB saves Rs. 10,000 (100,000 × (140–130)).
  • If spot rate = Rs. 120/$, NMB loses Rs. 10,000 (but avoids exchange risk).

Visualizing the Hedge:

flowchart TD
    A["NMB Bank"] -->|"Needs $100,000 in 6 months"| B["Forward Contract"]
    B -->|"Locks rate at Rs. 130/$"| C["Exchange Rate in 6 Months"]
    C -->|"Rs. 140/$"| D["NMB gains Rs. 10,000"]
    C -->|"Rs. 120/$"| E["NMB loses Rs. 10,000"]
    F["Spot Market"] --> C

4. Why Use Financial Derivatives?

Derivatives serve three primary functions:

A. Hedging (Risk Management)

• Purpose: Protect against price fluctuations.
• Example: A wheat farmer in Nepal uses futures contracts to lock in a selling price before harvest.
• Real-World Tie: NTC (Nepal Telecom) uses interest rate swaps to manage debt costs.

B. Speculation (Betting on Price Movements)

• Purpose: Profit from price changes (high risk, high reward).
• Example: A trader buys NEPSE call options expecting the index to rise.
• Risk: Can lead to margin calls (forced selling to cover losses).

C. Arbitrage (Exploiting Price Differences)

• Purpose: Buy low in one market, sell high in another.
• Example: If gold is cheaper in Dubai than in Kathmandu, traders buy in Dubai and sell in Nepal.

5. How Derivatives Create Value (and Risk)

Leverage: The Double-Edged Sword

• Definition: Small margin payments control large positions.
• Example: A trader deposits Rs. 50,000 (5% margin) to control a futures contract worth Rs. 1,000,000.
• Risk: A 10% adverse move = Rs. 100,000 loss (vs. Rs. 5,000 in a spot trade).

Zero-Sum Nature

• One party’s gain = another’s loss.
• Example: If you sell a put option on NMB shares, you profit if the stock does not fall (but the buyer profits if it does).

6. Misuse of Derivatives: Lessons from History

Derivatives can be misused, leading to market crashes. Three common abuses:

Real-World Example: NEPSE’s Derivatives Scandals

• In 2015, some brokers manipulated futures prices to trigger stop-loss orders, causing Rs. 200M+ losses for retail investors.
• Lesson: Derivatives require discipline and regulation.

7. Key Players in the Derivatives Market

8. Worked Example: Calculating a Futures Contract Value

Scenario: A trader buys 1 futures contract on gold at Rs. 70,000 per tola. The contract size is 100 tolas, and the margin is 10%.

1. Contract Value: $100\text{ tolas}\times Rs.70,000/\text{tola}=Rs.7,000,000$

2. Margin Required: $10\%\times Rs.7,000,000=Rs.700,000$

3. If gold rises to Rs. 75,000/tola:

   • New Contract Value: $100\times 75,000=Rs.7,500,000$
   • Profit: $Rs.7,500,000-Rs.7,000,000=Rs.500,000$
   • Profit Margin: $Rs.500,000/Rs.700,000\approx 71.4\%$ (high leverage!)

4. If gold falls to Rs. 65,000/tola:

   • Loss: $Rs.7,000,000-Rs.6,500,000=Rs.500,000$
   • Margin Call: If the trader’s account drops below Rs. 700,000, the broker may liquidate the position.

9. Exam Tip: How This Unit Is Tested

1. Definitions:

   • Expect short-answer questions on:
     • What is a derivative?
     • Difference between futures and options.
     • Why are derivatives leveraged?

2. Applications:

   • Case studies: How does NMB Bank use swaps? How does a farmer hedge crop prices?
   • Numerical problems: Calculate margin, profit/loss, or hedging gains.

3. Misuse:

   • Essay-style: Explain three ways derivatives can be misused (speculation, manipulation, regulatory arbitrage).
   • Critical thinking: "Are derivatives purely speculative?" (Discuss hedging vs. gambling.)

4. Diagrams:

   • Draw a flowchart of the derivatives market (exchanges → brokers → clearinghouses).
   • Sketch a t-account showing how margin calls work.

Common Pitfalls:

• Confusing forwards/futures: Futures are standardized; forwards are custom.
• Ignoring leverage: Always calculate margin requirements.
• Overlooking zero-sum: Gains/losses offset between parties.

In the Real World

1. eSewa & Khalti (Digital Payments)

   • Idea Used: Forward contracts on USD/NPR exchange rates.
   • How: When eSewa processes remittances (e.g., from the US), it locks in future exchange rates to avoid losses if the NPR weakens.

2. NEPSE Derivatives Segment (Stock Options)

   • Idea Used: Call/Put options on NEPSE stocks.
   • How: Retail investors use options to speculate on NMB Bank or Global IME stock movements without owning the shares.

3. NTC’s Debt Management

   • Idea Used: Interest rate swaps.
   • How: NTC converts floating-rate debt (tied to market rates) into fixed-rate payments to stabilize costs.

Final Summary Table

Next Steps for TU Exam:

• Practice numerical problems on futures/options pricing.
• Memorize key players (SEBON, CDSC, NEPSE).
• Relate theory to Nepal’s market (NMB, NTC, NEPSE).