This time I am with the new topic “Financial Derivatives”, the discussion on the said topic has been presented in power point (which is attached in this article).
In the article instances have been incorporated from various international books and papers and I have acknowledged the names of writers/books wherever required, so the readers are requested not to raise any issues on the content/copy right issues. I express my sincere gratitude to the writers/ my FM Guru and all the finance books which helped me write few words on this topic. Every efforts have been made to avoid copyright issues.
I thank the entire Tax Guru Team, especially Sandeep Sir for uploading the article in the website and making the article available to number of readers.
Let’s move to the topic…
A derivative is contractual relationship established by two or more parties where payment is based on (or derived from) some agreed upon benchmark, i.e. a derivative is an instrument whose value is derived from the value of one or more underlying. Remember, derivative does not have value of its own rather it derives its value from some underlying. Simply stated pricing of derivative is based on the change in the price of underlying.
See what International writer writes on derivatives:
Sir John Hull in his books introduces this segment as: (An Extract)
Derivatives segment has been gaining its significance in last 20 years in the world of finance.
Futures and options are now traded actively on many exchanges throughout the world. Forward contracts, swaps, and many different types of options are regularly traded outside exchanges by financial institutions, fund managers, and corporate treasurers in what is termed the over-the-counter market. Derivatives are also sometimes added to a bond or stock issue…..
Sir Damodaran in his book Applied Corporate Finance says: (An Extract)
In the last 30 years, the futures and options markets have developed to the point that firms can hedge exchange rate, interest rate, commodity price and other risks using derivatives.
In fact, firms can use derivatives to protect themselves against risk exposures that are generated by mismatching debt and assets. Thus, a firm that borrows in dollars to fund projects denominated in Yen can use dollar/yen forward, futures and options contracts to reduce or even eliminate the resulting risk….
An extract from RWJ book on Corporate Finance:
The price of jet fuel can greatly affect the profitability of an airline. With rising fuel costs during 2008, fuel became the largest expense for many airlines, accounting for 40 percent or so of operating costs. Southwest Airlines became an innovator when it began to hedge its fuel costs by using a variety of sophisticated financial tools to deal with risks associated with volatile fuel costs, including heating oil futures contracts, jet fuel swaps, and call options. During periods of rising fuel costs, Southwest was often one of the few profitable airlines, saving millions of dollars through hedging.
During the third quarter of 2011, the cost of jet fuel dropped sharply, which sounds like good news for the airline industry. However, airlines frequently hedge fuel costs, a practice that can be costly when prices fall. During this quarter, Southwest Airlines announced a loss of $140 million, in large part due to a hedging loss of $262 million. This loss was Southwest’s first quarterly loss in more than 2 years, and only its second loss in more than 18 years. Southwest was not alone. For the same period, United Continental lost $56 million on its hedges, and Delta lost $220 million. Hence it is derivatives allow a company’s management to control risk and hedging.
(I am trying to focus on Derivatives and Hedging Risk)
Now refer the attachment of this article to read the entire topic, you can download the pdf file easily.
The above article is contributed by Niraj Thapa (ICAI Reg. No. : FRO0004147), a CA Final Student currently doing Article ship in a Delhi based Firm. For any queries and suggestions you may reach him at: email@example.com, (Mob. No: +91-7503500777).