QUESTION TWO (25 marks)

Derivatives are specific types of instruments that derive their value over time from the performance of an underlying asset: e.g. equities, bonds, commodities. A derivative is traded between two parties - who are referred to as the counterparties. These counterparties are subject to a pre-agreed set of terms and conditions that determine their rights and obligations. Derivatives can be traded on or off an exchange and are known as: a) Exchange-Traded Derivatives (ETDs): Standardized contracts traded on a recognized exchange, with the counter parties being the holder and the exchange. The contract terms are non-negotiable and their prices are publicly available, b) Over-the-Counter Derivatives (OTCs): Bespoke contracts traded off-exchange with specific terms and conditions determined and agreed by the buyer and seller (counterparties). As a result OTC derivatives are more illiquid, e.g. forward contracts and swaps.

Required

Explain how a commercial bank can manage its risk using the following derivative instruments:

i)

Options

[5 marks]

ii)

Futures

[5 marks]

iii)

Forwards

[5 marks]

iv)

Swaps

[5 marks]

v)

Swaptions

[5 marks]