Free Financial Markets Operations Management by Keith Dickinson Page A

derivative product in which two counterparties exchange certain benefits of one party's financial assets for those of the counterparty's assets.
    The cash flows are calculated on a notional principal amount and these cash flows are known as the legs of a swap.
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    This derivative type is OTC.
2.6.3 Derivative Usage
Hedging: A broad range of market participants use derivatives to hedge or reduce their exposure to future market conditions, for example, an airline will ask its bank to design a combination of option contracts against rising jet fuel prices. If the fuel price increases to a predetermined amount, then the bank, in effect, refunds the difference between the cash price of the fuel and the strike price of the option contract. We will look at an example later in this chapter. As a further example, a fund manager can hedge a portfolio of bonds against a decrease in value by selling an appropriate number of futures contracts. If the portfolio does, in fact, decrease in value, then the fund manager will receive benefit from an increase in the value of the futures contract. A perfect hedge would therefore be a decrease in the portfolio value of X, mirrored by an increase in the value of the futures contracts also of X.
Dealing: Both ETD and OTC contracts are traded by dealers who work for banks and securities houses. Their role is to trade on behalf of their employer companies and to advise and trade on behalf of their clients. They will have expertise in a wide variety of derivative products ranging from standard ETDs to complex combinations of OTC contracts.
Speculation: It can be time-consuming and expensive to buy or sell the underlying assets such as equities and bonds. For a speculator it can be a lot more straightforward to purchase a derivative contract and benefit by selling it when the price increases. It may not be possible to sell the underlying asset “short”; by contrast, it is just as easy to sell the derivative short as it is to buy long. Furthermore, these transactions can be executed much more quickly and more cheaply.
    A common variant of speculative trading is spread trading, whereby there is a combination of buys and sells in the same product but with two different aspects, for example:
Two different delivery months (e.g. March and June);
Two different stock market indices (e.g. DAX and CAC);
Two different commodities (e.g. West Texas Intermediate and Brent crude).
Arbitrage: Arbitrageurs attempt to exploit the price differences between two similar products traded in two different markets. By way of comparison, in Table 2.29 we can see how an arbitrageur might benefit from the price differences on an interest-rate future and an underlying government bond.
The arbitrageur has made a profit by benefiting from price differences that might only remain for a short period of time. Note that the arbitrageur has closed out both positions at the conclusion of this transaction.
Asset allocation: An institutional client such as an insurance company might be holding a portfolio of securities in one particular market. It might wish to reduce its exposure to that market and increase exposure in another market. There are two ways that the insurance company can achieve this:
The insurance company can sell securities in the first market and with the cash buy securities in the second. This can be expensive in terms of transaction costs, time-consuming in selecting appropriate securities and uncertain in terms of pricing. Furthermore, it may not be part of the insurance company's investment strategy to reallocate funds for a long-term time horizon. In other words, this might be a short-term strategy.
The insurance company can reduce exposure in the first market by selling an appropriate number of futures contracts and can increase exposure in the second by buying an appropriate number of futures contracts. This can be achieved by two transactions and can be quick to execute with low transaction charges. If