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A fixed-income derivative is a contract whose value derives from the value of a fixed-income
security like a bond.

There are two basic types of fixed-income derivatives. The first type, interest-rate derivatives, is
based on the direction of interest rates. The second type, credit derivatives, is based on credit
risk, or the probability of a bond issuer defaulting on an obligation.

There is a wide range of fixed income derivative products: options, swaps, futures contracts as
well as forward contracts.

They can benefit your portfolio by reducing transactions costs and improving your trading
efficiency. There are various types of derivative instruments that can help you maximize gains
and minimize losses in your investments.

Interest Rate Swaps: An interest rate swap is a fixed-income derivative in which counterparties
exchange different cash flows. One cash flow is based on a fixed interest rate applied to a
notional, or imaginary, principal amount; the other cash flow is a floating interest rate applied to
the same notional amount.

Bond Futures Contract: A bond futures contract is an agreement to buy or sell a bond in the
future at a price agreed upon now. Futures contracts are standardized instruments traded on
futures exchanges. The price of the futures contract is theoretically determined by the
anticipated future price of the underlying bonds discounted at the risk-free rate.

Fixed income derivative products include:

Option Contracts

The two main types of options available for purchase are call and put options. The holder of a
call option has the right to buy an asset and the holder of a put option has a right to sell an
asset. Options can offer protection from price swings by allowing investors to guess, or
speculate, on the price movement of a particular investment.

Futures Contracts

Futures contracts are used to promise the delivery at a future date, known as the settlement
date, of a financial instrument or commodity at a specified price; the contract can also be settled
in cash. Traded on futures exchanges, the value of these contracts change from day to day and
an investor can close out the contract before the settlement date. Unlike options, the buyer or
seller of a futures contract must carry out the transaction.

Forward Contracts

Forward contracts are similar to futures; they require a future delivery of a commodity or
instrument or a cash settlement of the contract, and their objective is to profit from changes in
price. Unlike futures, forward contracts are not traded on an established and regulated
exchange. Forward contracts typically trade over the counter and are private agreements with
more flexible terms. However, the private nature of the contract makes it susceptible to default
by either party to the contract.

Credit Default Swaps

The purchase of credit default swaps is similar to the purchase of an insurance contract. The
buyer of a credit default swap receives protection from the possible nonpayment of a debt
security. The seller of a credit default swap agrees to pay the buyer a specified amount if the
debtor defaults on her payments. This type of derivative is a useful way to transfer an
investment’s credit exposure to a third party without having to sell the asset.

Financial instruments involve various risks, several risk factors are discussed below:

a) Market risk: The risk that changes in market prices may have adverse effect on financial
instruments.

b) Interest rate risk: The risk that changes in interest rates may have adverse effect on the value
of a financial instrument.

c) Currency risk: Exchange rates fluctuate and financial instruments that are registered in foreign
currency can entail currency risk. Changes in currency rates can cause profit or loss although the
currency value in which the underlying instrument is registered does not change.

d) Liquidity risk: Lack of liquidity may prevent an investorfrom selling financial instruments at
market prices, possibly causing him/her to sell instruments at a substantial discount to fair price.
This can becaused by various factors, such as inactive market with a particular instrument,
contract size and other factors that mayaffect the supply and demand and market participants’
behaviour.

e) Economic risk: Economic fluctuations often affect the prices of financial instruments. The
fluctuations are variable, they can variate in time and magnitude and can affect different
industries in various ways. When deciding on an investment an investor must be aware of the
general impact of economic fluctuations, including between countries and different economies,
on the value of financial instruments. For example, shares typically do well inperiods of
economic growth and underperform during downturns. High quality sovereign bonds typically
do well in periods of economic slowdown as interest rates tend to decline.
f) Country risk: The risk includes, among other things, political risk, currency risk, economic risk
and risk relating to capital transfers. This refers to the economic factors that could have a
significant impact on the business environment in the country in which the financial instrument
is registered. For example, investors might lend money to a solvent foreign debtor and not be
able to collect the proceeds of their investments in their domestic country because of capital
controls. In that scenario, investors will be “stuck” with their investments in the foreign country
and not be able to transfer them home.

g) Legal risk: The risk that the government makes changes to existing laws or regulations that
can have adverse effect on financial instruments, for example changes in tax laws or laws
regarding capital transfers across borders.

h) Inflation risk: When investors assess the yield of a specific financial instrument, it is necessary
to do so with regard to inflation and inflation outlook to estimate the expected real return on
investment and current asset value.

i) Counterparty risk: The risk that a counterparty will not meet his contractual obligations in full.
It occurs each time a party lends money to another party. When investors lend money to an
issuer, for example by purchasing debt-related instruments counterparty risk refers to the
inability of a debtor (the issuer in this case) to honor his debt payment(s). This inability is called
“default” and investors may lose part or all of the capital they lent.

j) Settlement risk: The risk related to a counterparty not meeting the contractual obligations on
the settlement date. Settlement loss may occur due to default or due to the different timings of
the settlement between relevant parties.

Reference: https://www.islandsbanki.is/library/Files/InvestorProtection/financial_instruments_and_associated_risks.pdf

https://www.lombardodier.com/files/live/sites/loportail/files/Documents/Disclaimers/Europe/LOESA%20-%20Risques%20-%20EN.pdf

Some key reforms can be:

·0 Increase banks’ resilience through stronger capital and liquidity buffers. Liquidity needs to be
reexamined. Relying solely on the old model will likely not sufce. Investors need to think about how
best to access liquidity across products and asset classes, using a broader, more robust suite of liquidity
measures and exposure vehicles.
·1 Reduce implicit public subsidies. Example: Volcker Rule - prohibits banking entities from engaging in
short-term (non market-making related) trading of securities, derivatives, commodity futures and
options on these instruments for their own account. In addition, banks are not permitted to own,
sponsor, or have certain relationships with hedge funds or private equity funds.

·2 Reduce impact of bank failures on the economy: Example: As a part of Dodd-Frank, The Financial
Stability Oversight Council and Orderly Liquidation Authority monitors the financial stability of major
firms whose failure could have a major negative impact on the economy (companies deemed "too big
to fail"). It also provides for liquidations or restructurings via the Orderly Liquidation Fund, which
provides money to assist with the dismantling of financial companies that have been placed in
receivership, and prevents tax dollars from being used to prop up such firms.

·3 Enhance recovery and resolution regimes.

·4 Index-based products central to portfolio construction and risk management: Post-crisis, demand for
transparent, standardized and bundled exposures has manifested in growth among index-based
products like credit default index swaps (CDX), total return swaps (TRS) and bond exchange traded
funds (ETFs). These products are fulflling investor needs for building blocks to construct portfolios and
manage risk more eficienctly.

·5 Change in market structure: The growth in electronic trading and participation by these new players has
been a result of the development of alternative trading protocols, an evolution in trading platforms and
venues as well as the ongoing adaptation of operating models to the regulatory environment.
Traditional banks and broker-dealers are also investing in the technology and personnel necessary to
position for the continued growth in electronic trading.