3 - Derivatives Markets

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DERIVATIVES MARKETSSession 3

Derivatives and Risk Control

IMBA 2010

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DEFINITION

A derivative is an instrument whose value depends on the price ofother more basic assets (called underlying assets):

Stocks, Bonds,

Commodities,

Currencies,

Weather,

Real Estate,

Credit events (default),

Portfolio of mortgages,

Etc

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EXAMPLES OF DERIVATIVES

Forward Contracts

Futures Contracts

SwapsOptions

Options on Futures , Swaptions, etc.

Non standard derivatives

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DERIVATIVES MARKETS

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ORGANIZED MARKETS

Most Important Derivatives Exchanges:

Chicago Board of Trade www.cbot.com

Chicago Mercantile Exchange www.cme.com

Chicago Board of Options Exchange www.cboe.com NYMEX www.nymex.com

Euronext www.euronext.com

Eurex www.eurex.com

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SPANISH OPTIONS AND FUTURES OFFICIAL MARKET:MEFF- MERCADO ESPAOL DE FUTUROS FINANCIEROS

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MEFF clears and trades: Options and Futures on Bonds, Interest rates, and

IBEX-35 index and Futures and Options on the leading Spanish stocks

Source: Bolsa de Madrid


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ORGANIZED MARKETS

Contracts are standardized and well defined:

y Underlying asset to be delivered: what, amount, quality,

y Where it can be delivered

y When it can be delivered

Negotiation is carried out in a blind way through theClearing House

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ORGANIZED MARKETS

Operation of the Clearing House

TRADINGy Traditionally derivatives were traded using the open outcry

system

y Now this is being replaced by electronic tradingwhere acomputer matches buyers and sellers

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Clearing House

Buyer Seller

BrokerA

BrokerB

Market


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MARGINS

In order to eliminate the counterparty risk the ClearingHouseestablishes a system of guarantees to protect against losses incase of insolvency of any member of the market.

A margin in cash or marketable securities has to be deposited

by an investor with his or her broker on the margin account

Margins are calculated on the basis of the number ofcontracts bought and sold

To ensure that the guarantee remains untouched the balance inthe margin account is adjusted to reflect daily settlement(daily gains and losses) daily marking-to-market

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OVER-THE COUNTER MARKETS

Are an important alternative to exchanges

It is a telephone and computer-linked network of dealers who donot physically meet

Trades are usually between financial institutions, corporatetreasurers, and fund managers

Derivatives instruments traded at OTC markets are tailor-made

Do not require margin accounts

Less liquid

More credit risk

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SIZE OF OTCAND EXCHANGE MARKETS

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Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying

assets for exchange market


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FUTURES CONTRACTS

A futures contract is an agreement to buy or sell an assetat a certain time in thefuture for a certain price

By contrast in a spot contract there is an agreement to buy orsell the asset immediately (or within a very short period of

time) When investor enters into a futures contract (t0) he/she knows:

y Futures price price at which he will buy/sell the underlyingasset at the maturity (F0)

y Contract Maturity time when he will buy/sell the underlyingasset (T)

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FUTURES CONTRACTS

Examples:

Agreement to:y buy 100 oz. of gold @ $1300/oz. in December (NYMEX)

y sell 62,500 @ 1.9800 $/ in March (CME)

y sell 1,000 bbl. of oil @ $80/bbl. in April (NYMEX)

Terminology:

y The party that has agreed to buy has a long positiony The party that has agreed to sell has a short position

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PROFIT FROM A LONG FUTURES POSITION

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Profit

Price of Underlying

at Maturity


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PROFIT FROM A SHORT FUTURES POSITION

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Profit

Price of Underlying

at Maturity


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FUTURESVS. SPOT PRICE

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Time Time

(a) (b)

FuturesPrice

FuturesPrice

Spot Price

Spot Price

y At any point of timefutures price is determined by supply and

demand in the same way as a spot pricey At the maturity of the contract futures price converges to

the spot price


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FUTURES MARKETS

Futures are traded in the organized markets

They are standardized contracts:

y Underlying asset: type, quantity, quality

y Maturity

y Delivery: place, time, etc.

To trade futures investors are required to provide guarantees

No credit risk

There is daily marking-to-market

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EXAMPLE OF DAILYMARKING-TO-MARKET

On November 17 an investor takes a long position inDecember gold futures contracty Contract size: 100 ounces

y Initial margin/contract: $2,150

y Maintenance margin/contract: $1,650

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Futuresprice($ per oz)

Dailygain(loss)

Cumulativegain (loss) Marginaccountbalance

Margin call

Date

17 Nov 800 2150

18 Nov 797 -300 -300 1850

19 Nov 802 500 200 2350

20 Nov 794 -800 -600 1550 600

21 Nov 792 -200 -800 1950

24 Nov 795 300 -500 2250


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EXAMPLE OF DAILYMARKING-TO-MARKET

Investors earn interest on a margin account.

Initial margin requirements: cash (100%), T-bills (at 90% oftheir face value), stocks (at 50% of their market value).

Initial margin and maintenance margins (i.e. 75% of theinitial margin) are set by the exchanges.

Margins may depend on:

y Variability of the price

y Objectives of the trader, e.g. hedger vs. speculator

y Day trade and spread transaction vs. hedge transactions

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SETTLEMENT OF THE FUTURES CONTRACT

Physical Delivery

y Contract is settled by delivering the assets underlying thecontract.

y When there are alternatives about what is delivered orwhere and when it is delivered, theparty with the short

position chooses.y A few contracts (e.g. those on stock indices and Eurodollars)

are settled in cash

Closing out a futures position before the maturity

y Closing out a futures position involves entering into anoffsetting trade

y Most contracts are closed out before maturity21


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FORWARD CONTRACTS

Forward contracts are similar to futures except that theytrade in the over-the-counter market

There is no daily settlement (unless a collateralization

agreement requires it).

At the end of the life of the contract one party buys theasset for the agreed price from the other party

Forward contracts are popular on currencies and interestrates,

Example: FOREXwww.forex.com22


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FORWARD CONTRACTSVS FUTURES CONTRACTS

Forward Futures

Private contract between two parties Traded on an exchange

Not standardizedS

tandardizedUsually one specified delivery date Range of delivery dates

Settled at end of contract Settled daily

Delivery or final settlement usual Usually closed out prior to maturity

Some credit risk No credit risk

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OPTIONS

A call option is an option to buy a certain asset at acertain date for a certain price (the strike price)

Aput option is an option to sell a certain asset at acertain date for a certain price (the strike price)

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OPTION CONTRACTOption contract specifies:

y

Underlying asset: type, amount, qualityy Maturity (T)

y Strike (Exercise) price (X)

y Type of option:

European can only be exercised at maturityAmerican can be exercised at any time during options lifeExotic

y Delivery: place, time, etc.

Example: MEFF25


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OPTIONSVS. FUTURES/FORWARD CONTRACTS

A futures/forward contract gives the holder theobligation to buy or sell at a certain price

y Theres no exchange of capital when the contract is started

An option gives the holder the right to buy or sell at acertain price (there is apremium paid when the contractis started)

y For longposition it is a right (pays the premium)y For short positions it is an obligation (receives the premium)

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OPTION MONEYNESS

Depending on the relationship strike price market price ofthe underlying asset an option can be:

y

in-the-money (ITM)

y at-the-money (ATM)

y out-of-the-money (OTM)

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PROFIT FROM BASIC POSITIONS IN OPTIONS

Long Call

Your loss is limited to the premium

Profit is unlimited

Higher returns with low investment

(leverage effect) You fix the price at which you will buy the

underlying asset

Long Put

Loss is limited to the premium

Profit is limited

Insurance of the portfolio of stocks if you

expect stock price to decreaseprotective put

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XS,0

XS,SXp-)SX,0(Maxp

T

TT

TT

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cT

X

ST- c

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REASONS FOR TRADING DERIVATIVES:HEDGING, SPECULATION,ANDARBITRAGE

HEDGING

y trading for eliminating/reducing risk

Examples:

A US company willpay 10millionforimportsfrom Britainin 3months anddecidestohedgeusinga longpositionin a forwardcontract

Aninvestorowns 1,000 Microsoft shares currently worth $28per

share. A two-monthput with a strikepriceof$27.50 costs $1. Theinvestordecidestohedge by buying10 contracts.

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VALUE OF MICROSOFT SHARES WITHAND WITHOUTHEDGING

20,000

25,000

30,000

35,000

40,000

20 25 30 35 40

Stock Price ($)

Value of

Holding ($)

No Hedging

Hedging

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SPECULATION

y trading for profiting from expected differences in quotations based ontaking positions according to expected trends

y A speculator tries to maximize profits in the shortest period of

time, minimizing the investment of personal funds (dynamic/ activespeculation).

y But also holding a spot position without any type of hedge is also aspeculative strategy (passive/static).

Example:y Aninvestor with $2,000toinvestfeelsthat Amazon.coms stockprice

willincreaseoverthenext 2months. The currentstockpriceis $20

andthepriceofa 2-month calloption with a strikeof$22.50is $1.

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ARBITRAGEy Trading forprofiting from pricing anomalies in the markets

without assuming any risk

y Arbitrage opportunities are generated by imperfections orinefficiencies in the prices formation.

Example:

y A stockpriceis quoted at 100in London and $182in New York

y The currentexchangerateis 1.85y Whatisthe arbitrageopportunity?

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NON STANDARD DERIVATIVES CONTRACTSExample: Range forward contract (flexible forwards)

A currency range forward contract has the chosen band between 1.90 and1.95. If the spot rate at the maturity is less than 1.90, the buyer pays1.90; if it is between 1.90 and 1.95, the buyer pays the spot rate; if it isgreater than 1.95, the buyer pays 1.95.

ST < $1.90 $ST $1.90 (Loss)

$1.90 < ST < $1.95 $0

$1.95 < ST $S T $1.95 (Gain)

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NON STANDARD DERIVATIVES CONTRACTS

Example: ICON(index currency option notes) - bondsin whichthe amountreceived bytheholder atmaturityvaries with a foreignexchangerate:

Two exchange rates are specified, X1 and X2, where X1 > X2. If the exchange rate,ST, at the bonds maturity is above X1, the bondholder receives the full face value.If X1> ST >X2, a portion of the full face value is received. IfST 1.45 $1,000

1.42 > ST > 1.35 $1,000-max[0, 1000*(1.45/ST -1 )]ST< 1.35 $0

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3 - Derivatives Markets