56 Derivative markets and instruments ( Derivative markets and instrument…
56 Derivative markets and instruments
Derivative markets and instrument
Definition of derivative
A derivative is a financial instrument (contract) that derives its performance from the performance of an underlying asset.
Four main derivatives
A forward contract is a
that obligates one party to buy and the other party to sell a
of an underlying asset, at a
, at a
A future contract is a specialized version of a forward contract that has been
traders on a futures exchange
Guarantee provided by the exchange through the clearinghouse
the daily settlement for gains and losses
A Swap contact is a series of forward contracts
Exchange a series of cash flows
The owner has
not the obligation
to conduct a transaction
Right and obligations are not equal only in option contract, so the
long position need to pay option premium
According to contract features
is an agreement between two parties in which one party, the buyer, agrees to buy from the other party, the seller, an underlying asset at a future date at a price established at the start
forward, futures and swap contracts
is derived in which the payoffs occur if a specific event happens
According to trading place
place where traders can meet to arrange their traded
Over-the-counter (OTC) traded
where buy and sell orders initiated from various locations are matched through a communications network
forward, swap, option
Advantage & disadvantage of derivatives
Four main derivative products
Long and short forward position
No payments will be made at the inception of a forward contract. So both parties of a forward contract is exposed to potential default risk.
Risk-free arbitrage and no-arbitrage rule
Commodity forward contract
Financial forward contract
Purpose of trading forward contracts
Lock the cost in the future, but not sure to make money
have default risk
gambling the price movement
Each party are exposed to default risk (or counterparty risk)
Settling a forward contract at expiration
deliver an actual asset, has storage cost, mostly used in commodity forward
the party that has a position with negative value is obligated to pay that amount to the other party, mostly used in financial forward
Settling a forward contract prior to expiration
Entering into an opposite forward contract
with an expiration date equal to the time remaining on the original contract
Offsetting with a different party
some credit risk remains
Offsetting with the original party
can avoid credit risk
LIBOR, Euribor, and FRAs
An FRA can be viewed as a forward contract to borrow/lend money at a certain rate at some future date.
The long position
is the party that would borrow the money
The short position
is the party that would lend the money
settle in cash, but no actual loan is made at the settlement date
A future contract is an agreement that obligates one party to buy and the other party to sell a specific quantity of an underlying asset, at a set price, at a future date.
Futures contracts specify the
of goods that can be delivered, the delivery
Each exchange has a clearing house which is a third participant guaranteeing to each party that is ensures against the other party defaulting.
A clearinghouse acts as the
to each participant.
The clearinghouse is the buyer to the seller and the seller to the buyer by crediting gains to the winners and charging losses to the losers.
There is no need to worry about the counterparty default risk.
Each participants are allowed by the clearinghouse to reverse their positions in the future.
Risk control of Futures contract
Daily price limit
Limit on the extent of price movement from the settlement price of the previous trading day.
If traders wish to trade at price outside these limit --- no trades will take place. --- the settlement price will be reported upper or lower price limits
when the markets hits these limits (limit up or limit down) and trading stops.
Marketing to market
Characteristics of Swap Contracts
A swap contract obligates two parties to change
a series of cash flows
periodic settlement dates
over a certain time period.
Similarity with forward
No payment required by either party at initiation except the principle values exchanged in currency swaps.
Traded in OTC markets
Subject to default risk
Three types of swap contacts. Interest Rate Swaps
The plain vanilla interest rate swap involves trading
fixed interest payments for floating-rate payment
(paying fixed and receiving floating)
The parties involved in any swap agreement are called the counterparites
The counterparty that makes fixed-rage interest payment in exchange for variable interest rate.
The counterparty that makes variable-rate interest payment in exchange for fixed payment.
The Comparative Advantage Argument
wants to borrow floating
wants to borrow fixed
Definition of option
An option is a derivative contract in which one party, the buyer, pays a sum of money to the other party, the seller or writer, and receives the right to either buy or sell an underlying asset at a fixed price either on a specific expiration date or at any time prior to the expiration date.
Long call & Short call
Long put & Short put
The seller or short position in an options contract is sometimes referred to as the writer of the option
option premium paid by the buyer of option
Strike price (X) represents the exercise price specified in the contract.
Credit default swaps (CDS)
is essentially an
for the reference, the reference obligation is the fixed income security on which the swap is written-usually a bond but potentially also a loan.
Protection buyer receives a payment from the protection seller is default occurs on the reference entity.
The protection buyer pays the seller a premium. The default swap premium is also referred to as the CDS spread.
Credit spread option
the underlying is the credit (yield) spread on a bond, which is the difference between the bond's yield and the yield on a benchmark default-free bond
Risk free arbitrage