Reading 48: Derivative Markets and Instruments
Derivatives
Definition:
A derivatives is a security that derives its value by transforming the performance of underlying assets
Futures and Options are traded on organized exchanges
Forward contracts, swaps, credit derivatives, and some options are custom instruments created by dealers
Forward commitments and contingent claims
Futures, forward contracts, and swaps
Options and Credit Derivatives
Credit derivatives: Borrower credit event
Options: Exercised by holder
Forward Contracts
LONG Position obligated to buy;
SHORT Position obligated to sell
Characteristics
Specified date in the future
LONG GAINS: Future Asset price > Foward price
SHORT GAINS: Future Asset price < Foward price
No money paid at contract initiation
Settlement
Cash settlement: Negative side of contract pays the positive side
Delivery: Short delivers underlying to long for payment of the forward price
Futures Contracts
Like forward contracts but standardized
are the primary of commodity derivatives
Characteristics
Contract specifies: Quality and quantity of goods, delivery time, manner of delivery
Exchange specifies: Minimum price fluctuation (tick), daily price limit
Clearinghouse holds other side of each trade
Margin posted and marked to market daily
Margin is a performance guarantee, not a loan
Long buys and short sells the future
Vs. Forwards
Forwards
Private contracts
Unique contracts
Default risk present
No margin
Little regulation
Futures
Exchange-trade, active secondary market
Standardized
Guaranteed by clearinghouse, Require margin deposit, thus No default (counterparty) risk
Margin required
Regulated
Futures Margin
Initial margin: Deposited before trade occurs
Maintenance margin:
Minimum margin that must be maintained in a futures account
If account balance < maintenance margin, must deposit enough to restore initial margin or close the position
Prices
Settlement price: Average of trades during closing period, used to calculate margin
Spot price: Price of underlying asset for immediate delivery
Futures price converges to spot price as a futures contract nears expiration
Price limits
Exchange-imposed limits on how much the contract price can change each day, based on previous day's settlement price
Exchange member is prohibited from executing trades at prices outside these limits
If the new equilibrium price (at which traders would willingly trade) is outside the limits, trades cannot take place, locked limit
Marking-to-market:
Marking-to-market is the process of adjusting margin balance in a futures account each day for the change in the futures price (add gains, subtract losses)
The futures exchanges can require a mark-to-market more frequently than daily under extraordinary circumstances (increased volatility)
Swaps
A swap is a derivative contract through which 2 parties exchange the cash flows or liabilities from 2 different financial instruments
Custom instruments
Not traded in any organized secondary market
Largely unregulated
Default risk is a concern
Most participants are large institutions
Difficult to alter or terminate
Components
Notional principal: amount used to calculate periodic payments
Floating rate: usually LIBOR
Tenor: Time period covered by swap
Settlement dates: Payment due dates
Plain Vanilla Interest Rate Swap
Fixed interest rate payments are exchanged for floating-rate payments
Interest payments are netted, the party that owes more pays the difference
Credit Derivatives
Credit derivatives provide protection (from seller to buyer) against a credit event such as borrower default
With a credit default swap, the buyer makes periodic payments to the (protection) seller and receives a payment if a credit event (ex: default) occurs
Similar to insurance against a credit event
Options
BUYER / OWNER / LONG POSITION
Pays a premium to purchase the right to exercise an option at a future date
SELLER / WRITER / SHORT POSITION
Incurs an obligation to perform under the option contract terms
Call option:
Long has the right to buy the underlying asset at the exercise (strike) price
Short has obligation to sell the underlying asset at the exercise price
Put option:
Long has the right to sell the underlying asset at the exercise (strike) price
Short has obligation to buy the underlying asset at the exercise price
Option Exercise
European options can be exercised only at expiration
American options can be exercised any time prior to expiration
American options are worth at least as much as otherwise identical European options
Option Moneyness
An option is in the money if exercising it will be profitable
A put option is in the money if the underlying asset price < exercise price
"Has a value of $5 at exercise" = if exercise, profit = $5
Call:
Breakeven point = Exercise price + option premium
Gain for long position and Loss for short position is Unlimited as stock price can increase to any level
Put:
Breakeven point = exercise - option premium
Gain for long position and Loss for short position is maximum when stock price = 0 (stock price cannot <0)
Purposes and Criticisms of Derivatives
Criticism:
Risky
Like gambling
Benefits
Provide price information
Lower transaction costs
Allow transfer of risk
Arbitrage
Arbitrage is possible when 2 securities or portfolios have identical future payoffs but different market prices
Trading by arbitrageurs will continue until they affect supply and demand enough to bring asset prices to efficient (no-arbitrage) levels
Equivalent to a series of forward contracts
Company A has fixed interest rate, Company B has variable interest rate.
Both companies swap their interest rates: A now has variable, while B has fixed interest rate
A will benefit if interest rate falls, while B will benefit if interest rate rise
A call option is in the money if the underlying asset price > exercise price
Allows the transfer of risk between 2 parties
better risk management
Customized, Traded in OTC market. Need to be reported to regulator
Specified asset (currency, stock, index, bond)
Linear payoff: The payoff of a derivative contract that moves one-for-one with changes in the underlying price or rate
are forward commitments
are contingent claims: one party's obligation depends on an yet-to-realize event
either party can default. Unlike only Short Position can default in contigent claim
Maintenance Margin < Initial Margin
Can realize profit on day-to-day basis
Realize profit on day-to-day
Realize profit on expiration
Forward provide obligations to buy or sell the underlying assets at future date
Equity Swap:
Currency Swap:
involves trading principal and interest in one currency for the same in another currency.
Investor pays the return of a stock and receive a fixed rate
Can provide reference for price in future
More liquidity
Unlike gambling, derivative speculation at least can benefit financial market and thus society
High leverage means substantial loss if market move in unfavorable direction
The law of one price:
2 assets which will produce the same cash flows in the future must sell for equivalent prices