Derivatives Market Guide

Derivatives Market
Sugath Alwis, CFA
Introduction
z
There is no universally satisfactory answer

to the question of what a derivative is,
however one explanation ......
A financial derivative is a financial instrument

or security whose payoff depends on another
financial instrument or security ......the payoff
or the value is derived from that underlying
security
derivatives are agreements or contracts
between two parties
Introduction (contd)
z
Futures, options and swap markets are very

useful, perhaps even essential, parts of the
financial system
hedging or risk management

speculate or strive for enhanced returns
price discovery - insight into future prices of
commodities
Futures and options markets, and more

recently swap markets have a long history
of being misunderstood -
How many have heard of the following:
z Nick Leeson and Barings Bank $1.3B (1995)
z Orange County California - $1.7B (1994)
z Sumitomo Copper $2.6 B (1996)
z Proctor & Gamble $102 M (1994)
z Govt. of Belgium - $1.2B (1997)
....market type losses have often been attributed to the use of
4
derivatives - in many of these situations this has been the

case i.e a speculative application of derivatives that has gone
against the user
What many critics of equity derivatives fail to realize is that the
markets for these instruments have become so large not because of
slick sales campaigns, but because they are providing economic
value to their users
Alan Greenspan, 1988
In our view, however, derivatives are financial weapons of mass

destruction, carrying dangers that, while latent now, are potentially
lethal
Warren Buffett 2002 Berkshire Hathaway annual report
derivatives are something like electricity: dangerous if mishandled, but

bearing the potential to do good
Arthur Leavitt- Chairman SEC 1995
Derivatives & Risk

z
Derivative markets neither create nor destroy

wealth - they provide a means to transfer risk
zero sum game in that one partys gains are equal to

another partys losses
participants can choose the level of risk they wish to take
on using derivatives
with this efficient allocation of risk, investors are willing to
supply more funds to the financial markets, enables firms
to raise capital at reasonable costs
Derivatives & Risk

z
Derivatives are powerful instruments - they

typically contain a high degree of leverage,
meaning that small price changes can lead
to large gains and losses
this high degree of leverage makes them
effective but also dangerous when
misused.
Hedging
z
z
Hedging involves engaging in a financial

transaction that reduces or eliminates risk.
Definitions
long position: an asset which is purchased

or owned
short position: an asset which must be delivered to
a third party as a future date, or an asset which is
borrowed and sold, but must be replaced in the
future
Hedging
z
Hedging risk involves engaging in a financial

transaction that offsets a long position by
taking an additional short position, or offsets a
short position by taking an additional long
position.
Types of Derivatives
z
z
z
z
z
10
Forwards contracts
Futures contracts
Options
Swaps
Hybrids
Forward Markets
z
11
Forward contracts are agreements by two parties to

engage in a financial transaction at a future point in time.
Although the contract can be written however the parties
want, the contact usually includes:
The exact assets to be delivered by one party,

including the location of delivery
The price paid for the assets by the other party
The date when the assets and cash will be exchanged
Forward Markets
z
An Example of an Interest-Rate Contract
12
First National Bank agrees to deliver $5 million in

face value of 6% Treasury bonds maturing
in 2023
Rock Solid Insurance Company agrees to pay $5
million for the bonds
FNB and Rock Solid agree to complete the
transaction one year from today at the FNB
headquarters in town
Forward Markets
z
Long Position
Short Position
13
Agree to buy securities at future date

Hedges by locking in future interest rate of funds
coming in future, avoiding rate decreases
Agree to sell securities at future date

Hedges by reducing price risk from increases in
interest rates if holding bonds
Forward Markets
z
Pros
1.
Cons
1.
2.
14
Flexible
Lack of liquidity: hard to find a counter-party and thin

or non-existent secondary market
Subject to default riskrequires information to screen
good from bad risk
Financial Futures Markets

z
15
Financial futures contracts are similar to

forward contracts in that they are an
agreement by two parties to engage in a
financial transaction at a future point in
time. However, they differ from forward
contracts in several significant ways.

z
Financial Futures Contract

1.
2.
3.
4.
16
Specifies delivery of type of security at future date

Arbitrage: at expiration date, price of contract =
price of the underlying asset delivered
i , long contract has loss, short contract has
profit
Hedging similar to forwards: micro versus macro
hedge
Traded on Exchanges
Global competition regulated by CFTC
Example: Hedging Interest Rate Risk
A manager has a long position in Treasury

bonds. She wishes to hedge against interest
rate increases, and uses T-bond futures to do
this:
17
Her portfolio is worth $5,000,000

Futures contracts have an underlying value of
$100,000, so she must short 50 contracts.
Example: Hedging Interest Rate Risk
18
As interest rates increase over the next 12 months,

the value of the bond portfolio drops by almost
$1,000,000.
However, the T-bond contract also dropped almost
$1,000,000 in value, and the short position means
the contact pays off that amount.
Losses in the spot T-bond market are offset by
gains in the T-bond futures market.

z
19
The previous example is a micro hedge

hedging the value of a specific asset. Macro
hedges involve hedging, for example, the
entire value of a portfolio, or general prices for
production inputs.

z
20
In the U.S., futures are traded on the CBOT

and the CME in Chicago, the NY Futures
Exchange, and others.
They are regulated by the Commodity Futures
Trading Commission. The most widely traded
are listed in the Wall Street Journal, as we see
on the next slide.

z
z
z
z
21
The U.S. exchanges dominated the market for

years. However, this isnt true anymore.
The London Intl Financial Futures Exchange
trades Eurodollar futures
The Tokyo Stock Exchange trades Euroyen
and govt bond futures
Several others as well, as seen next.
Widely Traded Financial

Futures Contracts
22

z
23
Success of Futures Over Forwards

1.
Futures are more liquid: standardized contracts

that can be traded
2.
Delivery of range of securities reduces the

chance that a trader can corner the market
3.
Mark to market daily: avoids default risk
4.
Don't have to deliver: cash netting

of positions
Hedging FX Risk
z
24
Example: A manufacturer expects to be paid

10 million euros in two months for the sale of
equipment in Europe. Currently, 1 euro = $1,
and the manufacturer would like to lock-in that
exchange rate.
Hedging FX Risk
z
25
The manufacturer can use the FX futures

market to accomplish this:
1.
The manufacturer sells 10 million euros of futures

contracts. Assuming that 1 contract is for
$125,000 in euros, the manufacturer takes as
short position in 40 contracts.
2.
The exchange will require the manufacturer to

deposit cash into a margin account. For
example, the exchange may require $2,000 per
contract, or $80,000.
Hedging FX Risk
3.
26
As the exchange rate fluctuates during the two

months, the value of the margin account will
fluctuate. If the value in the margin account falls
too low, additional funds may be required. This is
how the market is marked to market. If
additional funds are not deposited when required,
the position will be closed by the exchange.
Hedging FX Risk
27
4.
Assume that actual exchange rate is 1 euro = $0.96 at the

end of the two months. The manufacturer receives the 10
million euros and exchanges them in the spot market for
$9,600,000.
5.
The manufacturer also closes the margin account, which

has $480,000 in it$400,000 for the changes in exchange
rates plus the original $80,000 required by the exchange
(assumes no margin calls).
6.
In the end, the manufacturer has the $10,000,000 desired

from the sale.
Futures/Forward Contracts History

z
Forward contracts on agricultural products began in the

1840s
28
producer made agreements to sell a commodity to a buyer at a

price set today for delivery on a date following the harvest
arrangements between individual producers and buyers contracts not traded
by 1870s these forward contracts had become standardized
(grade, quantity and time of delivery) and began to be traded
according to the rules established by the Chicago Board of
Trade (CBT)
Futures/Forward Contracts History Contd

z
1891 the Minneapolis Grain Exchange

organized the first complete clearinghouse
system
the clearinghouse acts as the third party to all

transactions on the exchange
designed to ensure contract integrity
z
z
29
buyers/sellers required to post margins with the

clearinghouse
daily settlement of open positions - became known as the
mark-market system
Futures/Forward Contracts History Contd

z
30
Key point is that commodity futures (evolving from

forward contracts) developed in response to an
economic need by suppliers and users of various
agricultural goods initially and later other
goods/commodities - e.g metals and energy
contracts
Financial futures - fixed income, stock index and
currency futures markets were established in the
70s and 80s - facilitated the sale of financial
instruments and risk (of price uncertainty) in
financial markets
Stock Index Futures
31
Financial institution managers, particularly

those that manage mutual funds, pension
funds, and insurance companies, also need to
assess their stock market risk, the risk that
occurs due to fluctuations in equity market
prices.
One instrument to hedge this risk is stock

index futures.
Stock Index Futures
32
Stock index futures are a contract to buy or

sell a particular stock index, starting at a given
level. Contacts exist for most major indexes,
including the S&P 500, Dow Jones Industrials,
Russell 2000, etc.
The best stock futures contract to use is

generally determined by the highest correlation
between returns to a portfolio and returns to a
particular index.
Hedging with Stock Index Futures

z
33
Example: Rock Solid has a stock portfolio

worth $100 million, which tracks closely with
the S&P 500. The portfolio manager fears that
a decline is coming and what to completely
hedge the value of the portfolio over the next
year. If the S&P is currently at 1,000, how is
this accomplished?

z
Value of the S&P 500 Futures Contract = 250

index
To hedge $100 million of stocks that move 1

for 1 (perfect correlation) with S&P currently
selling at 1000, you would:
34
currently 250 x 1,000 = $250,000
sell $100 million of index futures =

400 contracts

z
Suppose after the year, the S&P 500 is at 900

and the portfolio is worth $90 million.
If instead, the S&P 500 is at 1100 and the

portfolio is worth $110 million.
35
futures position is up $10 million
futures position is down $10 million
Either way, net position is $100 million
36
Note that the portfolio is protected from

downside risk, the risk that the value in the
portfolio will fall. However, to accomplish this,
the manager has also eliminated any
upside potential.
Now we will examine a hedging strategy that

protects again downside risk, but does not
sacrifice the upside. Of course, this comes at
a price!
Options
z
An option is the right to either buy or sell

something at a set price, within a set period
of time
37
The right to buy is a call option

The right to sell is a put option
You can exercise an option if you wish, but

you do not have to do so
Options
z
Options Contract
38
Right to buy (call option) or sell (put option) an

instrument at the exercise (strike) price up until
expiration date (American) or on expiration date
(European).
Options are available on a number of financial

instruments, including individual stocks, stock
indexes, etc.
Options
z
Hedging with Options
if i falls:
39
Buy same number of put option contracts as would

sell
of futures
Disadvantage: pay premium
Advantage: protected if i gains
Additional advantage if macro hedge: avoids
accounting problems, no losses on option if i falls
Options
40
Factors Affecting Premium
41
1.
Higher strike price, lower premium

on call options and higher premium on
put options.
2.
Greater term to expiration, higher premiums

for both call and put options.
3.
Greater price volatility of underlying

instrument, higher premiums for both call and
put options.
Option Contracts - History

z
Chicago Board Options Exchange (CBOE) opened in

April of 1973
42
call options on 16 common stocks
The widespread acceptance of exchange traded

options is commonly regarded as one of the more
significant and successful investment innovations of
the 1970s
Today we have option exchanges around the world
trading contracts on various financial instruments and
commodities
Options Contracts
z
z
z
z
z
z
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43
Chicago Board of Trade

Chicago Mercantile Exchange
New York Mercantile Exchange
Montreal Exchange
Philadelphia exchange - currency options
London International Financial Futures
Exchange (LIFFE)
London Traded Options Market (LTOM)
Others- Australia, Switzerland, etc.

z
44
Example: Rock Solid has a stock portfolio

worth $100 million, which tracks closely with
the S&P 500. The portfolio manager fears that
a decline is coming and what to completely
hedge the value of the portfolio against any
downside risk. If the S&P is currently at 1,000,
how is this accomplished?

z
Value of the S&P 500 Option Contract = 100

index
To hedge $100 million of stocks that move 1

for 1 (perfect correlation) with S&P currently
selling at 1000, you would:
45
currently 100 x 1,000 = $100,000
buy $100 million of S&P put options =

1,000 contracts
46
The premium would depend on the strike price.

For example, a strike price of 950 might have a
premium of $200 / contract, while a strike price
of 900 might have a premium of only $100.
Lets assume Rock Solid chooses a strike price

of 950. Then Rock Solid must pay $200,000
for the position. This is non-refundable and
comes out of the portfolio value (now only
$99.8 million).

z
Suppose after the year, the S&P 500 is at 900 and the
portfolio is worth $89.8 million (= 0.9*99.8).
options position is up $5 million (since 950 strike price)
in net, portfolio is worth $94.8 million
If instead, the S&P 500 is at 1100 and the portfolio is worth

$109.8 million.
47
options position expires worthless, and portfolio is worth

$109.8 million

z
48
Note that the portfolio is protected from any

downside risk (the risk that the value in the
portfolio will fall ) in excess of $5 million.
However, to accomplish this, the manager has
to pay a premium upfront of $200,000.
Swaps
z
z
z
49
Introduction
Interest rate swap
Foreign currency swap
Introduction
z
z
z
z
z
50
Swaps are arrangements in which one party

trades something with another party
The swap market is very large, with trillions
of dollars outstanding in swap agreements
Currency swaps
Interest rate swaps
Commodity & other swaps - e.g. Natural gas
pricing
Swap Market - History

z
Similar theme to the evolution of the other

derivative products - swaps evolved in
response to an economic/financial requirement
Two major events in the 1970s created this
financial need....
Transition of the principal world currencies from

fixed to floating exchange rates - began with the
initial devaluation of the U.S. Dollar in 1971
z
51
Exchange rate volatility and associated risk has been with

us since
Swap Market - History
The second major event was the change in policy of

the U.S. Federal Reserve Board to target its money
management operations based on money supply vs
the actual level of rates
U.S interest rates became much more volatile hence
created interest rate risk
z With the prominence of U.S dollar fixed income instruments
and dollar denominated trade, this created interest rate or
coupon risk for financial managers around the world .
The swap agreement is a creature of the 80s and emerged
via the banking community - again in response to the above
noted need
z
52
Interest Rate Swap

z
53
In an interest rate swap, one firm pays a

fixed interest rate on a sum of money and
receives from some other firm a floating
interest rate on the same sum
Interest-Rate Swaps
54
Interest-rate swaps involve the exchange of

one set of interest payments for another set of
interest payments, all denominated in the same
currency.
Simplest type, called a plain vanilla swap,

specifies (1) the rates being exchanged,
(2) type of payments, and
(3) notional amount.
Interest-Rate Swap Contract Example

z
z
z
z
55
Midwest Savings Bank wishes to hedge rate

changes by entering into variable-rate
contracts.
Friendly Finance Company wishes to hedge
some of its variable-rate debt with some fixedrate debt.
Notional principle of $1 million
Term of 10 years
Midwest SB swaps 7% payment for T-bill + 1%
from Friendly Finance Company.
Interest-Rate Swap Contract Example
56
Hedging with Interest-Rate Swaps

z
57
Reduce interest-rate risk for both parties

1.
Midwest converts $1m of fixed rate assets to ratesensitive assets, RSA, lowers GAP
2.
Friendly Finance RSA, lowers GAP
Hedging with Interest-Rate Swaps

z
Advantages of swaps
1.
2.
Disadvantages of swaps
1.
2.
58
Reduce risk, no change in balance-sheet

Longer term than futures or options
Lack of liquidity
Subject to default risk
Financial intermediaries help reduce

disadvantages of swaps (but at a cost!)
Foreign Currency Swap

z
z
59
In a foreign currency swap, two firms

initially trade one currency for another
Subsequently, the two firms exchange
interest payments, one based on a foreign
interest rate and the other based on a U.S.
interest rate
Finally, the two firms re-exchange the two
currencies
Commodity Swap
z
60
Similar to an interest rate swap in that one

party agrees to pay a fixed price for a notional
quantity of the commodity while the other party
agrees to pay a floating price or market price
on the payment date(s)
Credit Derivatives
z
61
Credit derivatives are a relatively new

derivative offering payoffs based on changes in
credit conditions along a variety of dimensions.
Almost nonexistent twenty years ago, the
notional amount of credit derivatives today is in
the trillions.
Credit Derivatives
z
62
Credit derivatives can be generally categorized

as credit options, credit swaps, and creditlinked notes.
Credit Derivatives
z
Credit options are like other options, but

payoffs are tied to changes in credit conditions.
63
Credit options on debt are tied to changes in credit

ratings.
Credit options can also be tied to credit spreads.
For example, the strike price can be a
predetermined spread between AAA-rated and
BBB-rated corporate debt.
Credit Derivatives
z
Credit options are like other options, but

payoffs are tied to changes in credit conditions.
64
Credit options on debt are tied to changes in credit

ratings.
Credit options can also be tied to credit spreads.
For example, the strike price can be a
predetermined spread between BBB-rated
corporate debt and T-bonds.
Credit Derivatives
z
65
For example, suppose you wanted to issue

$100,000,000 in debt in six months, and your
debt is expected to be rated single-A.
Currently, A-rated debt is trading at 100 basis
points above the Treasury. You could enter
into a credit option on the spread, with a strike
price of 100 basis points.
Credit Derivatives
z
66
If the spread widens, you will, of course, have

to issue the debt at a higher-than-expected
interest rate. But the additional cost will be
offset by the payoff from the option. Like any
option, you will have to pay a premium upfront
for this protection.
Credit Derivatives
z
67
Credit swaps involve, for example, swapping

actual payments on similar-sized loan
portfolios. This allows financial institutions to
diversify portfolios while still allowing the
lenders to specialize in local markets or
particular industries.
Credit Derivatives
z
68
Another form of a credit swap, called a credit

default swap, involves option-like payoffs
when a basket of loans defaults. For example,
the swap may payoff only after the 5th bond in
a bond portfolio defaults (or has some other
bad credit event).
Credit Derivatives
z
69
Credit-linked notes combine a bond and a

credit option. Like any bond, it makes regular
interest payments and a final payment
including the face value. But the issuer has an
option tied to a key variable.
Credit Derivatives
z
70
For example, GM might issue a bond with a

5% coupon rate. However, the covenants
would stipulate that if an index of SUV sales
falls by more than 10%, the coupon rate drops
to 3%. This would be especially useful if GM
was using the bond proceeds to build a new
SUV plant.
Product Characteristics
z
Both options and futures contracts exist on a wide

variety of assets
71
Options trade on individual stocks, on market indexes, on

metals, interest rates, or on futures contracts
Futures contracts trade on agricultural commodities such
as wheat, live cattle, precious metals such as gold and
silver and energy such as crude oil, gas and heating oil,
foreign currencies, U.S. Treasury bonds, and stock market
indexes
Product Characteristics (contd)

z
72
The underlying asset is that which you have

the right to buy or sell (with options) or to
buy or deliver (with futures)
73
Listed derivatives trade on an organized

exchange such as the Chicago Board
Options Exchange or the Chicago Board of
Trade, the NYMEX or the Montreal
Exchange
OTC derivatives are customized products

that trade off the exchange and are
individually negotiated between two parties

z
74
Options are securities and are regulated by

the Securities and Exchange Commission
(SEC) in the U.S and by the Commission
des Valeurs Mobilieres du Quebec or the
Commission Responsible for Regulating
Financial Markets in Quebec for the
Montreal Options Exchange
Futures contracts are regulated by the
Commodity Futures Trading Commission
(CFTC) in the U.S.
Participants in the Derivatives

World
z
Include those who use derivatives for:
75
Hedging
Speculation/investment
Arbitrage
Hedging
76
If someone bears an economic risk and

uses the futures market or other derivatives
to reduce that risk, the person is a hedger
Hedging is a prudent business practice;

today a prudent manager has an obligation
to understand and apply risk management
techniques including the use of derivatives
Speculation
z
z
z
77
A person or firm who accepts the risk the

hedger does not want to take is a
speculator
Speculators believe the potential return
outweighs the risk
The primary purpose of derivatives markets
is not speculation. Rather, they permit or
enable the transfer of risk between market
participants as they desire
Arbitrage
z
z
Arbitrage is the existence of a riskless

profit
Arbitrage opportunities are quickly
exploited and eliminated in efficient
markets
78
Arbitrage then contributes to the efficiency of

markets
Arbitrage (contd)
z
Persons actively engaged in seeking out

minor pricing discrepancies are called
arbitrageurs
Arbitrageurs keep prices in the marketplace
efficient
79
An efficient market is one in which securities are

priced in accordance with their perceived level
of risk and their potential return
The pricing of options incorporates this

concept of arbitrage
Uses of Derivatives
z
z
z
80
Risk management
Income generation
Financial engineering
Risk Management
z
z
z
z
81
The hedgers primary motivation is risk

management
Someone who is bullish believes prices are
going to rise
Someone who is bearish believes prices are
going to fall
We can tailor our risk exposure to any points
we wish along a bullish/bearish continuum
Income Generation
z
Writing a covered call is a way to generate

income
82
Involves giving someone the right to purchase

your stock at a set price in exchange for an upfront fee (the option premium) that is yours to
keep no matter what happens
Writing calls is especially popular during a

flat period in the market or when prices are
trending downward
Financial Engineering
z
Financial engineering refers to the practice

of using derivatives as building blocks in
the creation of some specialized product
83
e.g linking the interest due on a bond issue to

the price of oil (for an oil producer)
Financial Engineering (contd)

z
Financial Engineers:
Select from a wide array of puts, calls futures,
and other derivatives
Know that derivatives are neutral products
(neither inherently risky nor safe)
.....derivatives are something like electricity:
dangerous if mishandled, but bearing the
potential to do good
Arthur Leavitt
Chairman, SEC - 1995
84
Effective Study of Derivatives

z
The study of derivatives involves a

vocabulary that essentially becomes a new
language
85
Implied volatility
Delta hedging
Short straddle
Near-the-money
Gamma neutrality
Etc.
Effective Study of Derivatives

(contd)
A broad range of institutions can make productive use of
derivative assets:
z Financial institutions
Investment houses
Asset-liability managers at banks
Bank trust officers
Mortgage officers
Pension fund managers
z Corporations - oil & gas, metals, forestry etc.
z Individual investors/speculators
86
Questions.
87

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Derivatives Market

Sugath Alwis, CFA

There is no universally satisfactory answer

A financial derivative is a financial instrument

Futures, options and swap markets are very

hedging or risk management

Futures and options markets, and more

derivatives - in many of these situations this has been the

Alan Greenspan, 1988

In our view, however, derivatives are financial weapons of mass

Warren Buffett 2002 Berkshire Hathaway annual report

derivatives are something like electricity: dangerous if mishandled, but

Arthur Leavitt- Chairman SEC 1995

Derivatives & Risk

Derivative markets neither create nor destroy

zero sum game in that one partys gains are equal to

Derivatives & Risk

Derivatives are powerful instruments - they

Hedging involves engaging in a financial

long position: an asset which is purchased

Hedging risk involves engaging in a financial

Forward contracts are agreements by two parties to

The exact assets to be delivered by one party,

The price paid for the assets by the other party

The date when the assets and cash will be exchanged

An Example of an Interest-Rate Contract

First National Bank agrees to deliver $5 million in

Agree to buy securities at future date

Agree to sell securities at future date

Lack of liquidity: hard to find a counter-party and thin

Financial Futures Markets

Financial futures contracts are similar to

Financial Futures Markets

Financial Futures Contract

Specifies delivery of type of security at future date

Global competition regulated by CFTC

Example: Hedging Interest Rate Risk

A manager has a long position in Treasury

Her portfolio is worth $5,000,000

Example: Hedging Interest Rate Risk

As interest rates increase over the next 12 months,

Financial Futures Markets

The previous example is a micro hedge

Financial Futures Markets

In the U.S., futures are traded on the CBOT

Financial Futures Markets

The U.S. exchanges dominated the market for

Widely Traded Financial

Financial Futures Markets

Success of Futures Over Forwards

Futures are more liquid: standardized contracts

Delivery of range of securities reduces the

Mark to market daily: avoids default risk

Don't have to deliver: cash netting

Example: A manufacturer expects to be paid

The manufacturer can use the FX futures

The manufacturer sells 10 million euros of futures

The exchange will require the manufacturer to

As the exchange rate fluctuates during the two

Assume that actual exchange rate is 1 euro = $0.96 at the

The manufacturer also closes the margin account, which

In the end, the manufacturer has the $10,000,000 desired