CHAPTER 11

DERIVATIVES MARKETS

The Purpose of Futures and Forward Markets

Purpose is to eliminate the price risk inherent in transactions that call for future delivery of money, a security, or a commodity. Financial derivatives are financial instruments whose value is linked to, or derived from, the price or change in price of an underlying security such as a stock, bond, commodity, index or other asset.
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From the Wall Street Journal of March 11, 2003, p. A14

On balance, the $2 trillion derivatives market is a very good thing. It allows institutions to lay off risk, making the financial system less vulnerable But the real miracle of derivatives is that they allow investors to separate and manage specific risksThey let investors hedge risks, in varying degrees, by transferring it to investors who are more willing, or able, to assume it. Financial derivatives can be used to manage risk in prices, interest rates, currencies and credit.
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Forward Exchange Markets

Buying/selling of a specified amount, price, and future delivery date of foreign currency Direct relationship between buyer and seller (Counterparty) Foreign exchange dealers earn revenues on the spread between buying and selling Seller delivers at the specified date
e.g. 30, 90, 180 days
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Futures Markets
Buying/selling of standardized contracts specifying the amount, price, and future delivery date of a currency, security, or commodity. Buyers/sellers deal with the futures exchange, not with each other. A specific trade (buy/sell) involves a hedger and a speculator. Delivery seldom made -- buyer/seller offsets previous position before maturity. Either party can liquidate its futures position prior to the scheduled delivery date.
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Futures Markets - Continued

Futures contracts expire on specific dates. Futures markets require that the value of all contracts be marked to market constantly. Futures contracts require their owners to post margin money (if necessary) to take account of gains and losses accruing from daily price movements. When there is both a new buyer and a new seller, the open interest - or total number of contracts to deliver a contract through the exchange increases by one.
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Spot versus Futures Market

Trading for immediate or very-nearterm delivery is called the spot market. Trading for future delivery -- futures market.

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A Position in the Futures Market

Long -- an agreement to buy (purchase) in the future. Short -- an agreement to sell (deliver) in the future.

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Margin Requirements
Initial margin -- small percentage deposit required to trade a futures contract. Daily settlements -- reflect gains/losses daily and cash payments. Maintenance margin -- minimum deposit requirements on futures contracts. Margin call requires an investor to add money to his/her futures margin to offset his/her losses. Finance 308 9

Futures Exchanges
Competition between exchanges is keen. Contract innovation is common. Exchanges advertise and promote heavily. Financial exchanges develop contracts that it thinks will reduce the risk exposure of financial market participants.
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Futures Exchanges - continued

Exchange specifies terms of a contract. Dates Denomination Specific items that can be delivered Method of delivery Minimum price fluctuation Maximum daily price variance Rules for trading
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Interest Rate Futures Quotations

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Futures Markets Participants

Hedgers attempt to reduce or eliminate price risk. Speculators accept the price risk in turn for expected return.
Speculators may also enter into spreads or straddles, in which they buy one futures contract and sell a closely related contract in the hope that the price of one contract will move more favorably than the other.

Traders speculate on very-short-term changes in future contract prices.

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Regulation of the Futures Market

The Commodity Futures Trading Commission (CFTC)
5 member Federal Commission Formed in 1974

The Securities Exchange Commission (SEC) regulates options markets that have equity securities as underlying assets. Exchanges impose self-regulation with rules of conduct for members.
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Risks in the Futures Markets

Basis risk -- risk of an imperfect hedge because the value of item being hedged may not always keep the same price relationship to the futures contracts. Cross-hedges -- using the futures market to hedge a dissimilar commodity or security. Related-contract risk -- risk of failure due to a unanticipated change in the business activity being hedged, such as a loan default or prepayment.
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Risks in the Futures Markets

(concluded)
Manipulation risk -- risk of price losses due to a person or group trading (buying or selling) to affect price. Short squeezes are where an individual or group makes it impossible for short sellers to liquidate their position. Margin risk -- the liquidity risk that added maintenance margin calls will be made by the exchange.
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Stock Index Futures

Stock Index Futures are instruments for hedging exposure to changes in market values, specifically exposure to the change in value in equity portfolios. Stock-index futures can be used to control the systematic risk in an investors portfolio. Stock Index Futures derive their value by averaging the prices of a basket of underlying stocks that were included in the stock index. It is not possible to make or take delivery of an index.
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Stock Index Futures - continued

To hedge against a decline in the stock market, a portfolio manager could hedge using a short hedge by selling stock index futures. If the market indexes do indeed fall, so will the value of the contracts, resulting in a profit when the position is closed out and offsetting losses in the stock portfolio. It is portfolio insurance to protect against a possible market decline.
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GAP Management
We will cover this concept in depth in Chapter 14. Monitoring the interest rate sensitivities and maturities of a financial institutions assets and liabilities is called GAP management. The GAP is the difference between the Rate Sensitive Assets (RSA) and the Rate Sensitive Liabilities (RSL). Financial futures can be used to protect a financial institution against interest rate risk.
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Duration Gap
DG = MVA x DA MVL x DL + MVF x DF

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Swaps are like forward contracts in that they guarantee the exchange of two items in the future, but a swap only transfers the net amount. By 2000, the swaps market exceeded $46 trillion in notional principal Swaps do not pre-specify the terms of trade as do forward contracts. Prices are conditional on changes in a indexed interest rate such as LIBOR or T-bills. Swaps are used to hedge interest rate risk as are financial futures. Credit risk differences between the parties provide the economic incentive to swap future interest flows.
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Swaps Compared to Forwards and Futures

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Interest Rate Swaps

An arrangement whereby one party exchanges one set of interest rate payments for another. Most common arrangement involves an exchange of fixed-rate interest payments for floating-rate interest payments over time.
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Interest Rate Swaps - continued

Provisions of an interest rate swap include:
The notional principal value upon which the interest rates are applied to determine the interest payments involved The fixed interest rate The formula and type of index used to determine floating rate The frequency of payments such as every six months or every year. The lifetime of the swap
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Swap Dealers
Serve as Counter-parties to both Sides of Swap Transactions Dealers negotiate a deal with one party, then seek out other parties with opposite interests and write a separate contract with them. The two contracts hedge each other and the dealer earns a fee for serving both parties. Among others, many large banks in the U.S., Great Britain, and Japanese securities firms act as brokers and dealers in the swap markets. They earn substantial fees for arranging and servicing swaps.
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Swaps have Limited Regulation

Bank regulators require risk-based capital support for swap-risk exposure. Other swap competitors, investment banks and life insurance companies have no regulatory capital costs.

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Example of a Swap

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Options
Right to buy or sell an item at a predetermined price (strike price) until some future date The option itself is created by an option writer, someone who stands ready to buy or sell the asset when the holder wishes to make a transaction. The price written into the option agreement is the exercise or strike price. American options can be exercised at any point during their lives. European options can be exercised only at expiration.
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Options vs. Futures Contracts

The option at the strike price exists over the period of time, not at a given date. The buyer of an option pays the seller (writer) a premium which the writer keeps regardless of whether or not the option is ever exercised. The option does not have to be exercised by the buyer; it can be sold if it has a market value, before the expiration date. Gains and losses are unlimited with futures contracts; with options the buyer can lose only the premium and the commission paid.
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Calls and Puts

Call option -- buyer has the option to buy an item at the strike price.
A call option is often referred to as in the money when the market price of the of the underlying security exceeds the exercise price. Out of the money is when it is below the exercise price.

Put option -- buyer has the option to sell an item at the strike price.

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Covered and Naked Options

Covered option -- writer either owns the security involved in the contract or has limited his or her risk with other contracts. Naked option -- writer does not have or has not made provision to limit the extent of risk.

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Value of an Option
The value of an option is dependent upon: Price volatility of the underlying commodity or security Time to the options expiration The level of interest rates Strike or exercise price and stock or index price

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Gains and Losses on Options and Futures Contracts

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Option Quotations

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Another Example of Option Usage

A bank can hedge its commitment to lend in the future by buying a put option on a T-bond. If rates go up, bond values will fall, and the bank can exercise its right to sell bonds at the strike price. The profit on the hedge can be used to offset liability costs that will increase as market rates increase.
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Conclusion
Forward Market Futures Market Futures Contracts Stock Index Futures Risks in the Futures Market Swaps Interest Rate Swaps Options

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