Financial Markets

Topic 7: The Derivatives Market

 Overview
1. Nature of the market

2. Participants

3. Uses of derivatives

4. Forwards

5. Futures

6. Options

7. Swaps
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 What is a derivative?
• A financial asset which derives its value from the value
of some other asset, rate or index
 Future contract on gold is based on actual price of gold in

spot or physical market

 Future contract on interest rate may be based on a 90-day

BAB or 10-year T-bond rate

• Variation in the value of the underlying asset will result

in variation in the value of the derivative

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 1. Nature of the market
• Some derivatives are traded OTC

- Forward contracts

- Some types of options

- Swaps

• Some are traded via an exchange

- Futures

- Exchange Traded Options

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 2. Participants

Corporations Financial institutions

• Use derivatives to • Hedging, arbitrage &

hedge exposures speculation
• Arbitrage or • Make a market by
speculation if quoting 2-way prices
permitted and profit from the
spread

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 3. Uses for derivatives
The main reason for using derivatives is risk management

• Hedging - to reduce the overall level of risk (and

possibly the expected return)

• Speculation - to increase the level of risk in

expectation of a profit

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 4. Forward contracts

The Fundamental Type Of Derivative Products

Other types of derivatives represent variations

on forward contracts (e.g. options, futures and swaps)

Not Standardized, Flexible, Negotiable & Traded

over-the-counter (OTC)

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 Forward contracts (cont)
• A contract to buy or sell a commodity at a fixed price
on a fixed date in the future

• Two parties with opposite exposures can use a

forward contract to eliminate risk for both parties
• E.g. a wheat farmer and a bread manufacturer

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 Forward contracts (cont)
6 months later

Current Price: $7
Price 6 months later:
$6 $7 $8 ?

Risk

Forward Contract
Selling Price: $7 / bushel

Elimination of downside risk and upside risk for both parties

at minimal cost (no premium)
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Nature of the Forward Contracts market

Advantages Disadvantages

Flexible in terms of
Difficult To Find A
amount, time period,
Counterparty
price.

No premium is payable Difficult To Get Out Of

Credit Risk Of The

Counterparty (Risk Of
Default)

No “Upside” Benefit If
Price Moves In Your
Favour
Forward Rate Agreements (FRAs)
• Used to lock in future interest rates

Rate above

Compensate
FRA Buyer FRA Seller

Reference
(Agreed) rate
Compensate
FRA Buyer FRA Seller

Rate below
Forward Rate Agreements (FRAs) (cont)
• Company A wants to borrow 1 million, for a period of 1 year in 6
months (Company A is concerned that interest rate may rise)
• Company B wants to invest 1 million, for a period of 1 year in 6
months. (Company B is concerned that interest rate may fall)
Reference (or Agreed) interest rate is 6% pa

Actual
rate
$10,000
A B
7%

6%

$10,000
5% A B

Effective rate is still 6%

Forward Rate Agreements (FRAs) (cont)
• Unlike a loan, no exchange of principals occurs
• Payment between the parties involves the difference
between the agreed interest rate and the actual interest
rate at settlement
Advantages Disadvantages

Tailor-made, over-the- Risk of non-

counter contract settlement e.g. credit
risk

Flexibility with respect to

contract period and the No formal market
amount of each contract exists
 5. Futures contracts
• Futures contracts are forward contracts that are
standardised with respect to:

• The Underlying Asset

• E.g. Gold, Wool, Oil, Financial Assets

• The Contract Size

• E.g. 100oz Of Gold, 1000 Barrels Of Oil

• The Expiry Date

• E.g. Six Months, 1 Year

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 Futures contracts (cont)
• If you buy a futures contract (or “go long”), you are
entering into a contract to buy the underlying asset for
the agreed price on the maturity of the contract.

• If you sell a futures contract (or “go short”) you are

entering into a contract to sell the underlying asset in
the future

• To unwind (or close out) a futures position, you buy the

same contracts that you have sold, or vice versa

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 Hedging with futures - Case #1
If you plan to BUY a commodity in the future, a price rise will hurt you,
so you should BUY a futures contract.

• If the physical price rises,

• the value of the futures contract will increase,

• and you will make a profit in the futures market

• to offset your loss in the physical market

• If the price falls,

• the value of the contracts will fall,

• and you will make a loss in the futures market,

• but you will make a profit in the physical market

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 Hedging with futures - Case #2
If you plan to SELL a commodity in the future, a price fall will hurt you, so
you should SELL a futures contract

• If the physical price falls,

• the value of the futures contract will decrease,

• and you will make a profit in the futures market

• offset your loss in the physical market

• If the price rises:

• the value of the future contract will rise,

• and you will make a loss in the futures market (when you buy them to
close out your position )

• but you will make a profit in the physical market

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Hedging with futures
A mining company plans to sell gold and to hedge by selling futures
contracts (100oz) at $560 per ounce.
Current price of gold $560 per ounce

• In 6 Months, Price Gold  $550

 Loss in the physical market but profit on the futures contracts.

 Why? Price of futures contracts .

 The company buys back its futures contracts with a profit.

• In 6 Months, Price Gold  $570

 Profit in the physical market but loss on the futures contracts.

 Why? Price of futures contracts 

 The company buys back its futures contracts with a loss.

 Problems with hedging
Because futures contracts are standardised, it is difficult to
match your exposure perfectly with respect to:

• Size of contract
• Grade of underlying commodity (e.g. Grades of quality)
• Expiry date
• Residual Risk

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Speculation with futures
• If you buy or sell futures without an existing exposure, you
are speculating on future price movements

• If you expect the value of the contract to increase, you will

buy

• If you expect the value of the contract to decrease, you will

sell
Speculation with futures (cont)
Market view: Price Gold   Go short on futures

Price Gold 

Price Of Futures Contracts 

The Speculator Buys Back His

Futures Contracts At Lower Price.
Speculation with futures (cont)
Market view: Price Gold   Go long on futures

Price Gold 

Price Of Futures Contracts 

The Speculator Sells Back His

Futures Contracts At Higher Price.
 Nature of the futures market

Trading takes place via an exchange,

similar to the stock exchange

The exchange becomes the

counterparty for all traders,
eliminating counter-party risk

The exchange handles counter-party

risk using margin calls

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 Margin calls
• To manage the counterparty risk, the futures exchange
requires:
 Both the buyer (long position) and the seller (short position)

pay an initial deposit to a margin account

 Each day a contract is marked-to-market to reflect the current

market value, and the margin account is debited or credited

accordingly.

 If your margin account falls below certain level, you’re required

to “top up” your account to the original amount of the deposit.

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 Settlement of contracts
The great majority of futures contracts
(over 98%) are settled in cash rather than
by physical delivery
Hedgers can protect their position without
settling by physical delivery

Speculators may not be in a position to

buy or sell the underlying asset

Some contracts cannot be settled by

physical delivery – e.g. S&PI contracts

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 6. Options
 An Option is a contract that gives the buyer or holder of the option
the right, but not the obligation, to buy or sell an underlying
asset at an agreed price on or before a particular date in the
future.

 Call option is the option to buy an underlying asset

 Put option is option to sell an underlying asset

Note: the writer (or seller) of the option has no option, but must
comply with the contract if it is exercised

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 Options terminology
• Buyer (or holder)

o The party that has bought an option to buy or sell a

particular asset

• Seller (or writer)

o The party that has sold the option. This party must
perform under the contract if the option is exercised

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 Options terminology (cont)
• Exercise price (or strike price)

o The price at which the underlying asset will be bought or sold if

the option is exercised

• Maturity date (or expiry date)

o The date on which, or by which, the option must be exercised

• Premium

o The amount paid by the buyer of the option to the seller of the
option

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 Options terminology (cont)
• Call option
o The buyer of the option has the right to buy the
underlying asset

• Put option
o The buyer of the option has the right to sell the
underlying asset

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Options terminology (cont)
• European option
o The option can only be exercised on the expiry date

• American option
o The option can be exercised on or before the expiry
date

• Both types are available world-wide

• Australian options usually American

 Options terminology (cont)

Situation Call option Put option

In-the-money S>X S<X
At-the-money S=X S=X
Out-of-the-money S<X S>X

S = the spot or current market price of the underlying asset

X = the exercise or strike price of the option

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Example
Holder of a Call Option on BHP shares
Exercise price: $25; Premium: $0.50; Maturity date: 31/12/2013

• If BHP current share price is $30, so above $25:

the option is in the money. If exercised - Profit of $4.50

• If BHP current share price is $25,

the option is at the money. If exercised – Loss of $0.50 (the
premium)

• If BHP current share price $20, so below $25:

the option is out of the money.

Does this result in the option holder losing $5.50?

Example
Holder of a Put Option on BHP share
Exercise price: $25; Premium: $0.50; Maturity date: 31/12/2013

• If BHP share price is $20, so below $25:

the option is in the money. If exercised - Profit of $4.50

• If BHP share price is $25:

the option is at the money. If exercised - Loss $0.50 (the premium)

• If BHP share price is $30, so above $25:

the option is out of the money. (This does not mean that the option
holder is losing $5.50. He simply will not exercise the option at this
time)
Option contracts (cont)
• Call option profit and loss payoff profiles:
o Premium $1.50; Exercise price $20

a) Buyer of option b) Writer or seller of option

Profit
Break-even Profit Break-even

$1.50

Premium
$20.00 Market $21.50 Market
0 price
0
$21.50 $20.00 price
Premium

-$1.50

Loss Exercise price Loss Exercise price

Option contracts (cont)
• Put option profit and loss payoff profiles
o Premium $0.70; Exercise price $6.00

a) Buyer of option b) Writer or seller of option

Profit
Break-even Profit Break-even

$0.70

Premium
$5.30 Market $6.00
0 0 Market
$6.00 price $5.30 price
Premium

-$0.70

Loss Exercise price Loss Exercise price

 Exercise your brain
ANZ Bank shares currently trade at $6.98. An investor buys
a call option on ANZ Bank with an exercise price of $8.05
per share for two months, and a premium of $0.15 per share

(a) Calculate the break-even price.

(b) At what minimum stock price will the option buyer
exercise the option at the expiry date?

(c) Draw fully labelled diagrams showing the profit and

loss profile of the option buyer and the option seller
(writer).
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Uses for options
• An prospective investor in shares could use a Call option to
hedge against the possible rise in the share price prior to
the planned purchase date (i.e. to lock in a ceiling price).
• A current holder of shares can protect himself against a fall
in the market price of the share by buying a Put option (i.e.
to set a floor price)
• A Call option profits from increases in the price of the
underlying assets
• A Put option profits from falls in the price of the underlying
assets
• Options have value because they have unlimited upside
and no downside below the premium (i.e. the cost of the
option).
 Nature of the options market
Over-The-Counter Exchange
options Traded options

Negotiated directly
between the buyer Are standardised
and seller

Flexible to meet the Are traded via an

needs of each party exchange

The exchange acts as

counterparty to both
buyers parties

The exchange uses

margin calls to manage
default risks

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 7. Swaps
• A swap is an agreement between two parties to
exchange cash flows based on some agreed basis.

• Some of the most common are:

1. Interest rate swaps

2. Currency swaps

3. Commodity swaps

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 7.1. Interest rate swaps
• Also known as a “Plain Vanilla” Swap

• An agreement between two parties to exchange

interest payments

• It will occur when each party has a comparative

advantage in one market but would prefer to borrow in
another market

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 Interest rate swaps - example
Company A has a comparative advantage in the floating rate
market but prefers to borrow fixed-rate funds.

Company B has a comparative advantage in the fixed rate market

but prefers to borrow floating-rate funds.

Company Preference Fixed Floating

A Fixed 10% pa LIBOR + 1.5% pa

B Floating 9% pa LIBOR + 2.5% pa

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Interest rate swaps (cont)
• Company A borrows in floating rate market, where it
has comparative advantage (i.e. LIBOR + 1.5% pa)
• Company B borrows in the fixed rate market where it
has comparative advantage (i.e. 9% pa)

9% Fixed
Company A Company B
LIBOR + 1.5%

LIBOR + 1.5% 9% Fixed

Market Market
 Interest rate swaps (cont)
• The exchange of cash flows is separate from the actual
loans

• The parties do NOT literally pay each other’s interest

• There is no exchange of principal

• Only the net difference between the interest payment

changes hands

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 Interest rate swaps (cont)
• Firm A has a comparative advantage in the fixed rate
market.
• Firm A prefers a floating rate
• Firm B prefers a fixed rate

Table 20.1. Interest rate swap data

Debt market Firm A (%) Firm B (%) Differential (%)

Fixed-rate funds 12.00 14.00 2.00

Floating-rate funds BBSW + 0.50 BBSW +1.70 1.20

Net differential 0.80

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 Interest rate swaps (cont)
• Firm A borrows in fixed rate market, where it has
comparative advantage (i.e. 12%)

• Firm B borrows in floating rate market at BBSW +

1.70%

• One possible swap arrangement

- B pays A a fixed rate of 13.60%

- A pays B a floating rate of BBSW + 1.70%

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Interest rate swaps (cont.)

Fixed 13.6%
Firm A Firm B
BBSW + 1.70%

Borrows at 12% (fixed) Borrows at BBSW + 1.70% (floating)

(and pays interest to fixed rate (and pays interest to floating rate
lenders) lenders)

Firm A Firm B
Pays (-) 12% (-) BBSW +1.70%
(-) BBSW +1.70% (-) 13.60%
Receives (+) 13.60% (+) BBSW +1.70%
Net BBSW +0.10% 13.60%

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7.2. Currency swaps
• Similar to an interest rate swap, but the amounts borrowed are in
different currencies

• Because the loans are in different currencies the principal will be

swapped under a currency swap

• This is NOT the same as an FX swap as (Spot and forward

transaction) discussed in Topic 4

• One party may have a comparative advantage in their own

currency, but would prefer to borrow in the other party’s currency

• They will borrow in their own currency, swap the principal, swap
the interest payments, and swap the principal back upon maturity
 Currency swaps (cont)
• E.g. Comp AUD NZD
C 8% 10%
D 10% 8%

• Company C (an Aust. Company) would prefer to borrow

NZD, but has a comparative advantage in AUD

• Company D (a NZ company) would prefer AUD but has

a comparative advantage borrowing NZD

• Agreed exchange rate AUD/NZD = 1.5

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Currency swaps (cont)
Company C A$1 m. Company D
STEP 1 NZ$1.5 m.
AUS NZ

A$1 m. NZ$1.5 m.
Market Market
A$80,000
STEP 2 Company C NZ$120,000 Company D

8% = 8% =
A$80,000 NZ$120,000
Market Market
A$1 m.
STEP 3 Company C NZ$1.5 m. Company D

A$1 m. NZ$1.5 m.

Market Market
 Currency swaps (cont)
• The principal will be swapped at the beginning of the
swap, and swapped back at the end, at exchange rates
agreed upon at the beginning of the swap

• Rationale for the existence of currency swaps

o Obtaining lower cost of funds

Borrowers may obtain better terms/rates by borrowing in
different markets including those denominated in foreign
currencies; thus, creating the need for currency swaps

o Hedging FX risk

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 Commodity swaps
7.3. Commodity swaps
• Parties which have an opposite exposure to the price of
a commodity will swap a fixed rate with a floating rate
based on the price of the commodity

• The effect is to fix the price of the commodity for both

parties

• The party which benefits from a change in the price of

the commodity compensates the party which has
suffered as a result of the change

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Commodity swaps (Example)
• The airline wants to buy 1000 oil barrels.

• The oil producer wants to sell oil 1000 oil barrels.

Current Price is $55 per barrel

Airline (Oil $5000 Oil Producer

$60 Buyer) (Seller)

$55

$50 Airline (Oil $5000 Oil Producer

Buyer) (Seller)

Effective price is still $55

 Problems with commodity swaps

Difficult To Find A
Benchmark Perfectly Grade Mismatch
Correlated With Each & Residual Risk
Party’s Exposure

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 Nature of the commodity swaps market

Difficult To Find A Counterparty

A Broker Can Be Used To Match Parties

Intermediaries Often Quote 2-way Prices To

Make Profit And Compensate For Risk

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