Derivatives Market

Sugath Alwis, CFA

1
 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
2
 Introduction (cont’d)
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
z Futures and options markets, and more
recently swap markets have a long history
3 of being misunderstood -
 Introduction (cont’d)

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
‘derivatives’ - in many of these situations this has been the
case i.e a speculative application of derivatives that has gone
4 against the user
 Introduction (cont’d)

“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

5
 Derivatives & Risk

z Derivative markets neither create nor destroy

wealth - they provide a means to transfer risk
– zero sum game in that one party’s gains are equal to
another party’s 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

6
 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
z this high degree of leverage makes them
effective but also ‘dangerous’ when
misused.

7
 Hedging

z Hedging involves engaging in a financial

transaction that reduces or eliminates risk.
z 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

8
 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.

9
 Types of Derivatives

z Forwards contracts
z Futures contracts
z Options
z Swaps
z Hybrids

10
 Forward Markets

z 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

11
 Forward Markets

z An Example of an Interest-Rate Contract

– 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

12
 Forward Markets

z Long Position
– Agree to buy securities at future date
– Hedges by locking in future interest rate of funds
coming in future, avoiding rate decreases

z Short Position
– Agree to sell securities at future date
– Hedges by reducing price risk from increases in
interest rates if holding bonds

13
 Forward Markets

z Pros
1. Flexible

z Cons
1. Lack of liquidity: hard to find a counter-party and thin
or non-existent secondary market
2. Subject to default risk—requires information to screen
good from bad risk

14
 Financial Futures Markets

z 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.

15
 Financial Futures Markets

z Financial Futures Contract

1. Specifies delivery of type of security at future date
2. Arbitrage: at expiration date, price of contract =
price of the underlying asset delivered
3. i ↑, long contract has loss, short contract has
profit
4. Hedging similar to forwards: micro versus macro
hedge
z Traded on Exchanges
– Global competition regulated by CFTC
16
 Example: Hedging Interest Rate Risk

z 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:
– Her portfolio is worth $5,000,000
– Futures contracts have an underlying value of
$100,000, so she must short 50 contracts.

17
 Example: Hedging Interest Rate Risk

– 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.

18
 Financial Futures Markets

z 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.

19
 Financial Futures Markets

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

and the CME in Chicago, the NY Futures
Exchange, and others.
z 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.

20
 Financial Futures Markets

z The U.S. exchanges dominated the market for

years. However, this isn’t true anymore.
z The London Int’l Financial Futures Exchange
trades Eurodollar futures
z The Tokyo Stock Exchange trades Euroyen
and gov’t bond futures
z Several others as well, as seen next.

21
 Widely Traded Financial
Futures Contracts

22
 Financial Futures Markets

z 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

23
 Hedging FX Risk

z 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.

24
 Hedging FX Risk

z 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.
25
 Hedging FX Risk

3. 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.

26
 Hedging FX Risk

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.

27
 Futures/Forward Contracts -
History

z Forward contracts on agricultural products began in the

1840’s
– 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 1870’s 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)

28
 Futures/Forward Contracts -
History Cont’d

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 buyers/sellers required to post margins with the
clearinghouse
z daily settlement of open positions - became known as the
mark-market system
29
 Futures/Forward Contracts -
History Cont’d

z 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
z Financial futures - fixed income, stock index and
currency futures markets were established in the
70’s and 80’s - facilitated the sale of financial
instruments and risk (of price uncertainty) in
financial markets
30
 Stock Index Futures

z 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.
z One instrument to hedge this risk is stock
index futures.

31
 Stock Index Futures

z 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.
z 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.

32
 Hedging with Stock Index Futures

z 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?

33
 Hedging with Stock Index Futures

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

index
– currently 250 x 1,000 = $250,000
z To hedge $100 million of stocks that move 1
for 1 (perfect correlation) with S&P currently
selling at 1000, you would:
– sell $100 million of index futures =
400 contracts

34
 Hedging with Stock Index Futures

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

and the portfolio is worth $90 million.
– futures position is up $10 million

z If instead, the S&P 500 is at 1100 and the

portfolio is worth $110 million.
– futures position is down $10 million

z Either way, net position is $100 million

35
 Hedging with Stock Index Futures

z 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.
z 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!
36
 Options

z An option is the right to either buy or sell

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

z You can exercise an option if you wish, but

you do not have to do so

37
 Options

z Options Contract
– 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).

z Options are available on a number of financial

instruments, including individual stocks, stock
indexes, etc.

38
 Options

z Hedging with Options

– Buy same number of put option contracts as would
sell
of futures
– Disadvantage: pay premium
– Advantage: protected if i gains

z if i falls:
– Additional advantage if macro hedge: avoids
accounting problems, no losses on option if i falls
39
Options

40
 Factors Affecting Premium

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.

41
 Option Contracts - History

z Chicago Board Options Exchange (CBOE) opened in

April of 1973
– call options on 16 common stocks
z The widespread acceptance of exchange traded
options is commonly regarded as one of the more
significant and successful investment innovations of
the 1970’s
z Today we have option exchanges around the world
trading contracts on various financial instruments and
commodities
42
 Options Contracts

z Chicago Board of Trade

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

z 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?

44
 Hedging with Options

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

index
– currently 100 x 1,000 = $100,000

z To hedge $100 million of stocks that move 1

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

45
 Hedging with Options

z 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.
z Let’s 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).
46
 Hedging with Options

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

z If instead, the S&P 500 is at 1100 and the portfolio is worth

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

47
 Hedging with Options

z 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.

48
 Swaps

z Introduction
z Interest rate swap
z Foreign currency swap

49
 Introduction

z Swaps are arrangements in which one party

trades something with another party
z The swap market is very large, with trillions
of dollars outstanding in swap agreements
z Currency swaps
z Interest rate swaps
z Commodity & other swaps - e.g. Natural gas
pricing
50
 Swap Market - History

z Similar theme to the evolution of the other

derivative products - swaps evolved in
response to an economic/financial requirement
z Two major events in the 1970’s 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 Exchange rate volatility and associated risk has been with
us since
51
 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
z 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 80’s and emerged
via the banking community - again in response to the above
noted need
52
 Interest Rate Swap

z 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

53
 Interest-Rate Swaps

z Interest-rate swaps involve the exchange of

one set of interest payments for another set of
interest payments, all denominated in the same
currency.
z Simplest type, called a plain vanilla swap,
specifies (1) the rates being exchanged,
(2) type of payments, and
(3) notional amount.

54
 Interest-Rate Swap Contract Example

z Midwest Savings Bank wishes to hedge rate

changes by entering into variable-rate
contracts.
z Friendly Finance Company wishes to hedge
some of its variable-rate debt with some fixed-
rate debt.
z Notional principle of $1 million
z Term of 10 years
z Midwest SB swaps 7% payment for T-bill + 1%
from Friendly Finance Company.
55
 Interest-Rate Swap Contract Example

56
 Hedging with Interest-Rate Swaps

z Reduce interest-rate risk for both parties

1. Midwest converts $1m of fixed rate assets to rate-
sensitive assets, RSA, lowers GAP
2. Friendly Finance RSA, lowers GAP

57
 Hedging with Interest-Rate Swaps

z Advantages of swaps
1. Reduce risk, no change in balance-sheet
2. Longer term than futures or options
z Disadvantages of swaps
1. Lack of liquidity
2. Subject to default risk
z Financial intermediaries help reduce
disadvantages of swaps (but at a cost!)

58
 Foreign Currency Swap

z In a foreign currency swap, two firms

initially trade one currency for another
z Subsequently, the two firms exchange
interest payments, one based on a foreign
interest rate and the other based on a U.S.
interest rate
z Finally, the two firms re-exchange the two
currencies

59
 Commodity Swap

z 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)

60
 Credit Derivatives

z 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.

61
 Credit Derivatives

z Credit derivatives can be generally categorized

as credit options, credit swaps, and credit-
linked notes.

62
 Credit Derivatives

z Credit options are like other options, but

payoffs are tied to changes in credit conditions.
– 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.

63
 Credit Derivatives

z Credit options are like other options, but

payoffs are tied to changes in credit conditions.
– 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.

64
 Credit Derivatives

z 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.

65
 Credit Derivatives

z 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.

66
 Credit Derivatives

z 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.

67
 Credit Derivatives

z 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).

68
 Credit Derivatives

z 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.

69
 Credit Derivatives

z 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.

70
 Product Characteristics

z Both options and futures contracts exist on a wide

variety of assets
– 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

71
 Product Characteristics (cont’d)

z The underlying asset is that which you have

the right to buy or sell (with options) or to
buy or deliver (with futures)

72
 Product Characteristics (cont’d)

z 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

z OTC derivatives are customized products

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

73
 Product Characteristics (cont’d)

z 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
z Futures contracts are regulated by the
Commodity Futures Trading Commission
74 (CFTC) in the U.S.
 Participants in the Derivatives
World
z Include those who use derivatives for:
– Hedging
– Speculation/investment
– Arbitrage

75
 Hedging

z If someone bears an economic risk and

uses the futures market or other derivatives
to reduce that risk, the person is a hedger

z 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

76
 Speculation

z A person or firm who accepts the risk the

hedger does not want to take is a
speculator
z Speculators believe the potential return
outweighs the risk
z The primary purpose of derivatives markets
is not speculation. Rather, they permit or
enable the transfer of risk between market
participants as they desire
77
 Arbitrage

z Arbitrage is the existence of a riskless

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

78
 Arbitrage (cont’d)

z Persons actively engaged in seeking out

minor pricing discrepancies are called
arbitrageurs
z Arbitrageurs keep prices in the marketplace
efficient
– An efficient market is one in which securities are
priced in accordance with their perceived level
of risk and their potential return
z The pricing of options incorporates this
79 concept of arbitrage
 Uses of Derivatives

z Risk management
z Income generation
z Financial engineering

80
 Risk Management

z The hedger’s primary motivation is risk

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

81
 Income Generation

z Writing a covered call is a way to generate

income
– Involves giving someone the right to purchase
your stock at a set price in exchange for an up-
front fee (the option premium) that is yours to
keep no matter what happens
z Writing calls is especially popular during a
flat period in the market or when prices are
trending downward
82
 Financial Engineering

z Financial engineering refers to the practice

of using derivatives as building blocks in
the creation of some specialized product
– e.g linking the interest due on a bond issue to
the price of oil (for an oil producer)

83
 Financial Engineering (cont’d)

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
– Implied volatility
– Delta hedging
– Short straddle
– Near-the-money
– Gamma neutrality
– Etc.

85
 Effective Study of Derivatives
(cont’d)

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