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Derivatives
INTRODUCTION
Derivative instruments have been a feature of modern financial markets for several decades. They play a vital role in managing the risk of underlying securities such as bonds, equity, equity indexes, currency, and short-term interest rate asset or liability positions. In the commodity markets they have, in general, been around for a great deal longer. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.
What is a Derivative?
The financial instruments we've considered so far - stocks, bonds, commodities and currencies - are generally referred to as cash instruments (or sometimes, primary instruments). The value of cash instruments is determined directly by markets. By contrast, a derivative derives its value from the value of some other financial asset or variable. For example, a stock option is a derivative that derives its value from the value of a stock. An interest rate swap is a derivative because it derives its value from an interest rate index. The asset from which a derivative derives its value is referred to as the underlying asset. The price of a derivative rises and falls in accordance with the value of the underlying asset. Derivatives are designed to offer a return that mirrors the payoff offered by the instruments on which they are based
Ex: The Bombay stock exchange share index is called SENSEX it is a derivative
whose value depend upon the prices of the underling 30 shares. The weighted average of the prices of 30 shares is the SENSEX. If the prices of the entire share increase or decrease the SENSEX will also increase or decrease. So SENSEX is the derivative and 30 shares are the underling assets.
OBJECTIVES of Derivative
Demonstrate knowledge of the regulatory framework for financial derivatives; Demonstrate knowledge of the operations of derivatives exchanges, and be able to compare and contrast Exchange Traded and Over the Counter (OTC) instruments; Demonstrate a detailed knowledge of the different types of forwards, futures, swaps options and other financial derivatives, the principal differences between them, and where and how they are traded; Demonstrate a detailed understanding of the variables (inputs) which influence the value of such derivatives and the relationship of financial derivatives to their underlying assets; Present the alternative derivatives strategies that would be appropriate for different market circumstances, and describe the advantages and disadvantages of each; Demonstrate the uses of all financial derivatives, either alone, or in conjunction with underlying assets, to realize investment, hedging and trading objectives; Demonstrate an understanding of the risks of all types of financial derivatives and derivatives portfolios, and efficient ways of reporting and managing those risks.
Types of derivative:
There are four types of derivative are as follows: I. II. III. IV. Forward Futures Option Swap
Forward
A forward is an agreement between two counterparties a buyer and seller. The buyer agrees to buy an underlying asset from the other party (the seller). The delivery of the asset occurs at a later time, but the price is determined at the time of purchase. Key features of forward contracts are: Highly customized - Counterparties can determine and define the terms and features to fit their specific needs, including when delivery will take place and the exact identity of the underlying asset. All parties are exposed to counterparty default risk This is the risk that the other party may not make the required delivery or payment. Transactions take place in large, private and largely unregulated markets consisting of banks, investment banks, government and corporations. Underlying assets can be stocks, bonds, foreign currencies, commodities or some combination thereof. The underlying asset could even be interest rates.
They tend to be held to maturity and have little or no market liquidity. Any commitment between two parties to trade an asset in the future is a forward contract.
Like all forward contracts, in this example, no money exchanged hands when the contract was negotiated and the initial value of the contract was zero.
Future Contract
Future contracts are also agreements between two parties in which the buyer agrees to buy an underlying asset from the other party (the seller). The delivery of the asset occurs at a later time, but the price is determined at the time of purchase. Terms and conditions are standardized. Trading takes place on a formal exchange wherein the exchange provides a place to engage in these transactions and sets a mechanism for the parties to trade these contracts. There is no default risk because the exchange acts as counterparty, guaranteeing delivery and payment by use of a clearing house. The clearing house protects itself from default by requiring its counterparties to settle gains and losses or mark to market their positions on a daily basis. Futures are highly standardized, have deep liquidity in their markets and trade on an exchange. An investor can offset his or her future position by engaging in an opposite transaction before the stated maturity of the contract.
Let's assume that in September the spot or current price for hydroponic tomatoes is $3.25 per bushel and the futures price is $3.50. A tomato farmer is trying to secure a selling price for his next crop, while McDonald's is trying to secure a buying price in order to determine how much to charge for a Big Mac next year. The farmer and the corporation can enter into a futures contract requiring the delivery of 5 million bushels of tomatoes to McDonald's in December at a price of $3.50 per bushel. The contract locks in a price for both parties. It is this contract - and not the grain per se - that can then be bought and sold in the futures market.
In this scenario, the farmer is the holder of the short position (he has agreed to sell the underlying asset tomatoes) and McDonald's is the holder of the long position (it has agreed to buy the asset). The price of the contract is 5 million bushels at $3.50 per bushel.
Options
An option is common form of a derivative. It's a contract, or a provision of a contract, that gives one party (the option holder) the right, but not the obligation to perform a specified transaction with another party (the option issuer or option writer) according to specified terms. Options can be embedded into many kinds of contracts. For example, a corporation might issue a bond with an option that will allow the company to buy the bonds back in ten years at a set price. Standalone options trade on exchanges or OTC. They are linked to a variety of underlying assets. Most exchange-traded options have stocks as their underlying asset but OTC-traded options have a huge variety of underlying assets (bonds, currencies, commodities, swaps, or baskets of assets).
Call options provide the holder the right (but not the obligation) to purchase an underlying
asset at a specified price (the strike price), for a certain period of time. If the stock fails to meet the strike price before the expiration date, the option expires and becomes worthless. Investors buy calls when they think the share price of the underlying security will rise or sell a call if they think it will fall. Selling an option is also referred to as ''writing'' an option.
Put options give the holder the right to sell an underlying asset at a specified price (the
strike price). The seller (or writer) of the put option is obligated to buy the stock at the strike price. Put options can be exercised at any time before the option expires. Investors buy puts if they think the share price of the underlying stock will fall, or sell one if they think it will rise. Put buyers those who hold a "long" - put are either speculative buyers looking for leverage
or "insurance" buyers who want to protect their long positions in a stock for the period of time covered by the option. Put sellers hold a "short" expecting the market to move upward (or at least stay stable) A worst-case scenario for a put seller is a downward market turn. The maximum profit is limited to the put premium received and is achieved when the price of the underlie is at or above the option's strike price at expiration. The maximum loss is unlimited for an uncovered put writer.
To obtain these rights, the buyer must pay an option premium (price). This is the amount of cash the buyer pays the seller to obtain the right that the option is granting them. The premium is paid when the contract is initiated.
IBM is trading at 100 today. (June 1, 2005) The call option is as follows: Strike price = 120, Date = August 1, 2005, Premium on the call = $3 In this case, the buyer of the IBM call today has to pay the seller of the IBM call $3 for the right to purchase IBM at $125 on or before August 1, 2005. If the buyer decides to exercise the option on or before August 1, 2005, the seller will have to deliver IBM shares at a price of $125 to the buyer. Example: Put Option IBM is trading at 100 today (June 1, 2005) Put option is as follows: Strike price = 90, Date = August 1, 2005, Premium on the put = $3.00 In this case, the buyer of the IBM put has to pay the seller of the IBM call $3 for the right to sell IBM at $90 on or before August 1, 2005. If the buyer of the put decides to exercise the option on or before August 1, 2005, the seller will have to purchase IBM shares at a price of $90. Example: Interpreting Diagrams
American Option
This is an option that can be exercised at any time up to and including the expiry date. There are no general formulas for valuing American options, but a choice of models to approximate the price is available (for example Whaley, binomial options model, Monte Carlo and others), although there is no consensus on which is preferable. American options are rarely exercised early. This is because all options have a non-negative time value and are usually worth more unexercised. Owners who wish to realize the full value of their options will mostly prefer to sell them rather than exercise them early and sacrifice some of the time value. Note that the names of these types of options are in no way related to Europe or the United States.
Moneyless
The concept of moneyless describes whether an option is in-, out-, at-, or in-the-money by examining the position of strike vs. existing market price of the option's underlying security.
In the Money - Any option that has intrinsic value is in the money. A call option is
said to be in the money when the futures price exceeds the option's strike price. A put is in the money when the futures price is below the option's strike price. For example, a March CME euro 90 call options will be in the money if March CME euro futures are above 90, meaning that the holder has the right to buy these futures at 90, regardless of how much the price has risen. The further in the money an option, the less time value it will have.
Deep In the Money - These options represent a larger spread between the strike
and market price of an underlying security. Options that are deep in the money generally trade at or near their actual intrinsic values, calculated by subtracting the strike price from the underlying asset's market price for a call option (and vice versa for a put option). This is because options with a significant amount of intrinsic value built in have a very low chance of expiring worthless. Therefore, the primary value they provide is already priced into the option in the form of their intrinsic value. As an option moves deeper into the money, the delta approaches 100% (for call options), which means for every point change in the underlying asset's price, there will be an equal and simultaneous change in the price of the option, in the same direction. Thus, investing in the option is similar to investing in the underlying asset, except the option holder will have the benefits of lower capital outlay, limited risk, leverage and greater profit potential.
Out of the Money - These options exist when the strike price of a call (put) is
above (below) the underlying asset's market price. (Essentially, it is the inverse of an in the money option). Options that are out of the money have a high risk of expiring worthless, but they tend to be relatively inexpensive. As the time value approaches zero at expiration, out of the money options have a greater potential for total loss if the underlying stock moves in an adverse direction.
At the Money - These options exist when the strike price of a call or put is equal to
the underlying asset's market price. You can essentially think of at the money as the breakeven point (excluding transaction costs)
Payoff Calculated by deducting the option premium paid from the intrinsic value
of the option. In this case, an in-the-money option could produce a negative payoff if the premium is greater than the intrinsic value of the option.
Time Value - The time value is any value of an option other than its intrinsic value.
Time value is basically the risk premium that the seller requires to provide the option buyer with the right to buy or sell the stock up to the expiration date. While the actual calculation is complex, fundamentally, time value is related to a stock's beta or volatility. If the market does not expect the stock to move much (if it has a low beta), then the option's time value will be relatively low. Conversely, the option's time value will be high if the stock is expected to fluctuate significantly. Time value decreases as an option gets closer and closer to expiration. This is why options are considered "wasting" assets. As an option approaches expiration, the underlying stock has less and less time to move in a favorable direction for the option buyer; therefore, if you have two identical options - one that expires in six months and one expires in 12 months - the option that expires in 12 months will have greater time value because it has a better chance of moving higher.
Swaps
A swap is one of the most simple and successful forms of OTC-traded derivatives. It is a cash-settled contract between two parties to exchange (or "swap") cash flow streams. As long as the present value of the streams is equal, swaps can entail almost any type of future cash flow. They are most often used to change the character of an asset or liability without actually having to liquidate that asset or liability. For example, an investor holding common stock can exchange the returns from that investment for lower risk fixed income cash flows - without having to liquidate his equity position.
The difference between a forward contract and a swap is that a swap involves a series of payments in the future, whereas a forward has a single future payment.
As is obvious from the above example, swaps are private, negotiated and mostly unregulated transactions (although FASB 133 has begun to impose some regulations).
traditional investments. The two most widely recognized benefits attributed to derivative instruments are price discovery and risk management.
1. Price Discovery Futures market prices depend on a continuous flow of information from around the world and require a high degree of transparency. A broad range of factors (climatic conditions, political situations, debt default, refugee displacement, land reclamation and environmental health, for example) impact supply and demand of assets (commodities in particular) and thus the current and future prices of the underlying asset on which the derivative contract is based. This kind of information and the way people absorb it constantly changes the price of a commodity. This process is known as price discovery.
With some futures markets, the underlying assets can be geographically dispersed, having many spot (or current) prices in existence. The price of the contract with the shortest time to expiration often serves as a proxy for the underlying asset. Second, the price of all future contracts serve as prices that can be accepted by those who trade the contracts in lieu of facing the risk of uncertain future prices. Options also aid in price discovery, not in absolute price terms, but in the way the market participants view the volatility of the markets. This is because options are a different form of hedging in that they protect investors against losses while allowing them to participate in the asset's gains.
As we will see later, if investors think that the markets will be volatile, the prices of options contracts will increase. This concept will be explained later.
2. Risk Management This could be the most important purpose of the derivatives market. Risk management is the process of identifying the desired level of risk, identifying the actual level of risk and altering the latter to equal the former. This process can fall into the categories of hedging and speculation. Hedging has traditionally been defined as a strategy for reducing the risk in holding a market position while speculation referred to taking a position in the way the markets will move. Today, hedging and speculation strategies, along with derivatives, are useful tools or techniques that enable companies to more effectively manage risk.
3. They Improve Market Efficiency for the Underlying Asset For example, investors who want exposure to the S&P 500 can buy an S&P 500 stock index fund or replicate the fund by buying S&P 500 futures and investing in risk-free bonds. Either
of these methods will give them exposure to the index without the expense of purchasing all the underlying assets in the S&P 500. If the cost of implementing these two strategies is the same, investors will be neutral as to which they choose. If there is a discrepancy between the prices, investors will sell the richer asset and buy the cheaper one until prices reach equilibrium. In this context, derivatives create market efficiency.
4. Derivatives Also Help Reduce Market Transaction Costs Because derivatives are a form of insurance or risk management, the cost of trading in them has to be low or investors will not find it economically sound to purchase such "insurance" for their positions.
Because bond prices do not move in a linear fashion, there is a chance to use arbitrage to capitalize on the deviance of a bond when compared to the 6% standardized bond. To do this, traders look for the cheapest to deliver bond (CTD). This is the least expensive underlying product that can be delivered upon expiry to satisfy the requirements of a derivative contract. This helps minimize the slippage between the conversation factor and the actual price. The CTD bond is always changing because prices and yields are always changing. A contract covers $100,000 par value of U.S. Treasuries. Contract expires March, June, September and December
Currency Contracts
Currency contracts function in the same way as forward contracts for currency. They are typically much smaller than forward contracts. Each contract has a stated size and quotation unit.
Future price for Euros = 0.92, which leads to a contract price of 125,000(this is the contract size)(.92) = 115,000 Calls for actual delivery through book entry of the underlying currency.
Derivatives Markets
The derivatives market is the financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets. The market can be divided into two, that for exchange-traded derivatives and that for overthe-counter derivatives. The legal nature of these products is very different as well as the way they are traded, though many market participants are active in both. Derivatives markets broadly can be classified into two categories, those that are traded on the exchange and the traded one to one or over the counter. They are hence known as Exchange Traded Derivatives OTC Derivatives (Over The Counter)
outstanding notional amount is US$684 trillion (as of June 2008). Of this total notional amount, 67% are interest rate contracts, 8% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other. Because OTC derivatives are not traded on an exchange, there is no central counter-party. Therefore, they are subject to counter-party risk, like an ordinary contract, since each counter-party relies on the other to perform.
Equity
Interest rate
Option on Eurodollar Eurodollar future Interest rate Forward rate future swap agreement Option on Euribor future Euribor future Credit default Repurchase swap agreement Total return swap Currency swap Currency forward
Interest rate cap and floor Swaption Basis swap Bond option
Credit
Bond future
Foreign exchange
Currency future
Currency option
Commodity
Gold option
Conclusion
Derivative securities markets play an important role by allowing investors who do not want the risks associated with holding an asset to transfer it to those who do. However, because they are markets for risk as opposed to physical assets, derivatives markets can be very dangerous places for unsophisticated investors. People who reduce their risk by entering a derivative market are called hedgers, and those who increase their risk are called speculators. The derivative securities markets play a vital role in the modern financial systems and without them many common business transactions would be rendered much riskier or practically impossible. 1. Derivatives can enhance financial intermediation and economic growth but require efficient underlying cash markets and sound infrastructure 2. Modern exchanges with leading risk systems (CCP, dynamic margins, buffer) can enhance transparency, safety, and competitiveness of a financial system 3. Prudential supervision is critical for FX and credit derivatives which could undermine fixed prices, pegged FX regimes, and credit policies 4. Securitization products should be grounded on sound OTC derivative market structures