Understanding Derivative Securities Markets in Finance

1. Chapter Ten Derivative Securities Markets

2. Derivative Securities: Chapter Overview • Derivative security • An agreement between two parties to exchange a standard quantity of an asset at a predetermined price at a specified date in the future • Derivatives are contracts whose value is linked to and derived from something else. • The ‘something else’ is usually a security, a portfolio or an index. McGraw-Hill/Irwin

3. Derivatives are financial contracts or financial instruments • whose values are derived from the value of something else (known as the underlying). The underlying on which a derivative is based can be an asset (e.g., commodities, equities (stocks), residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer price index, or other items (e.g., weather conditions, or other derivatives). Credit derivatives are based on loans, bonds or other forms of credit McGraw-Hill/Irwin

4. Derivatives may be used for different purposes • For instance, mortgage backed derivatives are often created to improve the marketability of existing loans, thereby improving a FI’s liquidity. • The primary purpose of most derivative markets is however to reallocate risk from parties who do not wish to bear some or all of the risk arising from their underlying lines of business (hedgers) to other parties who are willing to bear the risk (speculators). McGraw-Hill/Irwin

5. Derivatives uses • Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation McGraw-Hill/Irwin

6. Hedging • Derivatives allow risk about the value of the underlying asset to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. However, there is still the risk that no wheat will be available due to causes unspecified by the contract, like the weather, or that one party will renege on the contract. (Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured against counterparty risk.) McGraw-Hill/Irwin

7. Speculation and arbitrage • Derivatives can be used to acquire risk, rather than to insure or hedge against risk. • Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings Bank, made poor and unauthorized investments in futures contracts. Through a combination of poor judgment, lack of oversight by the bank's management and by regulators, and unfortunate events like the Kobe earthquake, Leeson incurred a $1.3 billion loss that bankrupted the centuries-old institution. McGraw-Hill/Irwin

8. Types of derivatives; OTC and exchange-traded • Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way McGraw-Hill/Irwin

9. OTC2 • The OTC derivative market is the largest market for derivatives, and is unregulated. According to the Bank for International Settlements, the total outstanding notional amount is $596 trillion (as of December 2007). Of this total notional amount, 66% are interest rate contracts, 10% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other. McGraw-Hill/Irwin

10. OTC3 • OTC derivatives are largely subject to counterparty risk, as the validity of a contract depends on the counterparty's solvency and ability to honor its obligations. McGraw-Hill/Irwin

11. Exchange-traded derivatives • (ETD) are those derivatives products that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange acts as an intermediary to all related transactions, and takes Initial margin from both sides of the trade to act as a guarantee McGraw-Hill/Irwin

12. Derivatives traders at the Chicago Board of Trade McGraw-Hill/Irwin

13. Examples of Derivatives • Forward and futures contracts • currency forwards and futures • interest rate futures • Options contracts • call option • put option • Swaps • currency swap • interest rate swap McGraw-Hill/Irwin

14. History • Although commodity futures have a long history in the U.S., options were not widely traded until the development of the Black-Scholes Option Pricing Model in the early 1970s. • In modern times derivatives have developed as the need to manage the risk of a given commodity or exposure grew. McGraw-Hill/Irwin

15. For instance, currency futures were introduced by the International Monetary Market (IMM), a subsidiary of the Chicago Mercantile Exchange (CME) as the collapse of the Bretton Woods Agreement led to higher currency volatility . • Interest rate derivatives were created after the Fed stopped targeting interest rates in 1979 McGraw-Hill/Irwin

16. As stock trading grew, stock index derivatives were introduced in the early 1980s • With the extreme increases in short term interest rates in the early 1980s, institutions became interested in swaps to manage interest rate risk. • In the 1990s, credit risk derivatives were created that pay the holder if the credit risk on an underlying asset increases. • Enron was a major trader in credit risk derivatives. Trading gains from these derivatives were used to help mask losses on other business lines at Enron McGraw-Hill/Irwin

17. Banks are major players in derivative markets, particularly in certain OTC derivatives and in mortgage backed securities. Derivatives usage among banks however is limited to the largest 600 or so banks and 95% of derivatives held by banks are written by just 5 banks. McGraw-Hill/Irwin

18. in some contracts the volume of electronic trading is now exceeding the volume of traditional exchange trading • Derivatives are now being traded on electronic exchanges. • Eurex (a European exchange) launched a fully electronic exchange in Chicago offering futures and options on U.S. T-notes and T-bonds as well as contracts on Euro interest rates. • The CME’s Globex system is growing as well. Electronic trading is gaining ground on traditional pit trading;. McGraw-Hill/Irwin

19. Forwards and Futures • Spot Markets • A spot contract is a contract for immediate payment and delivery. Settlement is usually within two to three business days. McGraw-Hill/Irwin

20. Forwards and Futures • Both are agreements to deliver (or take delivery of) a specified asset at a future date • Prices of both are tied to the current price of the asset in the “spot” market McGraw-Hill/Irwin

21. Forward Markets • Forward contract • an agreement to transact, involving the future exchange of a set amount of assets at a set price • participants hedge the risk that the future spot price of an asset will move against them • FI’s are the major forward market participants • FIs agree to take the opposite side of the contract as the customer for a fee and to earn the bid-ask spread McGraw-Hill/Irwin

22. forward rate agreement • Forward contracts can specify interest rates on future borrowings as well as prices on specified assets. • A forward rate agreement (FRA) is a forward contract for loans that fixes the interest rate today on a loan that will be originated in the future McGraw-Hill/Irwin

23. Forward contracts are custom arrangements negotiated by the buyer and seller. • Both parties are at risk if the counterparty fails to perform as promised; hence, both parties should evaluate the creditworthiness of the counterparty. • If the counterparty is not known to the bank, collateral may be required. McGraw-Hill/Irwin

24. Futures Markets • Futures contract • Initial margin • Maintenance margin McGraw-Hill/Irwin

25. Futures Trading • Open-outcry auction • Floor broker • Professional traders • Position traders • Day traders • Scalpers • Long/Short position • Clearinghouse • Open interest McGraw-Hill/Irwin

26. A buyer of a futures contract (long position) incurs the obligation to pay the extant futures price at the time the contract is purchased. • Payment is made at contract maturity in exchange for receipt of the underlying commodity. McGraw-Hill/Irwin

27. A seller of a futures contract (short position) incurs the obligation to deliver the underlying commodity at contract maturity in exchange for receiving the futures price that was outstanding at the time the contract was enacted. McGraw-Hill/Irwin

28. initial margin requirement • On a forward contract, no cash is paid or received until contract maturity. Buyers and sellers of futures contracts however must post an initial margin requirement (IMR) to enter into a futures deal. The IMR is usually set at about 3%-5% of the face value of the contract, depending on the volatility of the underlying commodity and whether there are daily price limits on the futures contracts. McGraw-Hill/Irwin

29. maintenance margin requirement • Participants must also maintain minimum margin requirements called the maintenance margin requirement (usually about 75% of the IMR). Futures contracts are marked to market daily, which means that gains or losses on the contracts are realized daily. This may require additional cash outlays if the customer’s margin falls below the minimum required. McGraw-Hill/Irwin

30. Gambling? • Most futures contracts do not result in delivery; indeed some contracts do not even allow delivery. • The long position is eliminated by selling the same contract. • The clearinghouse nets the position (1 long and 1 short) to zero. Likewise, the short seller simply purchases the same contract and the clearinghouse nets their position to zero McGraw-Hill/Irwin

31. It is just a gambling • Because of the lack of delivery, futures contracts are really bets on the way the price of the underlying commodity will move. • The purchaser (seller) of a futures contract agrees to receive (pay) any increase in the value of the underlying commodity and agrees to pay (receive) any decrease in value between contract origination and termination. McGraw-Hill/Irwin

32. Why delivery is not an issue on futures contracts • I go long and default the pound futures contract F = futures price, S = spot price at time = 0 (today) or time = T at expiration. • Suppose F0=$110,000 but at contract expiration ST = $108,000 and I renege and refuse to pay $110,000 to receive £62,500 (contract size) when I could buy them in the spot for $108,000. • The seller of the pounds could sell the pound spot and receive $108,000 and the seller has ALREADY gained $2,000 from the daily marking to market. The net proceeds to the seller are $110,000, the same as if no default occurred. McGraw-Hill/Irwin

33. I go short and default the Pound futures contract: • F0= $110,000 but ST = $112,000 and I renege and refuse to deliver £62,500 in order to receive $110,000 when I could receive $112,000 in the spot. • The buyer of the pounds could buy the pound spot and pay $112,000 and (s)he (buyer) has ALREADY gained $2,000 from the daily marking to market. Net cost to buyer $110,000. McGraw-Hill/Irwin

34. Settlement • Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract: • Physical delivery - Physical delivery is common with commodities and bonds. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position (Use of an option in a trading strategy in the underlying asset which is already owned) . The Nymex crude futures contract uses this method of settlement upon expiration. • Cash settlement McGraw-Hill/Irwin

35. open interest • The amount of open interest on a contract is the amount of long (short) positions that have not executed offsetting trades. • Open interest is useful as a measure of liquidity on the contract McGraw-Hill/Irwin

36. clearinghouses • An agency associated with an exchange, which settles trades and regulates delivery • Clearing corporations, or clearinghouses, provide operational support for securities and commodities exchanges. They also help ensure the integrity of listed securities and derivatives transactions in the United States and other open markets. • For example, when an order to buy or sell a futures or options contract is executed, the clearinghouse compares the details of the trade. Then it delivers the product to the buyer and ensures that payment is made to settle the transaction McGraw-Hill/Irwin

37. open outcry auction • Futures trading uses an open outcry auction where traders communicate with each other via oral communications (usually shouted) and a variety of hand signals McGraw-Hill/Irwin

38. An observer would think the trading process rather chaotic but it seems to work. • Trading is very stressful, with hundreds or thousands of dollars quickly changing hands and emotions can run high, indeed fisticuffs are not unheard of on the exchange. • The NYSE, while it can be extremely busy, is typically much more quiet than trading in the futures and options pits. • The Chicago markets still hearken back to the style and zest of Chicago’s earlier days McGraw-Hill/Irwin

39. Professional traders • Position traders that maintain positions in a contract for longer than a day, • Day traders that liquidate their positions by the end of the day, • Scalpers who hold positions only a matter of minutes and attempt to profit from either very small price changes or the bid-ask spread. Scalpers who hold their positions for more than 3 minutes typically lose. McGraw-Hill/Irwin

40. Day traders and position traders often use proprietary models to estimate which way they believe prices will move. They normally will not disclose what their trading models. McGraw-Hill/Irwin

41. floor brokers • Similar to the NYSE, floor brokers process public orders to buy and sell. McGraw-Hill/Irwin

42. Today, there are more than 75 futures and futures options exchanges worldwide trading to include: • Chicago Mercantile Exchange(CME) • London International Financial Futures Exchange in 1982 (now Euronext.liffe), • Deutsche Terminbörse (now Eurex) • Tokyo Commodity Exchange (TOCOM). • CME Group (formerly CBOT and CME) -- Currencies, Various Interest Rate derivatives (including US Bonds); Agricultural (Corn, Soybeans, Soy Products, Wheat, Pork, Cattle, Butter, Milk); Index (Dow Jones Industrial Average); Metals (Gold, Silver), Index (NASDAQ, S&P, etc) McGraw-Hill/Irwin

43. ICE Futures - the International Petroleum Exchange trades energy including crude oil, heating oil, natural gas and unleaded gas and merged with IntercontinentalExchange(ICE)to form ICE Futures. • Liffe • South African Futures Exchange - SAFEX • Sydney Futures Exchange • London Commodity Exchange - softs: grains and meats. Inactive market in Baltic Exchange shipping. • Tokyo Stock Exchange TSE (JGB Futures, TOPIX Futures) • Tokyo Commodity Exchange TOCOM • Tokyo Financial Exchange TFX (Euroyen Futures, OverNight CallRate Futures, SpotNext RepoRate Futures) • Osaka Securities Exchange OSE (Nikkei Futures, RNP Futures) • London Metal Exchange - metals: copper, aluminium, lead, zinc, nickel ,tin and steel • New York Board of Trade - softs: cocoa, coffee, cotton, orange juice, sugar • New York Mercantile Exchange - energy and metals: crude oil, gasoline, heating oil, natural gas, coal, propane, gold, silver, platinum, copper, aluminum and palladium • Dubai Mercantile Exchange • Singapore International Monetary Exchange (SIMEX) • Futures on many Single-stock futures McGraw-Hill/Irwin

44. Futures Contracts Outstanding, 1992-2003 McGraw-Hill/Irwin

45. Who trades futures? • Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in the underlying commodity and are seeking to hedge out the risk of price changes; and speculators, who seek to make a profit by predicting market moves and buying a commodity "on paper" for which they have no practical use. McGraw-Hill/Irwin

46. Hedgers typically include producers and consumers of a commodity • For example, in traditional commodity markets, farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed. McGraw-Hill/Irwin

47. The social utility • The social utility of futures markets is considered to be mainly in the transfer of risk, and increase liquidity between traders with different risk and time preferences, from a hedger to a speculator for example. McGraw-Hill/Irwin

48. Options • A contract that gives the holder the right, but not the obligation, to buy or sell an asset at a prespecified price for a specified price within a specified period of time • American option - can be exercised at any time before the expiration date • European option - can only be exercised on the expiration date McGraw-Hill/Irwin

49. Definitions of a Call • Call option • an option that gives a purchaser the right, but not the obligation, to buy the underlying security from the writer of the option at a prespecified exercise price on a prespecified date. • The call buyer must pay the option premium (C) to the call writer. The option buyer may exercise the option and purchase the underlying spot commodity by paying the exercise or strike price (X). McGraw-Hill/Irwin

50. The option has intrinsic value if the underlying spot price (S) is greater than X. In this case the option is said to be ‘in the money.’ If at expiration S > X, the option will be exercised, if not the option expires worthless. In either case, the initial call price C is a sunk cost. McGraw-Hill/Irwin