Derivatives-market-1.pdf

Derivatives Market

Sugath Alwis, CFA

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Introduction z

There is no universally satisfactory answer to the question of what a derivative is, however one explanation ...... –

–

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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

Introduction (cont’d) z

Futures, options and swap markets are very useful, perhaps even essential, parts of the financial system – – –

z

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hedging or risk management speculate or strive for enhanced returns price discovery - insight into future prices of commodities

Futures and options markets, and more recently swap markets have a long history 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 4

‘derivatives’ - in many of these situations this has been the case i.e a speculative application of derivatives that has gone 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’ –

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Arthur Leavitt- Chairman SEC 1995

Derivatives & Risk z

Derivative markets neither create nor destroy wealth - they provide a means to transfer risk – – –

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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

Derivatives & Risk z

z

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Derivatives are powerful instruments - they typically contain a high degree of leverage, meaning that small price changes can lead to large gains and losses this high degree of leverage makes them effective but also ‘dangerous’ when misused.

Hedging z z

Hedging involves engaging in a financial transaction that reduces or eliminates risk. Definitions – –

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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

Hedging z

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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.

Types of Derivatives z z z z z

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Forwards contracts Futures contracts Options Swaps Hybrids

Forward Markets z

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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

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The price paid for the assets by the other party

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The date when the assets and cash will be exchanged

Forward Markets z

An Example of an Interest-Rate Contract –

– –

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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

Forward Markets z

Long Position – –

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Short Position – –

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

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

Forward Markets z

Pros 1.

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Cons 1. 2.

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Flexible

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

Financial Futures Markets z

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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.

Financial Futures Markets z

Financial Futures Contract 1. 2. 3. 4.

z

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Specifies delivery of type of security at future date Arbitrage: at expiration date, price of contract = price of the underlying asset delivered i ↑, long contract has loss, short contract has profit Hedging similar to forwards: micro versus macro hedge

Traded on Exchanges –

Global competition regulated by CFTC

Example: Hedging Interest Rate Risk

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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: – –

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

Example: Hedging Interest Rate Risk

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–

–

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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.

Financial Futures Markets z

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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.

Financial Futures Markets z

z

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In the U.S., futures are traded on the CBOT and the CME in Chicago, the NY Futures Exchange, and others. 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.

Financial Futures Markets z z z z

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

Widely Traded Financial Futures Contracts

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Financial Futures Markets z

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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

Hedging FX Risk z

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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.

Hedging FX Risk z

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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.

Hedging FX Risk 3.

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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.

Hedging FX Risk

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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.

Futures/Forward Contracts History z

Forward contracts on agricultural products began in the 1840’s – – –

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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)

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 z

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buyers/sellers required to post margins with the clearinghouse daily settlement of open positions - became known as the mark-market system

Futures/Forward Contracts History Cont’d z

z

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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 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

Stock Index Futures

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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.

Stock Index Futures

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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.

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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.

Hedging with Stock Index Futures z

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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?

Hedging with Stock Index Futures z

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

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To hedge $100 million of stocks that move 1 for 1 (perfect correlation) with S&P currently selling at 1000, you would: –

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currently 250 x 1,000 = $250,000

sell $100 million of index futures = 400 contracts

Hedging with Stock Index Futures z

Suppose after the year, the S&P 500 is at 900 and the portfolio is worth $90 million. –

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If instead, the S&P 500 is at 1100 and the portfolio is worth $110 million. –

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futures position is up $10 million

futures position is down $10 million

Either way, net position is $100 million

Hedging with Stock Index Futures

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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!

Options z

An option is the right to either buy or sell something at a set price, within a set period of time – –

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The right to buy is a call option The right to sell is a put option

You can exercise an option if you wish, but you do not have to do so

Options z

Options Contract –

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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).

Options are available on a number of financial instruments, including individual stocks, stock indexes, etc.

Options z

Hedging with Options –

– –

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if i falls: –

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Buy same number of put option contracts as would sell of futures Disadvantage: pay premium Advantage: protected if i gains Additional advantage if macro hedge: avoids accounting problems, no losses on option if i falls

Options

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Factors Affecting Premium

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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.

Option Contracts - History z

Chicago Board Options Exchange (CBOE) opened in April of 1973 –

z

z

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call options on 16 common stocks

The widespread acceptance of exchange traded options is commonly regarded as one of the more significant and successful investment innovations of the 1970’s Today we have option exchanges around the world trading contracts on various financial instruments and commodities

Options Contracts z z z z z z z

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z

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

Hedging with Options z

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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?

Hedging with Options z

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

z

To hedge $100 million of stocks that move 1 for 1 (perfect correlation) with S&P currently selling at 1000, you would: –

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currently 100 x 1,000 = $100,000

buy $100 million of S&P put options = 1,000 contracts

Hedging with Options

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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.

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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).

Hedging with Options z

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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)

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in net, portfolio is worth $94.8 million

If instead, the S&P 500 is at 1100 and the portfolio is worth $109.8 million. –

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

Hedging with Options z

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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.

Swaps z z z

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Introduction Interest rate swap Foreign currency swap

Introduction z z z z z

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Swaps are arrangements in which one party trades something with another party The swap market is very large, with trillions of dollars outstanding in swap agreements Currency swaps Interest rate swaps Commodity & other swaps - e.g. Natural gas pricing

Swap Market - History z

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Similar theme to the evolution of the other derivative products - swaps evolved in response to an economic/financial requirement 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

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Exchange rate volatility and associated risk has been with us since

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 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 z

–

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Interest Rate Swap z

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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

Interest-Rate Swaps

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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.

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Simplest type, called a plain vanilla swap, specifies (1) the rates being exchanged, (2) type of payments, and (3) notional amount.

Interest-Rate Swap Contract Example z

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z z z

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Midwest Savings Bank wishes to hedge rate changes by entering into variable-rate contracts. Friendly Finance Company wishes to hedge some of its variable-rate debt with some fixedrate debt. Notional principle of $1 million Term of 10 years Midwest SB swaps 7% payment for T-bill + 1% from Friendly Finance Company.

Interest-Rate Swap Contract Example

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Hedging with Interest-Rate Swaps z

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Reduce interest-rate risk for both parties 1.

Midwest converts $1m of fixed rate assets to ratesensitive assets, RSA, lowers GAP

2.

Friendly Finance RSA, lowers GAP

Hedging with Interest-Rate Swaps z

Advantages of swaps 1. 2.

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Disadvantages of swaps 1. 2.

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Reduce risk, no change in balance-sheet Longer term than futures or options Lack of liquidity Subject to default risk

Financial intermediaries help reduce disadvantages of swaps (but at a cost!)

Foreign Currency Swap z z

z

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

Commodity Swap z

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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)

Credit Derivatives z

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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.

Credit Derivatives z

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Credit derivatives can be generally categorized as credit options, credit swaps, and creditlinked notes.

Credit Derivatives z

Credit options are like other options, but payoffs are tied to changes in credit conditions. – –

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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.

Credit Derivatives z

Credit options are like other options, but payoffs are tied to changes in credit conditions. – –

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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.

Credit Derivatives z

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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.

Credit Derivatives z

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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.

Credit Derivatives z

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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.

Credit Derivatives z

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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).

Credit Derivatives z

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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.

Credit Derivatives z

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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.

Product Characteristics z

Both options and futures contracts exist on a wide variety of assets – –

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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

Product Characteristics (cont’d) z

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The underlying asset is that which you have the right to buy or sell (with options) or to buy or deliver (with futures)

Product Characteristics (cont’d)

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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

Product Characteristics (cont’d) z

z

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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 Futures contracts are regulated by the Commodity Futures Trading Commission (CFTC) in the U.S.

Participants in the Derivatives World z

Include those who use derivatives for: – – –

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Hedging Speculation/investment Arbitrage

Hedging

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z

If someone bears an economic risk and uses the futures market or other derivatives to reduce that risk, the person is a hedger

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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

Speculation z

z z

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

Arbitrage z z

Arbitrage is the existence of a riskless profit Arbitrage opportunities are quickly exploited and eliminated in efficient markets –

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Arbitrage then contributes to the efficiency of markets

Arbitrage (cont’d) z

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Persons actively engaged in seeking out minor pricing discrepancies are called arbitrageurs Arbitrageurs keep prices in the marketplace efficient –

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An efficient market is one in which securities are priced in accordance with their perceived level of risk and their potential return

The pricing of options incorporates this concept of arbitrage

Uses of Derivatives z z z

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Risk management Income generation Financial engineering

Risk Management z z z z

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The hedger’s primary motivation is risk management Someone who is bullish believes prices are going to rise Someone who is bearish believes prices are going to fall We can tailor our risk exposure to any points we wish along a bullish/bearish continuum

Income Generation z

Writing a covered call is a way to generate income –

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Involves giving someone the right to purchase your stock at a set price in exchange for an upfront fee (the option premium) that is yours to keep no matter what happens

Writing calls is especially popular during a flat period in the market or when prices are trending downward

Financial Engineering z

Financial engineering refers to the practice of using derivatives as building blocks in the creation of some specialized product –

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e.g linking the interest due on a bond issue to the price of oil (for an oil producer)

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

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Effective Study of Derivatives z

The study of derivatives involves a vocabulary that essentially becomes a new language – – – – – –

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

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

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Questions….

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