CHAPTER 11 DERIVATIVES MARKETS Copyright© 2012 John Wiley & Sons, Inc

The Nature of Derivative Securities Derivatives are securities whose values are based on values of other assets. Derivatives can be used to minimize exposure to various types of risk E.g., interest-rate, forex, commodity price risks The purpose is to eliminate the price risk inherent in transactions that call for future delivery of money, a security, or a commodity. Derivatives are also used to speculate. Copyright© 2012 John Wiley & Sons, Inc

Spot versus Forward Market Trading for immediate delivery takes place in the spot market at spot prices (rates). Trading for future delivery takes place in the forward market at forward prices (rates). Copyright© 2012 John Wiley & Sons, Inc

Forward Markets Forward contract is an agreement to buy or sell a specific amount of an asset at a specific future date and price. All terms are negotiated by counterparties. No money changes hands at the moment forward is negotiated. Buyers = long positions; sellers = short positions. Seller delivers at the specified date called the settlement date. Copyright© 2012 John Wiley & Sons, Inc

Futures Markets Futures contract is also an agreement to buy or sell an asset in the future. Unlike forwards, futures are standardized in terms of amounts, delivery dates, commodity grades. Buyers/sellers deal with the futures exchange, not with each other. Delivery seldom made - buyers/sellers offset their positions before maturity. Standardization of futures makes them much more liquid then forwards. Forwards, however, can be tailored exactly to the needs of counterparties. Copyright© 2012 John Wiley & Sons, Inc

Futures Market Transaction Copyright© 2012 John Wiley & Sons, Inc

Margin Requirements Initial margin - small percentage deposit required to start trading futures. Daily settlements (marking-to-market) reflect gains/losses daily and cash payments. Maintenance margin - minimum deposit requirements on futures contracts. If balance falls below maintenance margin, a margin call takes place and funds must be added back to the amount of initial margin. If funds not added, position is liquidated. Copyright© 2012 John Wiley & Sons, Inc

Competition between exchanges is keen. Contract innovation is common. Futures Exchanges Competition between exchanges is keen. Contract innovation is common. Exchanges advertise and promote heavily. Exchange specifies terms of a contract. Dates. Denomination. Specific items that can be delivered. Method of delivery. Minimum daily price variance. Trading rules. Copyright© 2012 John Wiley & Sons, Inc

Futures Markets Participants Hedgers attempt to reduce or eliminate price risk. Speculators consciously accept price risk hoping for high return. Traders speculate on very-short-term changes in futures contract prices. Copyright© 2012 John Wiley & Sons, Inc

Uses of Financial Futures Markets Reducing Systematic Risk in Stock Portfolios Stock-index futures contracts trading began in 1982. Stock-index futures derive their value from the value of an underlying group of selected stocks. Stock-index futures permit investors to alter the market or systematic risk of their portfolio. Investors who want to protect stock portfolio gains may hedge by selling (shorting) stock- index futures. Copyright© 2012 John Wiley & Sons, Inc

Stock-Index Program Trading Done to arbitrage price discrepancies between stock-index futures and the stocks that make up the index. Allows the program trader to earn a higher risk-free return than a T-Bill for the corresponding period. Involves buying or selling large number of stocks in high volume, which can influence stock prices dramatically over the short-term. Copyright© 2012 John Wiley & Sons, Inc

Guaranteeing Cost of Funds Futures and forwards can be used to hedge future borrowing costs. If interest rates are expected to rise: a borrower can sell T-bill or T-bond futures (executes a short hedge); the borrower will gain in the futures market and offset the increased borrowing cost. Copyright© 2012 John Wiley & Sons, Inc

Risks in the Futures Markets Basis risk - risk of an imperfect hedge because the value of item being hedged may not always keep the same price relationship to the futures contracts. Cross-hedging - using the futures market to hedge a dissimilar commodity or security. E.g., hedging a portfolio of common stocks different from those in the S&P 500 index with S&P 500 index futures. Related-contract risk - risk of failure due to unanticipated changes in the business activity being hedged, such as loan defaults or prepayments. Copyright© 2012 John Wiley & Sons, Inc

Risks in the Futures Markets (continued) Manipulation risk - risk of price losses due to a person or group trading to affect price. Margin risk - the risk of losing a hedge if margin calls cannot be satisfied and position is liquidated. Copyright© 2012 John Wiley & Sons, Inc

Call option = the right to buy Put option = the right to sell Options An option is a right to buy or sell an underlying asset on or before a specified date at a strike (exercise) price. Call option = the right to buy Put option = the right to sell American option can be exercised on or before the expiration date. European option can be exercised only on its expiration date. Copyright© 2012 John Wiley & Sons, Inc

Seller of the option = writer, buyer = holder. Options (cont.) An option that would be profitable if exercised immediately is said to be in the money. Otherwise, it is at the money or out of the money. Seller of the option = writer, buyer = holder. Buyer pays writer a premium for the option. Buyer can lose only the premium and commissions paid. If buyer exercises the option, writer must honor this request. Copyright© 2012 John Wiley & Sons, Inc

Covered and Naked Options Covered option - writer either owns the security involved in the contract or has limited his or her risk with other contracts. Naked option - writer does not have or has not made provision to limit the extent of risk. Copyright© 2012 John Wiley & Sons, Inc

Reading Option Quotes Copyright© 2012 John Wiley & Sons, Inc

Options versus Futures Contracts The option at the strike price exists over the period of time, not at a given date. The buyer of an option pays the seller (writer) a premium which the writer keeps regardless of whether or not the option is ever exercised. The option does not have to be exercised; it is a right, not an obligation. Gains and losses are unlimited with futures contracts; with options the buyer can lose only the premium and the commissions paid. Copyright© 2012 John Wiley & Sons, Inc

The size of the option premium varies: The Value of Options The size of the option premium varies: directly with the price volatility of the underlying asset; directly with the time to its expiration; directly with the level of interest rates. Copyright© 2012 John Wiley & Sons, Inc

Gains and Losses in Options & Futures Copyright© 2012 John Wiley & Sons, Inc

Regulation of the Futures Market The Commodity Futures Trading Commission (CFTC) The Securities Exchange Commission (SEC) regulates options that have equity securities as underlying assets. Exchanges impose self-regulation with rules of conduct for members. Copyright© 2012 John Wiley & Sons, Inc

Swaps Compared to Forwards and Futures Swaps are agreements to exchange series of payment obligations. E.g., Fixed-rate vs. variable-rate payments, both based on the notional principal. Only net amount is transferred. Amounts are conditional on changes in an interest rate such as LIBOR. Swaps are used to hedge interest rate risk. Credit risk differences between parties provide incentive to swap future interest flows. A swap can be viewed as a series of forwards. Copyright© 2012 John Wiley & Sons, Inc

Serve as counterparties to both sides of swap transactions. Swap Dealers Serve as counterparties to both sides of swap transactions. Dealers negotiate a deal with one party, then seek out parties with opposite interests and write a separate contract with them. The two contracts hedge each other and the dealer earns a fee for serving both parties. Copyright© 2012 John Wiley & Sons, Inc

Swaps Had Limited Regulation Bank regulators required risk-based capital support for swap-risk exposure. Other swap competitors, investment banks and life insurance companies had no regulatory capital costs. The market was self-regulated because of lack of any organized regulator. The International Swap Dealers Association leaded in this effort. Copyright© 2012 John Wiley & Sons, Inc

Example of a Swap Copyright© 2012 John Wiley & Sons, Inc

Credit Default Swaps Investors pay the counterparty a premium for the counterparty’s guarantee that in the event of a credit event (bankruptcy or restructuring), the investors would receive payment from the counterparty. Credit default swaps are similar to insurance but they were not regulated, had no capital requirements, and the investors do not have to own the underlying asset. Copyright© 2012 John Wiley & Sons, Inc

Dodd-Frank Act (2010) Reshaped the regulation of swaps market to increase transparency and reduce systemic risk. Five major changes for the swaps market: 1) A central clearinghouse; 2) Execution through exchange versus OTC; 3) Dealers have to post margin; 4) Capital requirements; 5) Register with the CFTC and/or the SEC. Copyright© 2012 John Wiley & Sons, Inc