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DERIVATIVES MARKETS

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Title: DERIVATIVES MARKETS


1
CHAPTER 11
  • DERIVATIVES MARKETS

2
The Purpose of Futures and Forward Markets
  • Purpose is to eliminate the price risk inherent
    in transactions that call for future delivery of
    money, a security, or a commodity.
  • Financial derivatives are financial instruments
    whose value is linked to, or derived from, the
    price or change in price of an underlying
    security such as a stock, bond, commodity, index
    or other asset.

3
From the Wall Street Journal of March 11, 2003,
p. A14
  • On balance, the 2 trillion derivatives market
    is a very good thing. It allows institutions to
    lay off risk, making the financial system less
    vulnerable
  • But the real miracle of derivatives is that they
    allow investors to separate and manage specific
    risksThey let investors hedge risks, in varying
    degrees, by transferring it to investors who are
    more willing, or able, to assume it. Financial
    derivatives can be used to manage risk in prices,
    interest rates, currencies and credit.

4
Forward Exchange Markets
  • Buying/selling of a specified amount, price, and
    future delivery date of foreign currency
  • Direct relationship between buyer and seller
    (Counterparty)
  • Foreign exchange dealers earn revenues on the
    spread between buying and selling
  • Seller delivers at the specified date
  • e.g. 30, 90, 180 days

5
Futures Markets
  • Buying/selling of standardized contracts
    specifying the amount, price, and future delivery
    date of a currency, security, or commodity.
  • Buyers/sellers deal with the futures exchange,
    not with each other.
  • A specific trade (buy/sell) involves a hedger and
    a speculator.
  • Delivery seldom made -- buyer/seller offsets
    previous position before maturity. Either party
    can liquidate its futures position prior to the
    scheduled delivery date.

6
Futures Markets - Continued
  • Futures contracts expire on specific dates.
  • Futures markets require that the value of all
    contracts be marked to market constantly.
  • Futures contracts require their owners to post
    margin money (if necessary) to take account of
    gains and losses accruing from daily price
    movements.
  • When there is both a new buyer and a new seller,
    the open interest - or total number of contracts
    to deliver a contract through the exchange
    increases by one.

7
Spot versus Futures Market
  • Trading for immediate or very-near-term delivery
    is called the spot market.
  • Trading for future delivery -- futures market.

8
A Position in the Futures Market
  • Long -- an agreement to buy (purchase) in the
    future.
  • Short -- an agreement to sell (deliver) in the
    future.

9
Margin Requirements
  • Initial margin -- small percentage deposit
    required to trade a futures contract.
  • Daily settlements -- reflect gains/losses daily
    and cash payments.
  • Maintenance margin -- minimum deposit
    requirements on futures contracts.
  • Margin call requires an investor to add money to
    his/her futures margin to offset his/her losses.

10
Futures Exchanges
  • Competition between exchanges is keen.
  • Contract innovation is common.
  • Exchanges advertise and promote heavily.
  • Financial exchanges develop contracts that it
    thinks will reduce the risk exposure of financial
    market participants.

11
Futures Exchanges - continued
  • Exchange specifies terms of a contract.
  • Dates
  • Denomination
  • Specific items that can be delivered
  • Method of delivery
  • Minimum price fluctuation
  • Maximum daily price variance
  • Rules for trading

12
Interest Rate Futures Quotations
13
Futures Markets Participants
  • Hedgers attempt to reduce or eliminate price
    risk.
  • Speculators accept the price risk in turn for
    expected return.
  • Speculators may also enter into spreads or
    straddles, in which they buy one futures contract
    and sell a closely related contract in the hope
    that the price of one contract will move more
    favorably than the other.
  • Traders speculate on very-short-term changes in
    future contract prices.

14
Regulation of the Futures Market
  • The Commodity Futures Trading Commission (CFTC)
  • 5 member Federal Commission
  • Formed in 1974
  • The Securities Exchange Commission (SEC)
    regulates options markets that have equity
    securities as underlying assets.
  • Exchanges impose self-regulation with rules of
    conduct for members.

15
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-hedges -- using the futures market to hedge
    a dissimilar commodity or security.
  • Related-contract risk -- risk of failure due to a
    unanticipated change in the business activity
    being hedged, such as a loan default or
    prepayment.

16
Risks in the Futures Markets (concluded)
  • Manipulation risk -- risk of price losses due to
    a person or group trading (buying or selling) to
    affect price. Short squeezes are where an
    individual or group makes it impossible for
    short sellers to liquidate their position.
  • Margin risk -- the liquidity risk that added
    maintenance margin calls will be made by the
    exchange.

17
Stock Index Futures
  • Stock Index Futures are instruments for hedging
    exposure to changes in market values,
    specifically exposure to the change in value in
    equity portfolios. Stock-index futures can be
    used to control the systematic risk in an
    investors portfolio.
  • Stock Index Futures derive their value by
    averaging the prices of a basket of underlying
    stocks that were included in the stock index.
  • It is not possible to make or take delivery of an
    index.

18
Stock Index Futures - continued
  • To hedge against a decline in the stock market, a
    portfolio manager could hedge using a short hedge
    by selling stock index futures. If the market
    indexes do indeed fall, so will the value of the
    contracts, resulting in a profit when the
    position is closed out and offsetting losses in
    the stock portfolio.
  • It is portfolio insurance to protect against a
    possible market decline.

19
GAP Management
  • We will cover this concept in depth in Chapter
    14.
  • Monitoring the interest rate sensitivities and
    maturities of a financial institutions assets
    and liabilities is called GAP management.
  • The GAP is the difference between the Rate
    Sensitive Assets (RSA) and the Rate Sensitive
    Liabilities (RSL).
  • Financial futures can be used to protect a
    financial institution against interest rate risk.

20
Duration Gap
DG MVA x DA MVL x DL MVF x DF
21
Swaps Compared to Forwards and Futures
  • Swaps are like forward contracts in that they
    guarantee the exchange of two items in the
    future, but a swap only transfers the net amount.
    By 2000, the swaps market exceeded 46 trillion
    in notional principal
  • Swaps do not pre-specify the terms of trade as do
    forward contracts. Prices are conditional on
    changes in a indexed interest rate such as LIBOR
    or T-bills.
  • Swaps are used to hedge interest rate risk as are
    financial futures. Credit risk differences
    between the parties provide the economic
    incentive to swap future interest flows.

22
Interest Rate Swaps
  • An arrangement whereby one party exchanges one
    set of interest rate payments for another.
  • Most common arrangement involves an exchange of
    fixed-rate interest payments for floating-rate
    interest payments over time.

23
Interest Rate Swaps - continued
  • Provisions of an interest rate swap include
  • The notional principal value upon which the
    interest rates are applied to determine the
    interest payments involved
  • The fixed interest rate
  • The formula and type of index used to determine
    floating rate
  • The frequency of payments such as every six
    months or every year.
  • The lifetime of the swap

24
Swap Dealers
  • Serve as Counter-parties to both Sides of Swap
    Transactions
  • Dealers negotiate a deal with one party, then
    seek out other 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.
  • Among others, many large banks in the U.S., Great
    Britain, and Japanese securities firms act as
    brokers and dealers in the swap markets. They
    earn substantial fees for arranging and servicing
    swaps.

25
Swaps have Limited Regulation
  • Bank regulators require risk-based capital
    support for swap-risk exposure.
  • Other swap competitors, investment banks and life
    insurance companies have no regulatory capital
    costs.

26
Example of a Swap
27
Options
  • Right to buy or sell an item at a predetermined
    price (strike price) until some future date
  • The option itself is created by an option writer,
    someone who stands ready to buy or sell the asset
    when the holder wishes to make a transaction.
  • The price written into the option agreement is
    the exercise or strike price.
  • American options can be exercised at any point
    during their lives. European options can be
    exercised only at expiration.

28
Options vs. 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 by the
    buyer it can be sold if it has a market value,
    before the expiration date.
  • Gains and losses are unlimited with futures
    contracts with options the buyer can lose only
    the premium and the commission paid.

29
Calls and Puts
  • Call option -- buyer has the option to buy an
    item at the strike price.
  • A call option is often referred to as in the
    money when the market price of the of the
    underlying security exceeds the exercise price.
  • Out of the money is when it is below the exercise
    price.
  • Put option -- buyer has the option to sell an
    item at the strike price.

30
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.

31
Value of an Option
  • The value of an option is dependent upon
  • Price volatility of the underlying commodity or
    security
  • Time to the options expiration
  • The level of interest rates
  • Strike or exercise price and stock or index price

32
Gains and Losses on Options and Futures Contracts
33
Option Quotations
34
Another Example of Option Usage
  • A bank can hedge its commitment to lend in the
    future by buying a put option on a T-bond. If
    rates go up, bond values will fall, and the bank
    can exercise its right to sell bonds at the
    strike price. The profit on the hedge can be used
    to offset liability costs that will increase as
    market rates increase.

35
Conclusion
  • Forward Market
  • Futures Market
  • Futures Contracts
  • Stock Index Futures
  • Risks in the Futures Market
  • Swaps
  • Interest Rate Swaps
  • Options
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