Title: DERIVATIVES MARKETS
1CHAPTER 11
2The 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.
3From 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.
4Forward 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
5Futures 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.
6Futures 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.
7Spot versus Futures Market
- Trading for immediate or very-near-term delivery
is called the spot market. - Trading for future delivery -- futures market.
8A Position in the Futures Market
- Long -- an agreement to buy (purchase) in the
future. - Short -- an agreement to sell (deliver) in the
future.
9Margin 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.
10Futures 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.
11Futures 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
12Interest Rate Futures Quotations
13Futures 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.
14Regulation 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.
15Risks 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.
16Risks 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.
17Stock 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.
18Stock 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.
19GAP 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.
20Duration Gap
DG MVA x DA MVL x DL MVF x DF
21Swaps 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.
22Interest 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.
23Interest 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
24Swap 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.
25Swaps 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.
26Example of a Swap
27Options
- 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.
28Options 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.
29Calls 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.
30Covered 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.
31Value 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
32Gains and Losses on Options and Futures Contracts
33Option Quotations
34Another 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.
35Conclusion
- Forward Market
- Futures Market
- Futures Contracts
- Stock Index Futures
- Risks in the Futures Market
- Swaps
- Interest Rate Swaps
- Options