Chapter 4: Derivative Markets

Derivatives and Derivative Markets

Derivatives are high leverage contracts that require a small amount of capital to initiate a derivative related contract.

Derivative contracts are recognized by the legal system as commercial contracts and they set the right and obligations of each involved party.

Derivatives are useful instruments in financial markets through which a risk can be transferred from one party to another.

There are two categories of markets where derivatives are created: Exchange-traded derivatives markets and Over-the-counter derivatives markets (OTC).

Exchange-traded derivatives: They are standardized such that its terms and conditions are precisely specified by the exchange. In other words, derivatives exchange-trade standardizes every term and condition of contracts except their prices.

When two parties get involved in a contract on an exchange-traded market, ultimately, one party will make a profit and the other party will lose money. Hence, the clearinghouse of the exchange provides a guarantee to the winning party that if the counterparty refuses to pay, the clearinghouse will pay instead.

Any participant that wants to engage in exchange-traded derivative needs to deposit cash usually called margin bond or performance bonds that secures that there will not be any default. The other attribute of cleaning houses is that there are daily settlements and any party, which is in the profit as a result of the performance of the underlying asset, the clearinghouse deducts money from the losing party and adds them to the winner party.

Exchange-traded derivatives also provide credit guarantee and ensure that there will not be any credit risk.

Over-the-counter derivatives: Over-the-counter derivatives markets (OTC) is the customizable contract that can be customized by the involving parties.

In the over-the-counter derivatives markets, investors directly trade legal derivative without involving an intermediary. Such markets are also called informal derivative markets because the engaged parties are not obligated to carry out their promises.

Though both buyer and seller of OTC contracts informally agree to buy or sell derivative contracts, there is still the possibility of a default. It is worth mentioning that the market makers make a profit through the bid-ask spread as they fulfill the needs of both buyer and seller through buying from a seller at one price and selling to a buyer at a higher price.

The OTC contracts are customized contracts, and they are less liquid than exchange-traded derivative contracts. They are also relatively less transparent.

Types of Derivates: Forward, Future, Swap and Options

Derivatives can be classified into two main groups such as forward commitments and contingent claims.

Forward commitments impose an obligation on both sides of the contract to engage in a future transaction as agreed upon previously, whereas contingent claims give the right but not the obligation to do so.

Forward Commitments

They can be defined as contracts entered into at one point in time that require both parties to engage in a transaction at a later point in time (the expiration) on terms agreed upon at the start. The parties establish the identity and quantity of the underlying, the manner in which the contract will be executed or settled when it expires, and the fixed price at which the underlying will be exchanged. This fixed price is called the “forward price”.

In brief, forward commitments have the following characteristics:

• They are customized contracts so to suit both involving parties’ needs i.e. grade, time, and place of delivery.
• There is no specific location or address to trade forward contracts.
• Any type of commodities can be traded via forward contracts.

There are three different types of forward commitments.

1. Forward contracts
2. Futures contracts
3. Swaps contracts.

Forward Contracts

It is an OTC contract in which a buyer and a seller commits each other to do a transaction on a specific underlying asset at a future date at a previously determined fixed price.

Even though forward contracts play a significant role in managing risks, there are still some associated problems. One of these problems is counterparty risk. This risk raises when one of the agreement parties refuses to carry out his/her obligation to deliver the underlying asset on the expiration date at the location specified in the forward contract.

Since the forward contract is signed between two parties without the intermediation of a third party; therefore, there will not be anyone to resolve this matter except if one of the parties ask for the intervention of the court. Here, futures contracts emerge as a solution to forward contracts. Futures contracts present a solution for the default hazard natural in forward contracts through the conventions shown below.

Futures Contracts

Futures contracts are the same as forward contracts except that futures contracts are organized, regulated and managed by an exchange. In other words, futures contracts are standardized. A futures contract is an agreement made through an organized exchange to buy or to sell a fixed amount of an underlying commodity or financial asset on a future date (or within a range of dates) at an agreed price.

Unlike forward contracts, futures contracts require the existence of a legally recognized futures exchange that provides, manages and organizes these contracts. On the exchange, not all types of derivatives are allowed, only certain contracts are authorized for trading. Futures contracts can be accessed through both physical locations as well as through an electronic system. The derivative exchange has a mechanism that offers the two parties a guarantee against any default. An organized Exchange has a Clearing house through which it settles daily the losses and gains of futures contracts and protects itself against loss.

After a contract is bought or sold, both parties are asked to maintain an extra amount in their margin accounts to surplus their initial margin deposits. In other words, the amount of money in margin account must be greater than the initial margin to meet any drop in futures price. At the end of the day, the Clearing house will mark to market and compare each party’s balance with the maintenance margin, and if there is any increase or decrease in futures price, both parties’ margin accounts will be settled accordingly.

If the price of a future increases in favor of a long party such that the balance of short party falls below the maintenance margin requirement, the short party will then receive a margin call requesting to deposit additional funds to raise its balance level up to initial margin requirement level. The short party can choose not to deposit additional funds and just close its position. Additionally, through a margin account, an investor can borrow from a broker to buy extra other assets and his/her maintenance margin functions as a deposit with the broker.

Through this process, the clearinghouse’s exposure to default risk or currency risk is bounded to the gain or loss from daily fluctuations in the currency price. The Clearing house sets the maintenance margins big enough to cover all daily price volatility except for the unexpected big movements. In case if an investor’s loss is higher than the maintenance margin and the investor cannot meet a margin call on the following day, the Clearing house liquidates the contract and offsets its position.

Swaps

A swap contract can be defined as an OTC contract between two parties who agree to exchange cash flows on regular dates, where one party pays a variable payment,

and the other party pays either a fixed or variable amount calculated on a different basis. Since swap is an OTC contract, it contains terms and conditions such as the identity of the underlying asset, dates of payments, and the procedure of payment that are agreed upon and written in the contract. In currency swap trades, one party trades swaps currency for a fixed interest rate and where another party trades another currency for a floating interest. Traders usually exchange only the difference in interest payments. In swap trades, the principal traded is called notional.

Currency swaps first traded in 1970 when two financial managers from two different firms in two countries borrowed money in two different currencies and agreed to pay each other’s obligation. Later in 1981, the first official swap was traded between the World Bank and

International Business Machines. Since then, investment banks have started providing swap services and the volume and liquidity have started to grow and “plain vanilla” swaps have been introduced. Plain vanilla swaps are the most famous swap contracts that pursue the conventions of the International Swaps and Derivatives Association Butler. Plain vanilla swap for fixed-for-floating interest rate swap is the most popular type of swap that was introduced to the market in the 1980s.

A firm’s commitment to pay an international counterparty with an asset also contains a swap. These firms use swap to offset position on the balance sheet and records the swap output as interest expense in the profit and loss sheet. In the currency swap, one party trades one type of currency for a fixed interest rate and another party trades another type of a currency for a floating interest.

Similar to futures and forward contracts, swap contracts do not require money exchange at the beginning of the contract, the initial value of a swap contract is zero.

In comparison to futures contracts, swaps contracts are more prone to default risk in the following aspects:

1. A performance bond is not required in swaps contracts, whereas a margin is required in futures contracts, and this tends to give swaps slightly more default risk than futures contracts.
2. The counterparty in swaps contracts are generally a commercial or investment bank, whereas in futures contracts the clearinghouse is considered the counterparty and commercial or investment bank are more prone to default than a clearinghouse.
3. Futures contracts are daily marked-to-market and the entire gain or loss is settled from day to day, whereas the settlement in swaps contracts are longer payments is longer i.e. six months. The riskiness of a swaps contracts falls somewhere between the riskiness of futures contracts and the forward contracts.
4. Swaps are less risky than straight debt because the principal is not at risk as it is in a loan.
5. Since interest payments depends on the difference between the interest rates, they are less prone to default risk.

Contingent Claims

A contingent claim is a derivative that provides a buyer of option the right to buy or sell an underlying asset at a price previously agreed upon on a specified future date. Unlike forward commitment contracts, contingent claims give the holder of the contract the right, not the obligation to buy or sell an underlying asset. Its payoff also depends on the performance of the underlying asset.

Options

Options are contingent claim contracts that provide the right but not the obligation to buy an asset at a specific price at a later date in the future. In other words, the buyer pays a sum amount of money, known as premium, to the writer of a contract to receive the right to either buy or sell an underlying asset at a specific price at a later date in the future. In options, one side of the contract has the option to carry out the terms and the other side of contracts has obligation.

Option contracts convey most of the characteristics of forward, and futures contract as options can be traded on the OTC markets. They can be customized as well as they can be traded on options exchanges as regulated standardized contracts. The customized options contracts are subject to default risk like forward contract, whereas standardized options are protected by clearing house of options exchange. With an option contract, the biggest money that a buyer may lose on the deal is the option premium of the deal, while the loss that the writer of option may face is virtually unlimited.

Almost all multinational corporations use options as a tool to manage their exposure to currency risk, and exchange rates are the underlying assets in their case.

Based on the right to exercise a buy or sell, options contracts can be divided into two: call options and put options.

Call Options: A call option is the right to buy an underlying asset. It offers unlimited upside return with limited downside risk.

• A call option is in the money if the market price is above the strike price.
• A call option is out of the money if the market price is below the strike price.
• A call or put option is at the money if the market price is equal to the strike price.
• A put option is in the money if the market price is below the strike price.
• A put option is out of the money if the market price is above the strike price.

Put Options: Put option contracts grant their buyers the right but not obligation to sell the underlying asset.

A call option is the right to buy an underlying asset, while a put option is the right to sell an underlying asset.

Additionally, options can also be divided into two types according to the time when options can be exercised: American Options can be exercised any time up to the expiration date, while European Options are exercised only on the expiration date.

Basics of Derivative Pricing and Valuation

A derivative drives its value from an asset or a rate. Therefore, the value of a derivative depends on an underlying asset or a rate.

If there is any benefit, we add that benefit into it, and if there is any risk, we deduct that cost discounted at a rate appropriate for the risk assumed.

Pricing and Valuation of Forward Contracts

The value of a forward contract is positive to the short party if F0 (T) > ST and negative if F0(T) < ST at expiration.

Pricing and Valuation of Futures Contracts

At the expiration date, if it is written on the contract to deliver physical product to a specific location, the seller of the contract must deliver the underlying asset to the designated location, and the buyer of the contract is required to pay for it at the spot price.

Since clearing houses settle every futures contract on a daily basis, a futures contract can be considered a bundle of consecutive 1-day forward contracts. In other words, at the beginning of each day a forward contract is constructed and at the end of that day the forward contract is delivered and at the beginning of the next day again a new forward contract is constructed and the process continues until the expiration of the future contract. The buyer of this contract buys the entire package of forward contracts.

Pricing and Valuation of Swap Contracts The value of a swap at the start of contract is typically zero, and the swap price is determined through replication. The swap price is simply the PV of all net cash flow payments from the swap. Throughout the life of a swap contract, the value of a swap also changes.

Swap rates are locked in for the future like in the case of a forward rate agreement. It is the same as locking in multiple forward rate agreements for different periods at different forward prices.

Pricing and Valuation of Option Contracts

The option-pricing models are mathematical formulas or calculation processes that use certain variables to calculate the theoretical value of an option. In the option pricing models, the output is the theoretical actual value of an option. If the model works well, the market price (option premium) of the option will be equal to its theoretical actual value. Option-pricing models provide us with the fair value of an option.

Knowing the estimate of the fair value of an option, finance professionals could adjust their trading strategies and portfolios. Therefore, option-pricing models are powerful tools for finance professionals involved in options trading.

Binomial Option Pricing Model

It assumes that the price of the underlying asset will either go up or down in the period. Given the possible prices of the underlying asset and the strike price of an option, we can calculate the payoff of the option under these scenarios, then discount these payoffs and find the value of that option as of today.

Black-Scholes Option Pricing Model

In 1973, Fisher Black and Myron Scholes proved a formula for pricing European call options and put options on non-dividend- paying stocks. Their model is probably the most famous model of modern finance.

In general, the higher the historical volatility of the underlying asset, the higher the option price.

The model operates under certain assumptions regarding the distribution of the stock price and the economic environment.

The main variables used in the Black-Scholes model include:

• Price of underlying asset, which is a current market price of the asset.
• Strike price, which is a price at which an option can be exercised.
• Volatility, which is a measure of how much the security prices will move in the subsequent periods. Volatility is the trickiest input in the option-pricing model as the historical volatility is not the most reliable input for this model.
• Time until expiration, which is a time between calculation and option’s exercise date.
• Interest rate, which is the risk-free interest rate.