DERIVATIVES MARKETS

1 Session 3
Derivatives and Risk Control
IMBA 2010
DEFINITION

A derivative is an instrument whose value depends on the price of other more

basic assets (called underlying assets):

 Stocks,
 Bonds,
 Commodities,
 Currencies,
 Weather,
 Real Estate,
 Credit events (default),
 Portfolio of mortgages,
 Etc…
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EXAMPLES OF DERIVATIVES

 Forward Contracts
 Futures Contracts

 Swaps

 Options

 Options on Futures , Swaptions, etc.

 Non standard derivatives

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DERIVATIVES MARKETS

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ORGANIZED MARKETS

Most Important Derivatives Exchanges:

 Chicago Board of Trade www.cbot.com

 Chicago Mercantile Exchange www.cme.com
 Chicago Board of Options Exchange www.cboe.com
 NYMEX www.nymex.com
 Euronext www.euronext.com
 Eurex www.eurex.com
 …

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SPANISH OPTIONS AND FUTURES OFFICIAL MARKET:
MEFF- MERCADO ESPAÑOL DE FUTUROS FINANCIEROS
MEFF clears and trades:
 Options and Futures on Bonds, Interest rates, and
 IBEX-35 index and Futures and Options on the leading Spanish stocks

Source: Bolsa de Madrid

ORGANIZED MARKETS

 Contracts are standardized and well defined:

 Underlying asset to be delivered: what, amount, quality,…
 Where it can be delivered
 When it can be delivered

 Negotiation is carried out in a “blind way” through the Clearing

House

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ORGANIZED MARKETS

Operation of the Clearing House

Buyer Seller

Clearing House
Broker Broker
A B

Market
 TRADING
 Traditionally derivatives were traded using the open outcry system
 Now this is being replaced by electronic trading where a computer
matches buyers and sellers
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CLEARING HOUSE

Functions:

 acts as the counterparty in each operation

 eliminates counterparty risk

 ensures investors anonymity

 supervises and controls the settlement and clearing systems

 guarantees the operations.

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MARGINS
 In order to eliminate the counterparty risk the Clearing House establishes a
system of guarantees to protect against losses in case of insolvency of any
member of the market.

 A margin in cash or marketable securities has to be deposited by an investor

with his or her broker on the margin account

 Margins are calculated on the basis of the number of contracts bought and
sold

 To ensure that the guarantee remains untouched the balance in the margin
account is adjusted to reflect daily settlement (daily gains and losses) –
“daily marking-to-market”

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OVER-THE COUNTER MARKETS

 Are an important alternative to exchanges

 It is a telephone and computer-linked network of dealers who do not
physically meet
 Trades are usually between financial institutions, corporate treasurers, and
fund managers
 Derivatives instruments traded at OTC markets are “tailor-made”
 Do not require margin accounts
 Less liquid
 More credit risk

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SIZE OF OTC AND EXCHANGE MARKETS

Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying
assets for exchange market
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FUTURES CONTRACTS

 A futures contract is an agreement to buy or sell an asset at a certain

time in the future for a certain price

 By contrast in a spot contract there is an agreement to buy or sell the

asset immediately (or within a very short period of time)
 When investor enters into a futures contract (t0) he/she knows:

 Futures price – price at which he will buy/sell the underlying asset at the
maturity (F0)
 Contract Maturity – time when he will buy/sell the underlying asset (T)

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FUTURES CONTRACTS

Examples:
Agreement to:
 buy 100 oz. of gold @ $1300/oz. in December (NYMEX)
 sell £62,500 @ 1.9800 $/£ in March (CME)
 sell 1,000 bbl. of oil @ $80/bbl. in April (NYMEX)

Terminology:
 The party that has agreed to buy has a long position
 The party that has agreed to sell has a short position

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PROFIT FROM A LONG FUTURES POSITION

Profit

Price of Underlying
at Maturity

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PROFIT FROM A SHORT FUTURES POSITION

Profit

Price of Underlying
at Maturity

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FUTURES VS. SPOT PRICE
 At any point of time futures price is determined by supply and demand in
the same way as a spot price
 At the maturity of the contract futures price converges to the spot price

Futures
Price Spot Price

Spot Price Futures

Price

Time Time

(a) (b) 17
FUTURES MARKETS

 Futures are traded in the organized markets

 They are standardized contracts:
 Underlying asset: type, quantity, quality
 Maturity
 Delivery: place, time, etc.

 To trade futures investors are required to provide guarantees

 No credit risk
 There is daily marking-to-market

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EXAMPLE OF DAILY MARKING-TO-MARKET

 On November 17 an investor takes a long position in December gold

futures contract
 Contract size: 100 ounces
 Initial margin/contract: $2,150
 Maintenance margin/contract: $1,650

  Futures Daily Cumulative Margin

price gain gain (loss) account Margin call
($ per oz) (loss) balance

Date        
17 Nov 800     2150
18 Nov 797 -300 -300 1850  
19 Nov 802 500 200 2350  
20 Nov 794 -800 -600 1550 600
21 Nov 792 -200 -800 1950  
24 Nov 795 300 -500 2250  

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EXAMPLE OF DAILY MARKING-TO-MARKET

 Investors earn interest on a margin account.

 Initial margin requirements: cash (100%), T-bills (at 90% of their
face value), stocks (at 50% of their market value).
 Initial margin and maintenance margins (i.e. 75% of the initial
margin) are set by the exchanges.
 Margins may depend on:
 Variability of the price
 Objectives of the trader, e.g. hedger vs. speculator
 Day trade and spread transaction vs. hedge transactions

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SETTLEMENT OF THE FUTURES CONTRACT
 Physical Delivery
 Contract is settled by delivering the assets underlying the contract.
 When there are alternatives about what is delivered or where and when
it is delivered, the party with the short position chooses.
 A few contracts (e.g. those on stock indices and Eurodollars) are
settled in cash

 Closing out a futures position before the maturity

 Closing out a futures position involves entering into an offsetting trade
 Most contracts are closed out before maturity

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FORWARD CONTRACTS

 Forward contracts are similar to futures except that they trade in the
over-the-counter market

 There is no daily settlement (unless a collateralization agreement

requires it).

 At the end of the life of the contract one party buys the asset for the
agreed price from the other party

 Forward contracts are popular on currencies and interest rates,

Example: FOREX www.forex.com

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 FORWARD CONTRACTS VS FUTURES CONTRACTS

Forward Futures
Private contract between two parties Traded on an exchange
Not standardized Standardized
Usually one specified delivery date Range of delivery dates
Settled at end of contract Settled daily
Delivery or final settlement usual Usually closed out prior to maturity
Some credit risk No credit risk

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OPTIONS

 A call option is an option to buy a certain asset at a certain date for a

certain price (the strike price)

 A put option is an option to sell a certain asset at a certain date for a

certain price (the strike price)

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OPTION CONTRACT
Option contract specifies:
 Underlying asset: type, amount, quality
 Maturity (T)
 Strike (Exercise) price (X)
 Type of option:
 European – can only be exercised at maturity
 American – can be exercised at any time during option’s life

 Exotic

 Delivery: place, time, etc.

Example: MEFF
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OPTIONS VS. FUTURES/FORWARD
CONTRACTS

 A futures/forward contract gives the holder the obligation to buy or

sell at a certain price
 There’s no exchange of capital when the contract is started

 An option gives the holder the right to buy or sell at a certain price
(there is a premium paid when the contract is started)
 For long position it is a right (pays the premium)
 For short positions it is an obligation (receives the premium)

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OPTION MONEYNESS

Depending on the relationship strike price – market price of the

underlying asset an option can be:
 in-the-money (ITM)
 at-the-money (ATM)
 out-of-the-money (OTM)

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 PROFIT FROM BASIC POSITIONS IN
OPTIONS

 Long Call  Long Put

S T  X , S T  X X  ST , ST  X
c T  Max( 0, S T  X)  c   c p T  Max(0, X  S T ) - p   -p
 0 , ST  X  0 , ST  X

cT
pT

ST
-c ST
X -p X
• Your loss is limited to the premium • Loss is limited to the premium
• Profit is unlimited • Profit is limited
• Higher returns with low investment (leverage • Insurance of the portfolio of stocks if you
effect) expect stock price to decrease “protective
• You fix the price at which you will buy the put”
underlying asset

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REASONS FOR TRADING DERIVATIVES:
HEDGING, SPECULATION, AND ARBITRAGE

 HEDGING
 trading for eliminating/reducing risk

Examples:

 A US company will pay £10 million for imports from Britain in 3 months and
decides to hedge using a long position in a forward contract

 An investor owns 1,000 Microsoft shares currently worth $28 per share. A two-
month put with a strike price of $27.50 costs $1. The investor decides to hedge
by buying 10 contracts.

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VALUE OF MICROSOFT SHARES WITH AND
WITHOUT HEDGING

40,000 Value of
Holding ($)
35,000

No Hedging
30,000 Hedging

25,000

Stock Price ($)

20,000
20 25 30 35 40

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 REASONS FOR TRADING DERIVATIVES:
HEDGING, SPECULATION, AND ARBITRAGE
 SPECULATION
 trading for profiting from expected differences in quotations based on taking
positions according to expected trends
 A speculator tries to maximize profits in the shortest period of time,
minimizing the investment of personal funds (dynamic/ active speculation).
 But also holding a spot position without any type of hedge is also a speculative
strategy (passive/static).

Example:
 An investor with $2,000 to invest feels that Amazon.com’s stock price will
increase over the next 2 months. The current stock price is $20 and the price of
a 2-month call option with a strike of $22.50 is $1.

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REASONS FOR TRADING DERIVATIVES:
HEDGING, SPECULATION, AND ARBITRAGE
 ARBITRAGE
 Trading for profiting from pricing anomalies in the markets without assuming
any risk
  Arbitrage opportunities are generated by imperfections or inefficiencies in the
prices formation.

 Example:
 A stock price is quoted at £100 in London and $182 in New York
 The current exchange rate is 1.85
 What is the arbitrage opportunity?

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NON STANDARD DERIVATIVES CONTRACTS
Example: Range forward contract (flexible forwards)
A currency range forward contract has the chosen band between 1.90 and 1.95. If the
spot rate at the maturity is less than 1.90, the buyer pays 1.90; if it is between 1.90 and
1.95, the buyer pays the spot rate; if it is greater than 1.95, the buyer pays 1.95.
  ST < $1.90 $ST – $1.90 (Loss)
$1.90 < ST < $1.95 $0
$1.95 < ST $S T – $1.95 (Gain)

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NON STANDARD DERIVATIVES CONTRACTS
Example: ICON (index currency option notes) - bonds in which the amount received by the
holder at maturity varies with a foreign exchange rate:
 Two exchange rates are specified, X1 and X2, where X1 > X2. If the exchange rate, ST, at the
bond’s maturity is above X1, the bondholder receives the full face value. If X1> ST >X2, a
portion of the full face value is received. If S T<X2, the bondholder receives nothing.
 X1=1.45, X2=1.35. The payoff pattern is:

ST > 1.45 $1,000

1.42 > ST > 1.35 $1,000-max[0, 1000*(1.45/ST -1 )]
ST< 1.35 $0

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