DERIVATIVE MARKETS
A derivatives
exchange is a market where individuals trade standardized contracts that have
been defined by the exchange. Derivatives exchanges have existed for a long
time.
The value of the derivative instrument is DERIVED
from the underlying security
Financial
Marketplace
·
Forward Markets
·
Futures Markets
·
Options
FORWARD MARKETS:
A forward
contract is an agreement between a bank and its client to buy or sell a
financial asset for a delivery on a future date at a predetermined price.
Gives holder the right and obligation to purchasean asset at a preset
price for a specified period oftime.
The owner of a forward has the OBLIGATION to sell or buy
something in the future at a predetermined price. The difference to a future
contract is that forwards are not standardized.
A Forward Contract underlies the same principles as a future contract,
besides the aspect of non-standardization. Thus, a detail illustration is not
necessary as I already elaborated in the mechanism of the futures contract.
One of the
parties to a forward contract assumes a long position and agrees to buy the
underlying asset on a certain specified future date for a certain specified
price. The other party assumes a short position and agrees to sell the
asset on the same date for the same price.
Forward
contracts on foreign exchange are very popular, and can be
used to hedge foreign currency risk.
Example:
Dell enters into a contract with a broker for delivery of 10,000 shares of Google stock in three months at its current price of $110 per share. => $1,100,000
Dell enters into a contract with a broker for delivery of 10,000 shares of Google stock in three months at its current price of $110 per share. => $1,100,000
Dell has
received the right to receive 10,000 shares in three months and incurred an
obligation to pay $110 per share at that time.
Characteristics of Forward Contracts and Markets:
OTC market,
tailor-made, typically a credit instrument (but sometimes a collateral may be
asked)
FUTURES MARKETS
Futures are
standardized forward contracts, traded in organized exchanges and ensured by a
central clearing house.
The owner of a future has the OBLIGATION to sell or buy
something in the future at a predetermined price.
A margin is
always required, deposited at the Clearing House. (Initial Margin vs.
Maintenance margin)
Standardized
contracts permit centralized trading without market makers.
In a futures
market, the size, the maturity (delivery) date, and the specifications of the
traded asset (for commodities and agriculturals) are standardized.
Unlike forward
contracts, futures contracts are normally traded on an exchange.
To make trading
possible, the exchange specifies certain standardized features of the
contract.
The differences between forwards and futures
Forward
contact is typically a credit instrument between a bank and its client; in
futures delivery is reinforced only by depositing a margin.
Forwards
are tailor-made (the bank sets the maturity date and the amount by responding
to its client’s needs), futures contracts are standardized.
Forwards
are an OTC instrument, futures trade in organized centralized exchanges
supported by centralized clearing houses.
Thus,
settlement and margins are strictly regulated in futures; subject to
‘relations’ in forwards
In
futures, there is daily mark-to-market, in forwards not (therefore, the payoff
structure with futures is slightly different from forwards; you may gain or
lose slightly more with futures)
In futures, the
clearing house is the counterparty to alloutstanding contracts.
OPTIONS
An
option is the right but not the obligation to buy or sell a financial asset at
a predetermined price.
Gives
the holder the right, but not the obligation, to buy share at a preset
price for a specified period of time.
The owner of an
options has the OPTION to buy or sell something at a
predetermined price and is therefore more costly than a futures contract.
The
price in the contract is known as the exercise price or strike
price.
The
date in the contract is known as the expiration date or maturity.
American options can be exercised at any
time up to the expiration date.
European options can be exercised onlyon
the expiration date itself.
Most of the
options that are traded on exchanges are American
There are four
types of participants in options markets:
1. Buyers of calls
2. Seller of calls
3. Buyer of puts
4. Seller of puts
It is an
agreement whereby the option seller (writer) gives the option buyer this right,
in exchange for a premium (called option price)
Two types of options: Call Options: The right to
buy Put options: The right to
sell
Two styles of options:
American
options: Can be exercised at any time till expiration, European options can
only be exercised on the maturity date.
Options
can trade both OTC and in organized exchanges.
Example:
Dell enters into
a contract with a broker for an option (right) to purchase 10,000 shares of
Google shares at its current price of $110 per share.
The broker
charges $3,000 for holding the contract open for two weeks at a set price.
Dell has received the right, but not the obligation to purchase this stock at $110 within the next two weeks.
Dell has received the right, but not the obligation to purchase this stock at $110 within the next two weeks.
SWAPS
A swap is an agreement between two parties to exchange a sequence of cash
flows.
An interest rate
swap is an agreement between two parties to exchange a sequence of fixed
interest rate payments against floating interest rate payments.
CONCEPT OF
DERIVATIVE INSTRUMENTS
The forward contract and the option contract both involve a future delivery of stock.
The value of each of these contracts relies on the underlying asset –the
Google stock.
Therefore, these financial instruments (the FORWARD and the OPTION
contracts) are known as derivatives because they derive their value from
values of other assets (e.g.,
Google stocks or other stocks or bonds or commodities). Or, their value
relates to a market –determined indicator
(e.g., interest rates or the S&P’s 500 index).
(e.g., interest rates or the S&P’s 500 index).
Who uses
derivatives?
a. Producers and consumers: Hedgers
Example:
Heartland –Large producer of potatoes
Heartland –Large producer of potatoes
McDonald
–Large consumer of potatoes
(French fries)
The objective is not to gamble on the outcome or to profit butto lock in a price at which both of them obtain an acceptable
profit.
Both companies, the producer and the consumer, are hedgers.
They hedge (protect) their positions to ensure an acceptable financial
outcome.
b. Speculators and arbitrageurs:Speculators
The objective is to gamble on the outcome or to profit based on the
outcome.
Types of traders
- Hedgers
Hedgers use derivatives to reduce the risk that they face
from potential future movements in a market variable.
- Speculators
Speculators use them to bet on the future direction of a market
variable.
- Arbitrageurs
Arbitrageurs take offsetting positions in two or more instruments
to lock in a profit.
Why use
derivatives?/Reasons to use derivatives
-Changes in
the price of jet fuel: Delta,
Continental, United….
-Changes in interest rates: Citigroup, AIG, BoA…..
-Changes in exchange rates: GE, GM, Cisco …..
•
Hedging- aganist volatility
•
Interest rate volatility
•
Stock price volatility
•
Exchage rate volatility
•
Commodity prices volatility
•
General Rule for
Hedgers:
•
If you are going to
sell something in the near future but want to lock in a secured price, you take
a short position.
•
If you are going to
receive/buy something in the future but want to lock in a secured price, you
take a long position.
Speculation-aganist extremely risk
•
High portion of
leverage
•
Huge returns
The Role of Speculators:
•
As the name
implies, speculators are involved in price betting and take the risk of price
movements against them.
Also derivatives create
•
a complete
market, defined as a market in which all identifiable payoffs can be
obtained by trading the securities available in the market*.
•
and market
efficiency, characterized by low transaction costs and greater
liquidity.
Summary
A forward or
futures contract involves an obligation to buy or sell an asset
at a certain time in the future for a certain price.
There are two
types of options: calls and puts.
A call option
gives the holder the right to buy an asset by a certain date for a
certain price.
A put option
gives the holder the right to sell an asset by a certain date for a
certain price.
Hedgers are in the
position where they face risk associated
with the price of an asset. They use derivatives to reduce or eliminate
this risk.
Speculators wish to bet on
future movements in the price of an asset. They use derivatives to get
extra leverage.
Arbitrageurs are in business
to take advantage of a discrepancy between prices in two different
markets.
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