CFA1. Derivatives Markets and Instruments.pdf, Study notes of Finance

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Derivatives Markets and Instruments

Learning objectives

• Understand what a derivative is
• Understand its core features
• Understand ways in which it is traded
• Understand types of derivatives
• Calculate Payoffs under various situations, including arbitrage

You agree to buy or sell (i.e. contract) a total of 50 shares of a company, Vimeo, at a price of $ 30 per share (the underlying security) 90 days from now (the settlement date)

1. underlying asset: Vimeo shares are the underlying asset for the forward contract.
2. forward price: $30 is the forward price in the contract.
3. contract size: 50 shares is the contract size of the forward contract.
4. settlement date (maturity date): The date of the future transaction (90 days from now), is the settlement date of the forward contract. Note: The forward price is set so that the forward contract has zero value to both parties at contract initiation; i.e. neither party pays at the initiation of the contract.

Elements of a derivative

Return on the derivative can be any one of three outcomes a) No profit or loss: If the spot price or the market price of Vimeo shares 90 days from now is $30, equal to the forward price of $30. Ignoring transactions costs, both the buyer and seller make no profit or loss. b) Buyer makes a profit: If the spot price of Vimeo shares is say $40, ($10 more than forward price of $30), the buyer gets 50 shares at $30 at settlement and sell at $40 in the market c) Seller makes a profit: If the spot price is $25 at settlement, seller can buy 50 shares from the market at $25 and deliver the same to the buyer at $30 per share Note: Gain of one party is always equal to the loss of the other party

Return on a derivative transaction

Spot / market price on Settlement date Who profits? Same as forward rate Neither gains nor lose Higher than forward rate Buyer Lower than forward rate Seller

• Derivatives have three potential advantages over selling shares directly in the market for three reasons

1. Investors can gain exposure to a risk at low cost, effectively creating a highly leveraged investment in the underlying security.
2. Transaction costs for a derivatives position may be significantly lower than for the equivalent cash market trade.
3. Initiating a derivatives position may have less impact on market prices of the underlying, relative to initiating an equivalent position in the underlying through a cash market transaction.

Selling shares versus using derivatives

Examples of other underlying (beyond stocks)

• E.g. 30-year government or bank bond Bond • Risk is on uncertainty of future bond prices
• E.g. Nifty Index • Risk is on uncertainty of the future value of the index
• E.g. US dollar to BGP or even cryptocurrencies Currency • Risk is on uncertainty of the future value of currency exchange
• E.g. 1 year treasury bill rate Interest rate • Risk is on uncertainty of the future value of the interest rate
• E.g. hard commodities (gold, iron) or soft commodities (cotton, oil) Commodities • Risk is on uncertainty of the future value of that commodity
• E.g. Credit derivatives, where risk is related to default by the borrower Other • E.g. Weather (good monsoon) or longevity (in insurance)

• Essential differences are as follows

Comparison

Exchange-traded

• Standardized contracts and have lower trading costs.
• Subject to the trading rules of the exchange
• Require deposits by both parties at initiation, and additional deposits when a position decreases in value.
• More liquid and more transparent, as all trades are visible to the exchange Dealer markets (Over The Counter)
• Custom instruments
• Less liquid and have higher transaction costs.
• Less transparent.
• Subject to counterparty risk.
• More difficult to clear and settle.
• Subject to higher trading costs.
• Not subject to requirements for the deposit of collateral.

Types of derivatives

- Forward commitment

and contingent claims

features and instruments

• Margin is cash or other collaterals that both the buyer and seller must deposit.
• Initial margin is the amount that must be deposited in a futures account before a trade may be made.
• Mark-to-market – Daily adjustment of margin balance for any gains and losses in the value of the futures position based on the new settlement price on that day
• Maintenance margin is the minimum amount that must be maintained in a futures account based on daily Mark-to-market. If actual margin is below the maintenance margin, the account holder must deposit additional funds
• price limits - exchange-imposed limits on how much each day’s settlement price can change from the previous day’s settlement price. Exchange members are prohibited from executing trades at prices outside these limits.
• circuit breakers - when a futures price reaches a limit price, trading is suspended

Elements of Futures / Future Exchanges

Contract for 100g of gold with initial margin of $5,000 + maintenance margin of $4,700.

• On Day 0:
  • Buyer and seller make a trade at a price of $1,950 per gram
  • both parties deposit the initial margin of $5,000 into their accounts.
• On Day 1: the settlement price falls to $1,947.50.
• On Day 2: the settlement price falls to $1,945.
• Question 1: What will happen to the buyer and sellers margin accounts on day 1 close
• Question 2: What will happen to the buyer and sellers margin accounts on day 2 close

Example: How exchanges handle trades

• Swaps are netted off, i.e. at each settlement date, all payments are netted so that only one net payment is made.
• Swaps are exposed to counterparty credit risk, unless the market has a central counterparty structure to reduce counterparty risk.
• Example of a simple swap
  • a fixed-for-floating interest rate swap for two years with quarterly interest payments based on a notional principal amount of $10 million.
  • One party makes quarterly payments at a fixed rate of interest (the swap rate)
  • The other makes quarterly payments based on a floating market reference rate.
  • Over time, the value of the swap can become positive for one party and negative for the other party.

2. Types of derivatives – Swaps

agreements to exchange a series of payments on multiple settlement dates over a specified time period (e.g., quarterly over 2 years)

• Consider an interest rate swap with a notional principal amount of $10 million, a fixed rate of 2%, and a floating rate of the 90-day secured overnight financing rate (SOFR).
• At each settlement date, the fixed-rate payment will be $10 million × 0.02/4 = $50,000.
• The floating-rate payment at the end of the first quarter will be based on 90-day SOFR at the initiation of the swap, so that both payments are known at the inception of the swap.
• If, at the end of the first quarter, 90-day SOFR is 1.6%, the floating-rate payment at the second quarterly settlement date will be $10 million × 0.016 / 4 = $40,000. The fixed- rate payment is again $50,000, so at the end of the second quarter the fixed-rate payer will pay the net amount of $10,000 to the other party.

Example:

3. Types of derivatives – Options

• Can be of two types based on an underlying Put option (buyer sells)
• gives the buyer the right (but not the obligation) to sell X shares at a specified price (the exercise price or the strike price) for specified period of time (the time to expiration).
• The put seller (also called the writer of the option) takes on the obligation to purchase the X shares at the price specified in the option, if the put buyer exercises the option. Call option (buyer buys)
• gives the buyer the right (but not the obligation) to buy X shares at a specified price (the exercise price) for a specified period of time.
• The call seller (writer) takes on the obligation to sell the 100 shares at the exercise price, if the call buyer exercises the option.

• Lets assume
  • X = the exercise price of a put = $25 at the expiration of the option.
  • S = Current trader price of the underlying
• If S is at or above $25, the put holder will not exercise the option.
  • There is no reason to exercise the put and sell shares at $25 when they can be sold for more than $25 in the market.
  • So the put buyer lets the option expire, and the put seller keeps the proceeds from the sale.
  • This is the outcome for any put option where market price is higher than put option,
• If S is below $25, the put buyer will exercise the option.
  • the put seller must purchase shares for $25 from the put buyer.
  • On net, the put buyer essentially receives the difference between the stock price at expiration and $25 (times number of shares).

Example: How a simple one-way put option works