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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)
- underlying asset: Vimeo shares are the underlying asset for the forward contract.
- forward price: $30 is the forward price in the contract.
- contract size: 50 shares is the contract size of the forward contract.
- 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
- Investors can gain exposure to a risk at low cost, effectively creating a highly leveraged investment in the underlying security.
- Transaction costs for a derivatives position may be significantly lower than for the equivalent cash market trade.
- 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