introduction to derivative markets & instruments types of derivatives differences between...

INTRODUCTION TO DERIVATIVE MARKETS &

INSTRUMENTS•TYPES OF DERIVATIVES•DIFFERENCES BETWEEN EXCHANGE TRADED AND OVER THE COUNTER DERIVATIVES•FORWARD COMMITMENT & DIFFERENT TYPES OF FORWARD COMMITMENT

DERIVATIVES• Derivatives are products, instruments,

or securities which are derived from another security, cash market, index, or another derivative.

• A derivative instrument (or simply derivative) is, thus, a financial instrument which derives its value from the value of some other financial instrument or variable. Ex. stock option is a derivative because it derives its value from the value of a stock.

DERIVATIVES

• A derivative is a financial instrument that offers a return based on the return of some other underlying asset.

• Its return is derived from another instrument.

• A derivative’s performance is based on the performance of an underlying asset.

DERIVATIVES

• A derivative contract has a limited life, and its payoff is typically determined and/or made on the expiration date

Exchange-traded derivatives Vs Over-the-counter (OTC)

derivatives• Based on the markets where they are

created and traded, derivatives can be classified into two groups:

1.Exchange-traded derivatives

2.Over-the-counter derivatives

Exchange-traded derivatives

• Exchange-traded derivatives are those derivatives products that are traded via derivatives exchanges.

• A derivatives exchange acts as an intermediary to all transactions, and takes initial margin from both sides of the trade to act as a guarantee.

Features of Exchange-traded derivatives

• They are standardized instruments with respect to certain terms and conditions of the contract.

• They trade in accordance with rules and specifications prescribed by the derivatives exchange and are usually subject to governmental regulation.

• They are guaranteed by the exchange against loss resulting from the default of one of the parties.

Over-the-counter (OTC) derivatives

• Over-the-counter (OTC) derivatives are contracts that are traded directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way.

• Over-the-counter derivatives are transactions created by any two parties off a derivatives exchange.

Features of Over-the-counter (OTC) derivatives

• They don't have standardized terms and features. The parties set all of their own terms and conditions.

• Each party assumes the credit risk of the other party.

FORWARD COMMITMENTS AND CONTINGENT CLAIMS

• Based on the rights and obligations of the parties that enter into the contract, derivatives can be classified into two groups:

• (A) FORWARD COMMITMENTS

• (B) CONTINGENT CLAIMS

FORWARD COMMITMENTSThese are contracts in which the two parties enter into an agreement to engage in a transaction at a later date at a price established at the start.

• A forward commitment is an agreement between two parties in which one party agrees to buy and the other agrees to sell an asset at a future date at a price agreed on today.

FORWARD COMMITMENTS

• In essence, a forward commitment represents a commitment to buy or sell.

Ex are Forward contract; Future contract; Swap

CONTINGENT CLAIMS

Contingent claims are derivatives in which the payoffs occur if a specific event happens.

• A contingent claim is a derivative contract with a payoff dependent on the occurrence of a future event. It can be either exchange-traded or over-the-counter.

CONTINGENT CLAIMS

• The primary types of contingent claims are options. The payoff of an option is contingent on the occurrence of an event.

Types of Contingent ClaimsOther types of contingent claims involve variation of options, often combined with other financial instruments or derivatives such as:

1.Convertible Bonds

• Convertible bonds are bonds that can be exchanged for the stock of the issuing firm at a pre-agreed time and exchange ratio.

Types of Contingent Claims

• The bondholder has an option to participate in gains on the market price of the firm's stock without having to participate in losses on the stock.

2.Callable bonds

Callable bonds are redeemable by the issuer before the maturity under specific conditions and at a stated price. The issuer has an option to pay off the bonds before maturity.

Types of Contingent Claims

3. Warrants

Warrants are securities entitling the holder to buy a proportionate amount of stocks at some specified future date at a specified price. They are similar to call options.

Types of Contingent Claims

4. Exotic options

Exotic options are options that are more complex than basic put or call options.– Exotic options trade over-the-counter.

5. Interest rate options

Interest rate options are options whose underlying asset is an interest rate.

Types of Contingent Claims

6. Options on futures

Options on futures are options whose underlying asset is a futures contract.

They are all exchange-traded.

Types of Contingent Claims

7. Asset-backed securities

Asset-backed securities are securities that are collateralized by a pool of securities such as mortgages, loans or bonds.

Typically borrowers of mortgages, loans or bonds have the prepayment option to pay off their debts early.

TYPES OF DERIVATIVES

FORWARD CONTRACT

• A forward contract is an agreement to buy or sell an asset at a specified time in the future for a specified price.

Characteristics of Forward Contract

1. A forward contract is a forward commitment created in the over-the counter market.

2. It is not conditional - both the buyer and the seller are obliged to perform the contract as agreed.

3. It is negotiated in the present and will be settled in the future. In contrast a spot contract is settled immediately.

4.The parties to the transaction specify the forward contract's terms and conditions, such as when and where delivery will take place and the precise identity of the underlying. In this sense the contract is said to be customized.

Characteristics of Forward Contract

5. Each party is subject to the possibility that the other party will default.

6. In the financial world the underlying asset of a forward contract can be a security (e.g. a stock or bond), a foreign currency, a commodity, or combinations thereof, or sometimes an interest rate.

Characteristics of Forward Contract

7.The forward market is a private and largely unregulated market.

Characteristics of Forward Contract

FUTURE CONTRACTS

• A Futures contract is created and traded on a futures exchange.

• It is a variation of a forward contract that has essentially the same basic definition but some additional features.

• Both futures and forwards represent agreements to buy/sell some underlying asset in the future for a specified price.

DIFFERENCES BETWEEN FORWARDS & FUTURES

• Futures contracts are exchange-traded and, therefore, are standardized contracts.

• Forward contracts, on the other hand, are private agreements between two parties and are not as rigid in their stated terms and conditions. 

Characteristics of Futures Contract

1. Futures contracts always trade on an organized exchange.

2. Futures contracts are always highly standardized with specified underlying goods, quantity (contract size), delivery date, trading hours and trading area – some exchanges may specify that the contract can be only traded in a designated trading area on the floor (called a pit).

• Since futures contracts are standardized with generally accepted terms, they have an active secondary market where previously created futures contracts are bought and sold.

Characteristics of Futures Contract

3. Performance on futures contract is guaranteed by a clearing house -- a financial institution associated with the futures exchange that guarantees the financial integrity of the market to all traders.

Characteristics of Futures Contract

4. Since the clearing house is well-capitalized, its default risk is very small.

5. All futures contracts require that traders post margin in order to trade. The futures exchange requires traders to settle the gains/losses of their accounts on a daily basis. This is called daily settlement or marking to market.

Characteristics of Futures Contract

SWAPS• A swap is a variation of a forward contract

that is essentially equivalent to a series of

forward contracts.

Specifically, a swap is an agreement between two parties to exchange a series of future cash flows.

SWAPS

• Swaps are custom-tailored to meet the specific needs of counterparties, so counterparties can choose the exact dollar amount and/or maturity that they need.

• They are private transactions and thus are not traded on exchanges and can avoid regulation to a considerable degree.

CALL & PUT OPTIONS

• An option is a type of derivative, having the right but not the obligation to trade a specific quantity of a particular asset, such as a commodity or security, at a specified price, on, or before, a predetermined date.

CALL & PUT OPTIONS

• A call option gives the right to buy at a fixed price, on or before a fixed date, a fixed quantity.

• A put option gives the right to sell at a fixed price, on or before a fixed date, a fixed quantity.

AMERICAN & EUROPEAN OPTIONS

• AMERICAN OPTIONS can be exercised at any time up to the expiration date.

• EUROPEAN OPTIONS can be exercised only on the expiration date itself.

Buying Long and Selling Short

• Buying a derivative is said to be going long

Selling a derivative is said to be

going short.

ARBITRAGE

• Arbitrage occurs when equivalent assets or combinations of assets sell for two different prices.

• Arbitrage creates an opportunity to profit at no risk with no commitment of money.

ARBITRAGE• Arbitrage is a process through which an

investor can buy an asset or combination of assets at one price and concurrently sell at a higher price, thereby earning a profit without investing any money or being exposed to any risk.

• In a well-functioning market, arbitrage opportunities should not exist.

Law of One Price

• The principle that no arbitrage opportunities should be available is often referred to as the Law of one price.

Role of Arbitrage1. It facilitates the determination of

prices

The combined actions of many investors engaging in arbitrage result in rapid price adjustments that eliminate any arbitrage opportunities, thereby bringing prices back.

2. It promotes market efficiency

Efficient markets are those in which it is impossible to earn abnormal returns, which are returns that are in excess of the return required for the risk assumed. Arbitrage activities will quickly eliminate arbitrage opportunities available in the market, thereby promoting market efficiency.

Role of Arbitrage

SIMPLE ARBITRAGE

• Suppose that a stock is trading in two markets simultaneously. Suppose the stock is trading at $100 in one market and $98 in the other market.

HOW ARBITRAGE?

• Buy a share for $98 in one market and sell it for $100 in the other.

• The sale of the stock at $100 was more than adequate to finance the purchase of the stock at $98.

• Arbitrage process will stop when the two prices come together.

Hedgers vs. Speculators

• Depending on their prior risk exposures, participants in the derivatives market can be classified into:

1.hedgers; and

2.speculators.

Hedgers• A hedger trades futures to reduce some pre-

existing risk exposure.• Prior to the transaction, the hedger does have

risk exposure.• After the transaction, the hedger reduces risk

exposure.• At the time of entering into hedging

transactions, the hedger knows the benefit reduced risk.

• Hedgers are often producers or users of a given commodity.

Hedgers• At the time of entering into hedging

transactions, the hedger knows the benefit reduced risk.

• Hedgers are often producers or users of a given commodity.

Speculators• A speculator takes a view of the market,

and accepts the market's risk in pursuit of profit.

• Prior to the transaction, the speculator has no risk exposure.

• After the transaction, the speculator has increased risk exposure.

• The profits/losses of a speculative transaction are not known immediately.

Concept of Hedging• A hedge is a mechanism by which a party

minimizes its exposure to price volatility.

• The function of a hedge is to preserve the value of a product held by a party or to lock in a profit on a future sale or use of the product by the party.

• In other words, a party has a position in relation to the product and they want to protect that position

Concept of Hedging

• A long position means that a party has purchased or holds the commodity and has the need to protect the value of the commodity held or purchased.

• A short position means that a party has sold, or does not have the commodity, and has the need to protect the value of the sale made.

Concept of Hedging

• An ideal or perfect hedge leaves no remaining price risk.

• The hedge has covered the entire risk identified and the value is locked in or guaranteed.

Concept of Hedging• The cost of a hedge depends upon the: term of transaction - the longer the term, the

more expensive complexity of deal - the more complex, the more

expensive location of purchase (sale) - the longer the

distance the commodity has to travel, the more expensive, and

liquidity of the players - the less liquid, the more expensive. The advisability of the hedge depends upon the risk appetite of the participants and the results of the cost/benefit analysis performed.

PURPOSE OF DERIVATIVE MARKETS

1. Price discovery.

2. Market completeness.

3. Risk management.

4. Market efficiency.

5. Trading efficiency

LIMITATIONS OF DERIVATIVES MARKETS

1. The complexity of derivatives means that sometimes the parties that use them don't understand them well.

2. Derivatives are also mistakenly characterized as a form of legalized gambling.