3. Introduction to Derivatives Flashcards
1
Q
What is a derivative?
A
- value is “derived” from the value (or price movement) of another underlying asset.
- eg: bonds, shares, commodities and currencies.
2
Q
What is the largest class of derivative?
A
interest rate derivatives — Interest rates are not assets, but used as a measure for cost of money.
3
Q
What are some exotic underlying in derivatives?
A
weather futures — references the temperature in specific locations and are used by utility companies to hedge their financial risk exposure that fluctuates with the weather.
4
Q
What is th examples form of derivative?
A
A forward contract — contract between 2 parties whereby one party agrees to buy (and the other party agrees to sell):
• A specific underlying asset.
• At a specific price.
• For a specific amount/quantity.
• At a specific time/date in the future.
5
Q
What are some characteristics of a forward contract?
A
- can be customized since its a private transaction between the 2 parties.
- may not involve buying or selling — enables a borrower to lock in the borrowing cost in the future using forward rate agreements — underlying is the interest rate.
6
Q
Are both parties in a forward rate contract subject to counterparty credit risk?
A
yes, both parties has a risk of defaulting — not honour its obligation to buy or sell.
7
Q
To address the credit risk inherent in forward contracts, what contract can be used? & what are the characteristics?
A
- futures contract — standardized transaction that occur on an exchange.
- A futures exchange (like a stock exchange) is an organization that provides the platform for entering into futures transaction in a centralized location.
- Default risk is mitigated — only exposed to the credit risk of the exchange itself, which typically are large and financially strong entities.
8
Q
What is a swap?
A
- a bilateral contract between 2 parties to exchange of cashflows on specified dates — exchange of risk exposure between the 2 parties
- 2 legs (pay versus receive leg) of the swap
- a variation of forward contracts — swaps can be constructed using a series of equivalent forward contracts
9
Q
What is the most common and heavily traded form of swap?
A
plain vanilla interest rate swap (IRS) — 1 leg is fixed interest rate whereas the other leg is a floating leg which references a specific benchmark/index — Alternative Risk Free Rate (ARFR)
10
Q
What is a option?
A
- gives 1 party (option holder/buyer) the right, but not the obligation to buy/sell an underlying asset from the other party at a fixed price over a period of time
11
Q
What is a call & put option? & what are the other features of options contract?
A
- call option: option to buy
- put option: option to sell
- fixed: exercise/strike price
- When the option holder buys (or sells) at the fixed price = exercising the option.
12
Q
When will option holder exercise the option?
A
- The holder of the option will only exercise when profitable
- Hence may not necessarily be exercised during its lifetime
13
Q
What are the roles of the derivative market?
A
price discovery (for derivative contracts & underlying asset), hedging, speculation & arbitrage
14
Q
What does price discovery by derivative market entails?
A
- Futures markets is where most of commodity trading takes place.
- Commodity futures provide info about the prices of the underlying commodities on which the futures contracts are based — provide price info for 2 different purposes:
1. commodities (being physical assets) are traded in geographically dispersed markets — leads to different spot prices (price for immediate trading & delivery). - In the futures markets, the contract price with the shortest time to expiry instead can serve as a proxy for the price of the underlying commodity.
2. prices of futures contracts = prices that can be accepted by those who trade contracts in lieu of being exposed to the risk of price uncertainty in the future. - eg: a company that produces palm oil can hedge its exposure by selling a futures contract on palm oil expiring in 4 months, which locks in the price of palm oil — the uncertain price of palm oil in the next 4 months is substituted with the 4-month futures price.
15
Q
What does hedging involve?
A
enable risk management — process of reducing and in some cases eliminating risk exposure.
16
Q
What does speculation entail?
A
participants actively seek to increase risk exposure to profit from it
17
Q
How do derivative connect hedgers and speculators?
A
Hedgers seek to eliminate risk (with the intention to minimize losses) whereas speculators want to take on more risk (with the intention to profit). In fact, to hedge or speculate, one only needs to seek another party with the opposite views or opposite risk exposure.
18
Q
What does arbitrage entails & why does it occur?
A
- simultaneous process of buying & selling an asset to profit from the difference in the price — exploit the price differences of identical/similar financial instruments on different markets.
- arises from market inefficiencies
- buying of bonds (the cash market) combined with the selling of Treasury futures (the derivative market).
- derivatives are derived from another underlying instrument, the price of derivatives should move in tandem with the underlying but that does not always occur.
19
Q
Can derivatives be traded over-the-counter (“OTC”) or via organized exchanges?
A
Yes
20
Q
What is an OTC derivative?
A
- contract that is traded directly between 2 parties through private negotiations
- subject to credit/default risk of the contractual parties — risk that its counterparty will fail to fulfil its promised obligations
21
Q
What is exchange traded derivatives?
A
- standardized financial instruments, where the contract specifications are not determined by the dealing parties, but by a centralized exchange.
- minimal credit risk — investor deals with the exchange only
22
Q
What are the advantages and disadvantages of exchange-traded and OTC derivatives?
A
- exchange-traded derivatives: desirable for their lack of counterparty risk but shortcomings is their fixed specifications which can lead to hedging mismatches & gap exposures.
- OTC derivatives: have flexibility as their main advantage, but are often criticized for their lack of transparency.
23
Q
Why does OTC trading volumes rise over the past couple of decades?
A
overwhelming need for tailor-made financial solutions
24
Q
How are Derivatives transactions settled?
A
may be cash settled or physically settled
25
What’s the difference between physical & cash settlement?
- illustrated using commodity futures
- physically settled: require the party who is long (bought crude palm oil futures) to take delivery of the actual crude palm oil on expiry & paying the futures price — the party who is short (sold futures) is required to deliver the crude palm oil at expiry in exchange for payment based on the futures price.
- cash settled: (no physical delivery of the underlying) achieved via a debit/credit when the contract expires. The debit/credit amount depends on the difference in price between the original futures transacted price vs actual spot price of the underlying at maturity.
26
How does cash settlement with a physical delivery be achieved?
done by simply closing out the position prior to maturity i.e. buying (selling) futures if the original position was short (long).
27
When will a (potential) arbitrage occur?
- when assets which are similar sell for 2 different prices.
- can also occur with sum-of-parts scenario where the total price for a combination of assets differ with the sum of the individual prices.
28
Example of arbitrage opportunity & its impact.
- Suppose the share trades at $10.00 in one market and $9.90 in the other.
- To profit, buy the share at $9.90 & sell it for $10.00 — realize a risk-free profit of $0.10 & without the need to supply any funds of our own — If repeated for larger volumes, the profits can be much higher.
- but, other market participants would see the same opportunity & engage in the same transactions — create downward pressure on the share price where it trades for $10.00 (people keep selling) — upward pressure on the share price where it trades for $9.90.
- Eventually the prices in both markets will equalize & the arbitrage opportunity disappears.
29
Why is the ability to mark-to-market derivatives important?
1. need to determine the market value of the derivatives:
- For a party using derivatives to hedge, the derivative transaction is structured such that any gains (losses) on the market exposure is offset by losses (gains) on the derivatives — need to determine the MTM value at any point in time to determine the hedge effectiveness.
- For speculators, the use of derivatives is purely a profit-driven motive. Naturally there will be a need to determine at all times.
2. for OTC financial transaction, counterparty credit risk is always present.
- quantum of the credit risk = amount 1 party owes another, which is measured using MTM values — MTM enables one to determine the credit risk exposure arising from derivative transactions.
30
What is the accounting treatment for derivatives?
- as per IFRS 9, market value is recorded
- MTM values is recorded in the balance sheet as either:
(i) Derivative financial asset/liabilities
(ii) Unrealized gains/losse
31
What are the implications of accounting for derivatives in the balance sheet?
- impacts capital requirement — larger balance sheet will require a larger amount of capital.
- The higher implicit risk in derivatives has prompted regulators to impose additional capital requirement on derivative exposure (via the use of larger risk weights leading to higher risk weighted assets attributed to derivatives)
32
What are the key focuses of International Swaps & Derivatives Association (ISDA)?
reduce counterparty credit risk, increase transparency & improve the industry’s operational infrastructure
33
What gives rise to additional credit risk & added complexity in negotiating & agreeing on the legal aspects of the transactions?
The customization of OTC transactions
34
What is ISDA’s most prominent and visible activity thus far?
development of a set of standardized contractual terms & definitions for OTC derivatives transactions — ISDA Master Agreement
35
What are the components (essentially a framework of documents) of the ISDA Master Agreement ?
a) Master Agreement — pre-printed form published by ISDA.
b) A Schedule to the Master Agreement — what the 2 parties to a OTC transaction actually negotiate on.
- The Schedule modifies the terms of the Master Agreement, adding, removing or modifying provisions as agreed between the 2 parties.
c) Optional — Credit Support Annex that governs the posting of collateral between the 2 parties — a means to mitigate credit risk.
d) Each trade has a Confirmation that sets out the economic terms & forms part of the ISDA Master Agreement.
36
Why is there a need for standardised terms?
• Each derivative transaction creates a credit r/s between the parties, the terms of which need to be negotiated and documented
• the credit exposure in derivatives may be 2-way & unknown at the inception of the derivative transaction.
• Swaps are traded in the market & might involve repeated interaction between 2 parties.
• Renegotiation of credit terms for each & every transaction would be costly & drag trading activities.
ISDA Master Agreement was developed to address those issues:
• The Master Agreement would contain the non-economic/legal terms like representations & warranties, EOD & termination events — frees up parties to negotiate only the ‘economic’ terms: rate or price, notional amount, maturity, collateral, etc.
• These economic terms are stated in the Confirmations.
37
What’s the function of Credit Support Annex (CSA)?
- in a swap, the MTM can move both ways — meaning both parties may take turns & be exposed to each others credit risk (current/future) — need a procedure to facilitate these potentially frequent collateral postings.
- CSA specifies the terms for collateral management & arrangement between the two parties (signatories of the ISDA Master Agreement).
- eg of terms include type of collateral permitted: cash, currency options, government bonds, haircuts, thresholds etc
38
Why is there a need for a standard Credit Support Annex (CSA)?
- different ways used to book & model of CSA terms which lead to collateral disputes
- inconsistent & non-transparent valuations on various OTC transactions.
39
To summarize the role of CSA:
• legal document which regulates credit support (collateral) for derivative transactions.
• defines the terms for posting/transfer of collateral between swap/derivatives counterparties.
• Collateral is posted to mitigate the credit risk arising from “in the money” MTM of derivative positions.
• eg of key terms: Thresholds, MTA (Minimum Transfer Amount)
40
assume A & B has a CSA in place with the following terms:
Threshold: RM100k
minimum transfer amount (MTA): RM500k
MTM: RM250k (in favour of A)
Does B needs to transfer any amount to A & why?
given that the MTA is RM500k, B don’t need to transfer collateral to A at this point — MTA is used to minimize unnecessary posting on a daily basis which only impose transactional costs.
41
assume A & B has a CSA in place with the following terms:
Threshold: RM100k
minimum transfer amount (MTA): RM500k
MTM: RM650k (in favour of B)
Does A needs to transfer any amount to B?
Yes. Since the MTM value exceeds the threshold & the amount to be posted (RM650k – RM100k = RM550k) exceeds the MTA, A would transfer collateral of RM550k to B.
42
Shariah-compliant financial instrument must not contain which elements?
• Riba (usury) — risk-free profit, arbitrage.
• Rishwah (corruption)
• Maysir (gambling) — outcome is purely dependent on chance (similar to gambling)
• Gharar (unnecessary risk) — an or intentionally generated uncertainty — variability of the underlying contract such that 1/both parties are uncertain about possible outcomes.
• Jahl (ignorance) — A party is prohibited from benefiting from the gains in a transaction because of another party’s ignorance.
43
there are some basic conditions with regards to the sale of an asset (in this case a real asset such as a commodity as opposed to financial assets).
• For a sale to be valid:
a) The commodity/underlying asset must currently exist in its physical sellable
form.
b) The seller should have legal ownership of the asset in its final form.
• These conditions would obviously render impossible the trading of derivatives.
• However, Shariah provides exceptions to these general principles to enable deferred sale where needed.
a) The commodity or underlying asset must currently exist in its physical sellable
form.
b) The seller should have legal ownership of the asset in its final form.
44
What is a Tahawwut Master Agreement ("TMA")?
- standardised global master agreement to govern Shariah-compliant derivatives transactions
- designed to mirror the ISDA Master agreement except for a few clauses and definitions to cater to the needs for Shariah-compliant derivatives structures.
45
Why was London Interbank Offered Rate (LIBOR) discontinued?
- largely based on expert judgement, as there are few actual transactions
- caused international regulatory bodies to promote transaction-based alternative risk-free rates (ARFRs) due to limitations in the relevance of LIBOR as a benchmark and questions around its sustainability and stability in stressed market conditions.
46
USD: Secured Overnight Financing Rate (SOFR)
GBP: Sterling Overnight Index Average (SONIA)
CHF: Swiss Average Rate Overnight (SARON)
JPY: Tokyo Overnight Average Rate (TONAR)
EUR: Euro Short Term Rate (ESTER)
SGD: Singapore Overnight Rate Average (SORA)
THB: Thai Overnight Repurchase Rate (THOR)
MYR: Malaysia Overnight Rate (MYOR)
