7. DERIVS Flashcards
What is a deriv
- types?
Deriv = financial instrument whose value depends on the value of another underlying asset
Leveraged instruments with little/no upfront payment
settled @ future date
Exchange traded
- options
-futures
OTC
- forwards
-swaps
-options
-CFDs
uses of derivatives
hedging
- guarding against adverse price movements in the UL
- perfect hedge = taking opposite position to that in UL market
speculation
-taking a view on market direction, ST and higher risk
quick change of AA
- e.g. to reduce net long equity exposure with a short call
arbitrage
-exploiting price anomalies between markets
Derivative markets
XTD= standardised contract that trade son XC
futures, options
- minimized CP risk
-standardized
-liquid and cheap
OTC -financial contract that does not trade on an asset exchange, and which can be tailored to each party’s needs
swaps, forward, options, CFDs
- non fungible
-bespoke
-counterparty risk (reduced with EMIR = mandatory CCP clearing and enhanced collateral agreements)
-traded directly
Futures
Promise to buy/sell an asset @ fixed date in future @ fixed price
XTD
Guaranteed by exchange
Liquid, cheap and easy to trade
Fixed, standard delivery dates: March, June, Sept, Dec
Mostly cash settled
Reduced counterparty risk due to clearing house
Relatively low initial costs
Regulated.
Typical financial futures
FTSE100 Index future
S&P 500 Index future
3 Month Sterling future
UK Gilt future
US Treasury Bond future
Universal stock futures
Futures buyer and seller
Buyer = long
Commits to pay the agreed price and receive the underlying/cash on
agreed date
- Believes price of the underlying will rise
Seller = short
commits to sell @ agreed price on agreed date /pay cash difference
Believes price of UL will fall
Futures contract specification
Asset
- grade for commodities/volume/number
Contract Size
- volume/number
Delivery Month
- & date
Tick Size
- min no. by which contract can move
Tick Value
- monetary value for 1 tick
Index futures specification
Clearing of futures
With LCH or Ice futures Europe
= CCP to buyer and seller
-buyer/seller place orders with brokers (clearing members)
-clearing members enter order into CH, orders are matched and confirmed
-the CM registers the trade with the CH, giving details on type of account trade is assigned to (seg or non seg)
Novation = process by which CH become legal CP to trade
Clearing member collects margin on behalf of buyer
AL XCs have affiliated CHs
Structure of CH
CH= sits between two clearing member firms and main purpose is
to reduce CP risk by acting a CCP to each side of trade
Clearing members = strict financials reqs to be a clearing member, must contribute to clearing fund
Indiv clearing member = can clear for self or clients
General clearing member = can clear for self, clients + other non-clearing members of XC
Trade registration
Pre registration = trade given up to CM if broker is non clearing member
Registration = trade matched and registered
3 Accounts
House = proprietary trade
Segregated = protected against member firm default
Non-segregated = unprotected
Role of CH
Clearing = process by which derivs are confirmed and registered
CH become legal counterparty on principal to principal basis, this process = novation
removes most CP risk by guaranteeing trades
collects and holds margin from clearning members
other functions
- transparent post trade processing
- post trade management functions
- management of collateral
- settlemnt through payment or physical delivery
How does CH protect itself
-Only deals with clearing members who must adhere to strict financial reqs
- lines of credit with variety of major banks
-default/clearing fund
-insurance policies
-margin (initial, variation, maintenance)
margin = cash or equiv deposited with CH to cover risk of CM defaulting on position
futures - initial margin
calculated by CH @ outset of trade
- paid by CM to compensate for future possible losses
- can be collateral, cash, bank guarantees, CDs, gov bonds, T-bills
-re computed every bis day - intra day margin called to top up
-returned when position is closed out
-CMdeposit margin on their net positions with CH (e.g if they have 10 long contracts and 5 short, require margin on 5 long)
- spot month margin = increased margin in delivery month due to speculative and delivery pressures
variation margin
- collected by CH from CM is contract suffers from adverse price movements not covered by initial margin
- must be cash and in currency of contract
-positions marked to market @ close based on daily settlement price
- must be cash and in currency of contract
- CM collects from buyer and pays to CH
- must be transferred within 1 hr
Variation margin = ticks moved on the day x tick value x no of contracts
Maintenance margin
Agreement between CM and client (not involving CH)
-may ask client to deposit more than initial margin to enable variation margin to be easily taekn
once credit breaches maintenance limit - then CM issues margin call and client must top up acc to full amount
Acceptable and unacceptable collateral
to cover in initial margin in place of cash
GOOD
- cash in most major currencies
- bank guarantees from approved bank
-Western gov debt
-CDs in freely transferable currencies
Unnacaptable
- undated bonds
- swiss bonds
- bonds in a currency other than issuing currency
-full market val of collateral is marked to market daily and subject to haircut (full market val not credited)
-secs must be w/ depositories/custodians approved by CH
Futures pricing
- takes into acc cost of buying asset today and holding to delivery
- must be fair to buyer and seller
FAIR VAL = CASH PRICE + NET COST OF CARRY
cash price = price of UL today
net cost of carry = finance costs + (storage costs for commodity) - income
backwardation and contango
when future price > expected cash price = contango
expected cash price > future price = backwardation
divi yield > financing costs = backwardation
basis = cash price - futures price
positive basis - backwardation
negative basis - contango
Futures strategies
- hedging
Number of contracts needed to hedge
futures val = futures price x contract size
equities h = Beta
bonds; h = portfolio duration/futures duration
Futures strategies -
Imminent CF and anticipation of changes in market
Expecting cash in and expecting market will rise
3 choices
-wait for cash and buy @ higher price
-borrow to invest now and pay interest when CF received
- buy index futures to offset cost of entry to UL when CF comes in
Futures strategies
Moving money quickly between markets
Use index futures to quickly change profile of portfolios because of speed of dealing and lower costs
compared with trading the underlying assets
Futures strategies
- Speculation
Efficient and cost effective exposure to UL index
Can use to make large bets on market index w/out owning underlying
- quick
-foreign shares
effective exposure to the markets
A trader may run a large futures position to take bets on market index moves without owning the
underlying securities
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Long gilt future
uses = duration switches, speculation, hedging, AA
DELIVERABLE
UL asset = NOTIONAL bond w/ 100k NV, 10 yr mat, 4% coupon
XC publishes list of deliverable bonds w/ mats between 8.75 and 13 years + range of coups
conversion price factor - issued by XC and puts deliverable bonds on level playing field - determines price paid for each bond deliverable
seller chooses cheapest to deliver bond + exact delivery date in delivery month
Hedging with gilt futures
- if you think val of portfolio will decline due to rising rates
- sell gilt futures to hedge
- as rates rise, futures price will fall and seller will receive margin payments
no. of contracts to sell = (portfolio val / futures val) x h
h = portfolio duration/futures duration
futures val = 1000 x futures price
1 contract = per 100k nom
price = per 100 nom
OPTIONS
HOLDER has right not obligation to buy/sell specific asset @ specific price
writer/seller of option has obligation
upfront payment = ‘option premium’
futures have margin upfront payment but that is returnable
XTD or OTC
call = right to buy
option = right to sell
OPTIONS
= RIGHT not obligation to buy/sell specific asset @ specific price on/before specific date
buyers have right, selers have obligation
upfront payment = option premium
futures have margin @ outset but that is returned (type of insurance pol basically)
call = right to buy
put = right to sell
can be XTD or OTC
listed equity options = deliverable
other cash settled
LONG CALL OPTION
bullish - anticipating price rising
right but not obligation to buy @ strike price on specific date
max loss = limited to premium paid
limited loss w/ unlimited gain
BE = strike + prem
SHORT CALL OPTION
Bearish
Other side of long
= seller promises to sell UL @ fixed price in future if buyer exercises
BE = strike + premium received
Profit declines as UL value increases
Max gain = premium
max loss = unlimited
covered call = when you own the UL and sell the call
income maximiser funds do this to generate more income from equities and dont believe price will most substantially
LONG PUT
BEARISH
right to sell UL @ fixed price
BE = strike - premium
lower strike = lower premium (as waiting for price to fall more before exercising)
limited gain (UL value can only fall to 0)
limited loss (prem paid)
Long UL and long put = caps losses to premium but dampens upside
Long put can offset long position in UL
SHORT PUT
=bullish = writing/selling a put option (selling the right to sell)
max profit = premium
writer is obliged to buy @ strike price if long exercises option
believes price of UL will stay above strike price + option will expire worthless
Euro/American/Bermudan/Asian options
Euro = exercise by 6pm on last trading day only (3rd fri in expiry month)
American = exercise by 5.20 on any bis day before the expiry day (3rd fri in expiry month)
Bermudan = number of discrete dates on which you can exercise option
Asian style =payoff depends of avg price of UL over certain period
Option pricing
= INTRINSIC VALUE + TIME VALUE
IV= economic value of option if it were exercised now (measure of how far in the money an option is by comparing strike and asset price)
TV = option prem - any intrinsic value = represents uncertainty remaining before expiry
- underlying asset price (higher = more valuable call, less valuable put)
-strike price (higher = less valuable for call, more val for put)
-time to maturity = longer term, greater risk to writer option may expire ITM = higher prem
-implied vol of UL = higher vol = higher prem
-income yield on UL = greater = more valuable put and less valuable call
-ST IR = higher = greater val of call (more income on cash not committed to buying UL), less valuable put
What are option greeks
variables used to assess an option’s risk
DELTA = sensitivity of an options premium to a 1% move in UL security price
-vanilla options = rough proxy for likelihood option will be exercised
100% = certain to be exercised ITM. 0% = imminently about to expire OTM
GAMMA= sensitivity of delta to a 1% change in UL price (i.e. rate of change of delta). short dated ATM options will see delta change dramatically for a small change in UL (large gamma). Gamma is bell curve shaped with higher curve for shorter dated.
VEGA = sensitivity of premium to 1% change in implied volatility. Bell curve, highest for long dated ATM options.
THETA= sensitivity of an options premium to changes in time remaining to expiry. Measure of time decay of an option (highest for short dated, ATM options)
Bull spread with calls
CHEAPENS UP LONG CALL
- bull spread = profits with rising market
- call option = right to buy not obligation
-strike/expiry/premium/option types
Buy Low strike call. Sell high strike call
Low strike (100p) call = more expensive (higher IV) = 15p premium
high strike call (150p) = cheaper 10p prem
net prem = -5p
max profit = difference between strikes - abs val of net prem
BE= low strike + net prem abs value (calls)
as UL price rises to low strike: max loss = net prem
@100p low strike, exercise long call
@150p high strike price - short call exercised against you
max profit = 45p
-moderately bullish
- cheapen low strike call by selling high strike as dont think price will rise beyond
DEBIT SPREAD - net premium is neg
BULL SPREAD WITH PUTS
Put option = right but not obligation to sell
Bull spead - profits with rising market
BULL = Buy low strike (100p). Pemium -10p
Sell high strike (150p). Premium +15p
CREDIT SPREAD: Net premium = +5p
Max loss = diff in strikes - abs val of net prem
= 150p-100-5 = 45p
Max gain = net premium
BE = 150p-5p = 145p
Puts = high strike - net prem
MODERATELY BULLISH
- earning income with short put
- capping losses with long put
- think market will stay above 150p strike price
Bear spread with puts
Bear strat =profit as market falls
Put option = right but not obligation to sell
BUY HIGH strike (150p) put -15p
SELL LOW strike (100p) put +10p
Net prem = -5p = DEBIT SPREAD
Max profit = diff in strikes - net prem abs value
= 150-100-5 = 45p
BE puts (high strike - net prem
= 150-5p = 145p
CHEAPENS UP LONG PUT WITH SHORT PUT
Moderately bearish - think market will fall but not below 100
give up some upside to cheapen long put
Bear spread with calls
Call option = right not obligation to buy
Bear strat = profits with falling market
BUY HIGH strike call (150p) -10p
Sell Low strike call (100p) +15p
CREDIT SPREAD - net premium =+5p
Max loss = diff in strikes - abs val of net prem
= 150-50-5=45p
BE (calls) low strike + net prem
= 100+5 = 105p
As market falls below 150p, exercise long call
if market fell to 100 - short call would be exercised against you
MILDY BEARISH
limits losses of selling a short call
useful for income fund to limit losses
LONG STRADDLE
(straddles the strike)
Long vol trade
Buy call (-11p)
Buy put (-10p)
with same ATM strike (call will be more expensive) 125p
same expiry same UL
Call = RTB, put =RTS
Net prem = -10-11 = -21p
Max gain = unlimited
BE points = 125 +/- net premium
If market rises (long call ITM) if market falls (long put ITM)
Between BE points - lose money as neither option ITM
Quite expensive vol trade
Makes money so long as market moves
Profit in either direction
SHORT STRADDLE
Short vol trade
SELL CALL (11p)
SELL PULL (10p)
(same expiry, same UL, same strike 125p)
put = RTS, call = RTB
Net prem = 10+11 = 21
Max loss= unlimited
BE points = strike +/- net prem
CREDIT trade = income generating
used when trader doesnt think UL price will change dramtically
LONG STRANGLE
Cheap version of a long strangle
Define options
BUY HIGH STRIKE (150p) CALL -5p
BUY LOW STRIKE (150p) PUT -5p
Same UL, same expiry
Net premium = -5-5= -10p
= debit trade
Max gain is unlimited
BE = low strike - net prem and high strike + net premium
LONG VOL TRADE
cheaper than straddle but need more volatility to profit
very bullish on volatility
SHORT STRADDLE
Short vol trade
what is an option?
SELL HIG STRIKE CALL (150p) +5p
SELL HIGH STRIKE PUT (100p) +5p
Max profit = 5+5 = 10p = net premium
DEBIT SPREAD
Max loss = unlimited
BE = low strike - net prem
high strike + net prem
Short volatility trade - dont think price will move significantly
Less premium than with straddle but keep premium over longer range of price movements
Put call parity
synthetic long
synthetic short
What is a warrant
Warrant vs call?
Warrant = entitles holder to buy certain no. of UL shares of company for set period @ predetermined price. Company issues new shares if exercised
- often attached as sweetener to debt issuance
Warrants
- issued by and exercisable on company
- terms decided by company/not standardised
-longer expiry (yrs)
-dilutive
-not voting rights
Call options
-XC traded
- standardised by XC
-shorter expiry (m)
- Existing shares
-no voting rights
Warrant price
= [A / (1+ q) ] x no. of shares
A = price of regular call option
q= percentage increase in shares
Adv and disadv of warrants to issuer and investor
Adv to issuer
- equity sweetener to debt issue - cheapens debt in terms of yield required
- cash raised immediately but share issuance deferred (no divi/interest to pay now)
- if share price falls warrant won’t be exercised
-often detached from debt post issue and traded separately
Disadv to issuer
- issued @ big discount to current share price
- dilutive on exercise (more divi to pay)
Adv to investor
- geared investment in shares - cheaper than buying shares themselves, similar to call option
- debt + warrant = way of securing an income yield while keeping high equity perf available (similar to convertible, but warrant can be detached and traded separately)
Disadv to investor
- geared, so potential losses can be extreme if shares underperform
-risk of takeover : expiry date is accelerated to takeover date so lots of time value is lost. could become worthless if warrant is newly issued.
Warrant premium + gearing ration
= warrant price + exercise price - share price
/ share price
= time value/share price
GEARING RATIO = share price/ warrant price
Covered warrants
Gives holder the right but not obligation to buy (call warrant) or sell (put warrant) the UL asset @ strike price by exercise date
- issued by financial instits
-listed secs on exchange - give exposure to range of UL instruments (stocks, bonds, commodities)
- securitised derivative = option is covered by UL financial instrument
-non dilutive as issued by financial instit - max loss = premium paid. No margin calls etc
- avg life = 1-2yrs (longer than options)
-easier to access than options
Convertibles
Bond with embedded option giving the holder the right but not obligation to convert the bond into a fixed number of shares of the issuer (during a certain defined period of the bond’s life)
- usually exercise if conversion rights are more attractive that prevailing market price of shares
- typically pay lower coupon because of embedded option to convert
- employed as a deferred shares - issuer assumes conversion @ conversion date/period
- conversion rights often expressed as no. of shares/£100 NV
subordinated debt - senior creditors must be pid in full before any payments made to holders in event of insolvency
ADV and DISADV of convertibles to issuer and holder
Adv to issuer
- issue debt with cheaper coupons vs standard debt issue
- interest payments are tax deductable unlike equity finance
- no immediate loss of voting control
- deferral of dilution
-issuers w/ poor credit rating can issue @ lower yield
DisAdv to issuer
- if comp performs poorly, still obliged to make coupon payments unlike divi and redeem for cash if holder doesnt convert
- cannot be sure that it is issuing deferred share capital
- (deferred) dilution of equity
Adv to Investor
- Fixed income security offering downside protection if shares fall in value (tho subordinated debt) with equity uplift
- Higher coupon yield vs divi but lower than straight bond
- better liquidity vs straight bond
Disadv to investor
- if shares dont go up, yield has been scarified vs straight bond
- no voting rights
-dilution to existing holdings
-often callable
-low priority of debt in repayment (subordinated)
CoCos
Contingent convertibles - hybrid secs issued by banks and auto converted into equity if contractually pre agreed trigger event occurs
aka AT1 bonds
- created post GFC = help undercapitalized banks and to reduce the potential for taxpayer-funded bailouts and satisfy requirements imposed by Basel III
- often triggered if a bank’s capital adequacy ratios are breached
- conversion removes debt from the liability side of the balance sheet allowing bank to continue UW loans
-high return and high risk - can be written down to 0
conversion ratio
= no. of shares a bond converts to (usually per 100 NV)
conversion price
=convertible price/no. of shares
= share price where conversion is advisable
if bond only converts @ maturity = nominal val/conversion ratio
conversion value
= share price x conversion ratio
Conversion valuation - DIVI VAL METHOD
For bonds you MUST CONVERT @ MATURITY
- work out whether you convert and get shares or redeem for NV
- assume conversion @ maturity
- calc future share price @ maturity (share price x (1+g)^n)
- calc future conversion value @ maturity = conversion ratio x future share price
price bond as usual using future conversion value if >100
100 if future conversion value <100
Convertible valuation - CROSSOVER/INCOME BASED
Assumes conversion when divi income exceeds convertible income
- estimates date when divi will equal convertible coupon
- find conversion value today = share price x conversion ratio
- calc basic divi on all shares = divi/share x conversion ratio
- sum the PV of differences between the coupon and the future expected divi
TABLE W/ COLUMNS
year ! interest on debt ! grown divi ! income pickup ! PV of pickup ! - sum present val of income pickups (until they crossover) and add to today’s conversion value
Convertible valuation - OPTION/WARRANT PRICING
Convertibles priced as a bond with an embedded equity option
value comprised of = val of conventional bond + value of equity option (warrant)
Warrant price = equity call option premium / (1+q)
Forwards
OTC deriv contract to buy/sell and asset @ fixed price on fixed date
long = obliged to buy
short = obliged to sell
Forward rate agreement
Enables you to fix an IR in advance
Enables you to take a view on whether rates or rising/falling
No principal amount borrowed or lent - CF arises from difference between fixed and floating rate based on notional principal
e.g you take out a £10mn 6m loan with interest payments set to 3m rate
0-3m you know the rate. risk is the 2nd 3-6m payment
3v6 FRA can lock in rates between 3 and 6 months
FRA overlays loan - cash settles the difference between FRA and benchmark rate
You pay fixed amount (4%) to FRA provider
If benchmark loan rate goes up to 5%, you pay 4% and the FRA pays difference (1%)
If benchmark rate goes down to 3%, you pay 3% on loan and difference (1%) to FRA provider
FRA vs IR swap
IR swap is over much longer period = baso avg of multiple FRAs with constant rate
NET SETTLEMENT AMOUNT
USD uses days in year as 360
Sterling = 265
Deriving forward rates
Can also use first principles and derive spot rates
Options on short term IR
Provide right not obligation to enter benefit from rising/falling rates (as FRAs require you to pay out if rates move against you)
European style - exercise on day only
Pay premium as % of notional principal amount
CAP = call on ST IR
Protects loan as rates rise. Pays out difference between reference rate and strike rate if rates rise
FLOOR = put on ST IR
Pays out if rates fall (protects deposits from falling rates/speculation)
COLLAR = BUY CAP, SELL FLOOR (Buy call, sell put)
With same premium (so costless) but different strikes
high strike cap and low strike floor
selling floor cheapens cap (dont think rates will fall to floor strike price)
CFDs
OTC deriv contract between 2 parties to exchange diff between opening and closing prices of specific financial instrument
Cash settled
Trade on margin (initial and variation)
Leveraged instruments - max loss not limited to initial investment
Gains subject to CGT and losses can be offset unlike spread betting (considered gambling)
Daily funding charge - equiv to borrowing cost of full amount of investment paid by buyer to seller or else noone would buy the equity
Manufactured divi - paid by seller to buyer (so the buyer has the experience of owning the equity and the seller cannot own stock and sell CFD to have no exposure to stock but still receive divi)
Adv
Allow seller to short stock without owning UL
No set end date
Allows exposure to foreign markets
No stamp duty
Disadv
Leverage can amplify losses
Extreme price vol
weak industry regulation, not allowed in US
VANILLA INTEREST RATE SWAPS
Exchange of CFs based on different interest rates in same currency based on notional principal (pre set schedule of payments and calcs)
Typically one leg fixed and one leg floating to gain/decrease exposure to prevailing market rates
Notional principal never exchanged
Long term (years)
In contract: notional principal, fixed rate, maturity, floating rate index, frequency of reset
Diagram. Blue chip thinking rates will decrease and bond yield is high. Small bis want to hedge loan rate
Bank - want to offset IR risk
Paying fixed rate = benefit if rates rise
Paying floating = benefit if rates fall
Mandatory CCP clearing to remove CP risk post EMIR
Can be cancelled/terminated early - need agreement from both parties
mark to market value of swap calc and exchanged
SWAPTIONS
Options on swaps - physically delivered, actually receive swap
‘strike price’ is fixed rate
Payers swaption = right to enter into swap (@ exercise date) and pay fixed rate
Call on interest rates
Receivers swaption = right to enter into swap @ exercise day and recieve fixed rate
Put on interest rate
‘1yr 5yr receivers strike 5%’ = 1 yr option on a 5yr IR swap with strike 5%
Basis swap
Interest rate swap where both payment streams reference a floating rate = 2 parties agree to swap variable interest rates based on different money market reference rates
Useful to hedge against IR risks where you borrow and lend @ different rates
Can speculate on rate movements (time period, cross currency)
examples
3m LIBOr v 6m LIBOR (same rate different period)
US IM LIBOR v IM SOFR (same currency different rates)
3m SONIA v 3m SOFR (cross country)
(technically any floating for floating swap)
LT currency swap
Involves exchange of principal (sometimes) and interest in one currency for the same in another over an agreed period of time
Interest payments are exchanged @ fixed dates through life of contract
Orig principal is reexchanged @ the end
Uses:
- favourable loan rates in the currency than if they borrowed directly in the market
- hedging transaction risk on foreign currency loans they have already taken out
3 types
- fixed v fixed = pay fixed rate in one currency and receive fixed rate in another
- fixed v floating = exchanged fixed rate in 1 currency vs floating in another
- floating v floating = exchange two floating rates +/- a spread
generally not netted as in different currencies
US company issues 5y GBP bond and swaps it to USD SOFR
Cheaper than issuing FRN in domestic market
OVERNIGHT INDEX SWAP
Swap where floating leg is referenced to an overnight index rate
TONA - Tokyo
ESTR - Euro
SOFR - US
SONIA - UK
overnight leg isnt paid everyday (credit risk, expensive, admin, long) - compounded and paid per period (i.e. monthly)
- can do asset swap (e.g. swapping 5% return on fixed rate bond for OI) thereby receive income more quickly and frequently)
-arbitrage = borrow in O/N market and lend for 3m, the transact swap where you pay O/N and receive 3m for potential gain. - If bank borrows for 1 yr but would prefer to fund on daily basis due to IR risj - OIS where they receive 1 yr fixed and pay O/N rate
- liability swap = issues bond @5%, OIS where you pay O/N rate and receive 5% fixed
Total return swap
A swap agreement where 1 party pays the total return of a reference asset (any periodic cash flows and capital gains) and the other party pays a set rate (either variable or fixed) plus any losses on the reference asset
Total return payer hedges losses on reference assets
Receiver gains exposure to asset w/out owning it
IF TR payer doesnt own asset - they are speculating on it’s decrease in val - shorting it w/out needing to own UL/borrow.
Equity swap
OTC deriv where total return of stock/basket/equity index is swapped for fixed/floating leg + any losses on the reference stock
Usually equity leg v floating leg
sometimes equity leg x equity leg
Useful to circumvent restrictions on foreign stock purchase
Notional amount changes w/ every payment as value of UL changes to reduce credit risk
Diagram
COMMODITY SWAPS
cash settled
2 types: fixed v floating and price for interest
FIXED V FLOATING
- swapping the fixed price of a commodity for a variable price
- useful given significant vol of commodity prices and their supply/demand to hedge risk
- define amount/grade of commodity, fixed price, frequency of swaps.
- on settlement compare fixed with floating and make net payment
USES
-jeweller pays fixed rate in swap to hedge increase in the price of gold
-miner pays floating price and receives fixed to hedge against decrease in price/certainty of CFs (they receive the fixed price in the market)
PRICE FOR INTEREST
- value of fixed amount of commodty is exchanged for floating/fixed rate interest payment
Variance swap
Variance swap - allows investor to hedge against/speculate on future price movements (vol) of UL asset
One leg’s payments are linked to the realized variance of the UL (price of UL record on daily basis often closing price) and other leg pays fixed amount
Provides pure exposure to volatility of the UL (variance = vol squared)
Options also allow you to speculate on vol but are more expensive and carry directional risk. price also related to time to expiration etc
Clearing house ownership structure
Typically owned by its members or by the XC whose contracts it clears
OCC (options clearing corp in US) - jointly owned by several exchanges
ICE Clear Europe - owned by exchanges and clearing members
CME - division of exchange itself
OTC Clearing HK limited - owned by 12 shareholders including 5 mainland chinse banks
SA JSE Clear owned by the JSE
Exchange cleared OTC products
Increased concern over CP risk and XC wanted to diversify has led to XC offering clearing facilities and guarantees to range of OTC procs
CH does not assign or match buyers to sellers (as contract is already agreed OTC)
- does monitor and guarantee delivery
Attractive for long term contracts
Once OTC contract is cleared = subject to standard reqs of margin, delivery procedures etc
Both parties of trade must be exchange members and have direct or indirect clearing relationship with CH as usual
Advantages and disadvantages of OTC trades
ADV
- more flexible = can be tailor made for specific needs
- in some areas the market is significant so can gain access to areas may not be able to get to otherwise
-major role in companies providing customers with stable pricing
DISADV
- No secondary market for OTC derivs as terms not standardises
- Can be transacted directly between buyers and sellers with no CCP - credit risk
-opaque market with fewer regs so large systemic risk
-speculative nature of market can cause market integrity issues
