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
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
NET SETTLEMENT AMOUNT
USD uses days in year as 360
Sterling = 265
Deriving forward rates
Can also use first principles and derive spot rates
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
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
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
