Derivatives

Question 1

What is a derivative?

Answer 1

It is a generic term used to describe futures, options, swaps and various other similar instruments.
They are derived from underlying assets
Most derivatives are contracts for differences (between the agreed future price of an asset on a future date and the actual market price on that date).
Its main objective is insurance (but instead of insurance it is called hedging).

Question 2

Why did they sprang up?

Answer 2

They sprang up because of the votality of interest rates, floating currencies, shares, bonds and commodities and the nead for “insurance”.

International Swaps and Derivatives Association (ISDA) is the most important dealers association.

Question 3

Who are the main users of derivatives?

Answer 3

Sophisticated investors, especially banks, insurers, pension funds, mutual funds, corporates and hedge funds.

Sophisticated investors who hold large pools of intangible financial assets whose value they with to protect.

Question 4

What do the different type of derivatives depend on?

Answer 4

1. Negotiation/market (traded at an official secondary market or over the counter?)
2. Underlying assets (shares, commodities, currencies)
3. Purpose (hedge or investment, speculative or arbitrage?)
4. Method of liquidation
5. Structures (futures, options or swaps?)
6. Risk assumed by the parties ( symmetric or asymmetric?)

Question 5

What is the differene between negotiated and over the counter derivatives?

Answer 5

Negotiated derivatives are purchased and sold within an organized market and are represented by mean of book entries.

OTC terms and conditions are freely agreed between the arties and it is not possible to assign the contractual position of a party unless the counterparty expressly gives its consent in this regard.

Question 6

What are the underlying assets from which the derivatives may “derive”?

Answer 6

1. Stock exchange –> shares, indexes, pools of shares and indexes
2. Fixed income–> short and long term bonds, companies’ bonds and assets involved in monetary markets
3. Currency–> main international currencies
4. Commodities–> crude oil, cereal, oranges, oil, etc.
5. Other kind of financial assets–> investment funds, hedge fund, loans, stock exchange indexes, etc.
6. Other intangible assets–> artistic assets, etc.

Question 7

Which could be the different purposes of derivatives?

Answer 7

1. Hedge–> those which comply to the following requirements:
   a. Existence of effective risk over prices, interest rates or stock exchange in foreign currency
   b. Substantial coincidence and identification between the derivatie financial product and the asset hedged
   c. Suscription of a derivative financial product intends to eliminate or dramatically reduce foresaid risk
2. Speculative
3. Arbitrage

Question 8

Which could be the different form of liquidation of a derivative?

Answer 8

1. Physical delivery: each party complies with its respective obligations
2. By compensation or by differences: the obligations of payments of each party are turned into cash of the same currency, they are compensated and the difference is paid to the relevant party (most extended method)

Question 9

What are the types of derivatives depending on their structure?

Answer 9

1. Futures
2. Options
3. Warrants
4. Swaps
5. Caps
6. Collars
7. Fras
8. Floors

Question 10

What is futures contract?

Answer 10

Contract under which one party agrees to deliver to the other party on a specified future date a specified asset at a price agreed at the time of the contract and payable on the maturity date.

The effect is to guarantee or hedge the price.

They are usually performed by the payment of the difference between the strike price and the market price on the fixes future date, and not by physical delivery and payment in full on that date.

Question 11

What is call option?

Answer 11

It is the right (but not an obligation) to acquire an asset in the future at a price (the strike price) fixed when the option is entered into.

Question 12

What is a put option?

Answer 12

It is the right (but not the obligation) to sell an asset in the future at a price ( the strike price) fixed when the option is entered into.

Question 13

When is the option “in the money”?

Answer 13

When it is profitable. When in a put option, the strike price exceeds the market price.

If the strike price is less than the market price then there is a loss (out of the money).

Question 14

What is the difference between an american option, an european option and a bermudian option?

Answer 14

European option is exercisable only on a fixed future date by reference to prices on thate date.
American option is exercisable on any day over the agreed fixed period.
Bermudian option can be exercised on any one of a number of specified days.

Question 15

What are the diffence between options and future contracts regarding loss and risk?

Answer 15

The maximum loss that the buyer of an option can suffer is the loss of his premium. Unlike a futures contract, he is not committed to buy or sell but has merely the option to do so.

Conversely, the seller of the option has an unlimited risk because the buyer can, by exercising his option insist on performance.

The risk is the drop in the price of the option to zero in the case of a put (limited risk), but unlimited in the case of a call because only the sky is the limit to an increase in price (theoretically).

Question 16

What is gearing?

Answer 16

It is the potential of making a large profit out of a small outlay.

Question 17

What is an interest swap?

Answer 17

It a contract whereby each party agrees to make periodic payments to the other equal to interest on a agreed principal sums and where the interest is calculated on different basis.

Most are products provided by banks. Bank makes a profit or loss according to whether the floating rate is less or more than the fixed rate.

Question 18

What is an interest cap?

Answer 18

Derivative when one party, in return for a fee, to pay the other party amounts equal to interest above a specified rate on a notional principal amount.

Question 19

What is an interest floor?

Answer 19

Derivative where on party agrees, in return for a fee, to pay the other amount equal to interest below a specified rate on a notional principal amount.

Question 20

What is an interest collar?

Answer 20

Derivative where one party agrees, in return for a fee, to pay the other amounts equal to interest above a specified rate on a notional principal amount over an agreed period of time, and the other pays the first party amounts equal to interest below a specified rate.

Question 21

What is credit derivative?

Answer 21

A type of derivative in which a seller of protection agrees to pay the buyer of protection an amount if during an ageed period a prescribed credit event occurs signifying a problem in relation to a refence obligation.

Question 22

What is a credit default product?

Answer 22

Agreement where the seller of protection agrees with a buyer of protection, in return for a fee, that if, during a prescribed period, a credit event occurs, the seller will buy the bond at its face value.

Question 23

What are the three markets for derivative products?

Answer 23

1. Over the counter–> private transactions usually sold by banks.
2. Primary markets–> issues markets for primary offerings of debt securities
3. Exchanges–> organized securities and commodities exchanges.

Primary offerings are issues of debt securitie, often listed in the bond market which carry a derivative feature (like index linked notes).

Question 24

What are warrants?

Answer 24

A warrant is essentially a an option but used in the context of a primary offering.
Normally, the suscription price for the warrant is equivalent to the premium of the option.

Question 25

What are particularities of exchange-traded derivatives?

Answer 25

Exchances are usually constituted by companies which are ultimately owned by their members or financial institutions.
The members are traders whose credit-standing, competence and integrity have been approved by the exchange. Thus, outside investors must contract with a member who then enters into an identical contract with the exchange.

Under the rules of the exchange, the clearing house becomes the counterparty of each party to the original trade. Each trade concluded on the relevant exchange in fist matched either electronically or by the exchange, and then replaced by two trades:

(i) between one party to the original trade and the clearing house and
(ii) a mirror trade between the clearing house and the other party to the original trade.

Question 26

What are the advantages of exchange-traded derivatives?

Answer 26

1. Liquidity: the terms of contracts and size of lots are standarized.
2. Price transparency: price of trades are published immediately.
3. Counterparty is is minimized:
   a) each member of the exchange has to provide margin (collateral) to the clearing house to the extent that its contracts are out of the money. The contracts are regularly “marked to mark@ to determine the margin required
   b) Solvency of the clearing company may be further protected by initial capital reserves and by guarantees and liquidity facilities granted by its members.
4. Administration by the clearing house helps match and settle the transactions

Question 27

What are the disadvantages of exchange-traded derivatives?

Answer 27

1. Standarisation–> looses flexibility

2. Concentration of risk on the central counterparty which is party to all market trades.

Question 28

Are standard master agreements used in derivatives?

Answer 28

Yes. Even though in private over-the-counter markets, contracts may be tailored to the occasion, parties usually use STANDARD MASTER AGREEMENTS covering all transactions between the parties.

Each individual transaction is documented by an exchange of confirmations (written memoranda recording details of the transaction). The confirmations incorporate the terms of the master agreements. Standard forms are usually used.

Question 29

What are the advantages of master agreements?

Answer 29

1. Legal safety–> terms have been considered in depth and so are more likely to be legally safe and sophisticated.
2. Documentation–> there is massive saving time and expense compared to documenting each transaction seperately.
3. Netting–> master agreement can improve the efficacy of netting
4. Familiarity and trading–> many institutions are familiar with the standard. Therefore, there is greater speed and liquidity of sale.
5. Matching–> it is easier to match back-to-back transactions because of standardisation.

Question 30

What is the ISDA?

Answer 30

The International Swaps and Derivatives Association is an association which engages the principal agents involved in the OTC derivative market.

It incorporated in 1985 to promote the development of the business of derivatives OTC.

It has 500 member of different jurisdictions. There are three kind of members:

1. Primary members–> dealers
2. Associate members –> professional services companies
3. Suscriber members–> final users

Question 31

What is the structure of the ISDA Master Agreement?

Answer 31

It is probably the most remarkable standard form ever devised in view of the immense range of transactions that it covers because it is a world-wide standard for international and local deals.

The idea of the ISDA form is to settle the COMMON TERMS likely to apply to most transactions and to leave the terms of particular deals to be settled individually in contract entered into on each occasion and evidenced by confirmations agreed by the parties. In order to streamline these confirmations, ISDA has produced booklets of definitions to save the parties having to write thing out each time.

Question 32

What is the structure/party of the documentation ISDA?

Answer 32

ISDA Master Agreement is in printed version and has 14 clauses that establish the conditions and definitions to apply to operations carried out under the agreement.

Schedule is an annex and it is computerized that follows the structure of the Master Agreement that includes the general terms NEGOTIATED by the parties.

If there are warranties (aka credit support), there are different types which can be:
Credit Support Deed
Credit Support Annex
Credit Support Annex English Label.

Finally, there are Model of Confirmations and Definitions which include the SPECIFIC TERMS.

Question 33

What is ISDA Architecture?

Answer 33

It is a term that defines the hierarchical relationship existing among the documentation of the normative agreement.

If discrepancy between Definitions and Confirmation, Confirmations shall prevail.

If there is contradiction between statements of the Schedule and the statements of the Master Agreement, Schedule should prevail.

If there is a contradiction between the statement of any confirmation and the Master Agreement, the Confirmation shall prevail.

Question 34

What is the procedure of execution of operation under the ISDA Agreement?

Answer 34

1. Parties adhere to the normalized Framework Agreement.
2. Parties suscribe a Private Agreement (schedule), where they amend and adapt the terms and conditions of the ISDA MA.
3. Negotiations of the economic conditions of the derivatives agreement is carried out by trader which is carried out by traders.
4. Trader send to back office the terms of the agreement.
5. Back office receives the terms by means of the Confirmation and makes reference to the relevant definitions. Then trader send information to counterparty.
6. Finally, the Confirmation is expressly incorporated in the Framework Agreement.

In the end, there will be a Master Agreement+Schedule+Confirmation.

Question 35

What is the applicable law to the ISDA?

Answer 35

Commonly, it would be either English Law or New York State Law but other Laws are possible.

In Spanish Law, for example, clauses are binding except in cases they are contrary to article 1255 of the Spanish Civil Code and article 3 of the Rome Convention.

Question 36

What is the CMOF?

Answer 36

The “Asociacion Espanola de Banca” decided to set up a team of legal advisors to draft a model of contract that, taking advantage of the experience in the usage of other international agreements, to adapt to the Spanish legal system.

It covers the need of proposing to the agents of the market a framework agreement which covered every kind of cashing operative within non organized markets or OTC.

It is used in the domestic market. Hence, it is drafted in Spanish.

Question 37

What is Composition of the Contrato Marco de Operaciones Financieras?

Answer 37

1. There is the Framework Agreement.
2. There are up to three Annexes
3. Each operation has a confirmation

Question 38

Since contracts in the OTC market are often made orally and then there is a subsequent email or fax confirmation, when is the contract binding?

Answer 38

Contracts are binding during the phone call since the subsequent email or fax confirmation of the deal only evidences the oral agreement previously established.

Hence,tape recording of telephone conversations are usually taped by professional dealers to evidence the contract.

Question 39

What is set off and what is netting

Answer 39

Set off is the setting off of debts while close-out setting is the cancellation of open executory contracts.

They must be valid upon the insolveny of the counterarty and it is a mechanism to reduce exposure.

Question 40

What is a margin?

Answer 40

It is security that supports derivative transactions. It is a collateral form of investment securities.

The collateral is usually in the form of highly-rated debt securities or bank letters of credit. There are two types:

1. Initial margin: must be provided at the inception of the transaction to cover potential risks
2. Variation margin: must be provided if market rates on the transaction would cause a loss to the investo if the transaction were closed out immediately.

Question 41

How are derivatives regulated?

Answer 41

1. There must be an AUTHORISATION of entities which deal in derivative products so as to monitor the solvency, competency and honesty of dealers
2. Business is conducted by TRADERS.
3. PROMOTION of derivatives is carried out by ads and offering circulars
4. There must be CAPITAL ADEQUACY which is the amount of capitl which authorised institutions must maintain against exposures on derivative contract so as to protect the state and investors agains systemic risk resulting from an insolvency.
5. There are some CRIMINAL CONDUCT provisions to establish rules and discourage unwanted behaviour like insider trading.

Question 42

When is there legal liability in derivative contracts?

Answer 42

There will be legal liability if a trader misrepresented the market, benefits or documentation to the customer, who relied on the misrepresentation.

Dealers usually endeavour to obtain information from sophisticated counterparties to the effect that:

1. the counterparty relies on its own judgement and not on the dealer or any statements about the transaction made by the dealer
2. the counterparty is able to assess the merits of the transaction
3. the dealer is not a fiduciary or adviser to the counterparty.