Lecture 16 - Derivatives: Optios Fututres And Swaps Flashcards
Derivatives markets
Financial derivatives can be defined as instruments whose price is derived from some underlying security
The price of the derivative is linked to the price of the underlying asset and Arbitrage maintains this link
Main uses of derivatives
Hedging - purchase of financial instrument in order to ensure against a possible reduction in wealth caused by unforeseen economic fluctuations or to the process of transferring the risk to a party who is less risk averse than the ledger
Speculation implies profiting from any intervening price changes
Arbitrage takes advantage of price or yield differentials in different markets in a riskless transaction
Criticism: blamed for an increase in complexity and risk in financial markets
A variety of derivatives exists
Options Financial future Swaps Forward contracts Credit default swaps Contracts for difference
Derivatives on many underlying instruments
Stocks Bonds Currencies Market index Commodities Interest rates
Trading derivatives
Instruments: financial futures and traded options
Pros and con:
- liquidity, competition and good price, implicit protection against default through the clearing house, standardised products = lack of flexibility
OTC derivatives
Instruments bought directly from a banks or other financial institutions
Instruments: swaps, forward contracts and OTC options
Pros and cons
Flexibility, lack of liquidity and competition and risk of counterparty default
Clearing house
Derivative exchanges provide a clearing service which acts as a central counterpart for all trades
Initial/original margin - a clearing house requires both parties to deposit cash against the transaction
The each contract is marked to market daily to take into account movements in the price underlying security
Variation and maintenance margin is the difference between mark to market price and the purchase price
If the mark to market price < the purchase price
A holder of a future has to top up the margin account to the level it was before
If the mark to market price > the purchase price
The margin account will be credited
Options
Confer the right, but not the obligation to the purchaser to buy a call option or the right to sell an underlying instrument at a standard price and at a specified time in the future
Traded options
Can be bought from and sold to parties other than original writer of the option, this is not possible for the OTC options
Over the counter options
A financial contract
An agreement to sell or buy a quantity of a financial security on an organised market or exchange at a fixed future date and at a pprice specified at the time of making a contract
Security = bond, bill, currency or stock
Swap
An exchange of financial instruments between two parties
Traded options
Standardised exchange-traded options that grant the buyer the right, but not the obligation to buy or sell financial instruments at standard prices and dates in the future
Exercise/strike price
The price at which an option holder has the right to sell or buy an underlying security
Option writer
The person who sells a call or put option
Option premium
A fee that is paid by an option holder to the option writer in return for the right to buy or sell an underlying security at a given exercise price
Call options
Bought when one wishes to gain from an increase in price later. Buying a call option - long call; selling a call option - short call
Put option
Bought when one wishes to gain from a fall in price later.
Buying a put option-long put and selling a put option - short put
American options
Exercised at any time prior to the expiring date
European options
Only exercised at expiration date
Forward contract
Agreement between two parties to buy and sell an underlying asset for actual delivery at an agreed price at some time in the future
OTC instruments
Usually at least $5m
Currencies over fifth
Profit or loss realised at maturity
Contract is completed by actual delivery of the underlying asset
A future contract
A standardised notional agreement to buy or sell a given quantity of an underlying product by a given date in the future at a price agreed now
Exchange traded derivatives
Contract usually 50-100k
Currencies only major
Profit or loss can be realised prior to maturity
Futures vs options
Future market enable traders to take speculative positions
Enable traders to take short positions, that is sell something they don’t own
Futures contract types: bonds, interest rates and currencies
Options Not a commitment No premium to pay Futures gives the user protection from an adverse price movement but they cannot benefit from a favourable movement Risk is unlimited
Interest rate swaps
A contract to exchange fixed payments for floating payments linked to an interest rate, and is generally used to manage exposure to fluctuations in interest rates
Over the counter derivatives
Elements in the swap Fixed rate Variable rate Settlement period Total maturity Underlying national principal
Banks hedging strategies in swaps
Bank may not have interest rate risk, but does have counterparts risk
In providing a market in swaps, banks are exposed to risk until they find someone who wants to do a swap in the opposite directions
Hedging strategies in the risk events
A fall interest rate as it has lent floating and borrowed fixed
A rise in interest rate because it has borrowed floating and lent fixed
Misuse of derivatives
Can create leverage and give rise to contingent liabilities
The pricing and nature of some derivatives is complex
There have been some spectacular trading derivative disasters
