Notes 3 Flashcards
def of Derivatives
contracts whole value is derived from the price of other assets or another contracts
Forwards contracts
what is it
who uses it
advantage
exemption
- trade takes place directly. (negotiation over the counter)
involve buying something in the future, but the details agreed today.
-intermediaries usually banks.
(they are members of the ISDA) which provide some standardisation in swap agreements via its master swap agreement.
-can be adapted to accommodate most customer requirements
standardised versions of forwards
- cheaper, easier and more efficient to use.
exemption: currency forwards are often more liquid than currency futures.
What are swap contracts
series of forward contacts packaged together
Swaps (small portion of use)
-Interest rate swaps are traded between one party have a competitive advantage in fixed interest rates with another who has an advantage in floating rate contracts. (small portion)
What is the main use of interest rate swaps and forward rate agreements (FRAs) by banks/organisations and other significant use of swap
hedging interest rate exposure from business conducted and risking arising from them.
- synthetic lending by banks, hedge funds, investors. Produce similar cash flows to normal bank lending.
explain synthetic lending by banks
- bank lends for relatively long terms receive fixed rate.
- fund itself short term with floating rates.
- floating rates lower than fixed typically.
- interest rate swaps markets one of the biggest markets in the world.
Financial options what is
one party pays a premium for insurance against a movement higher or lower in the price of a specified asset.
- increasingly using financial option for hedging variable annuity products
- becoming involved in managing the option for exposure for financial institutions.
Swaptions
options on swaps. i.e option to enter a swap at some point in the future on pre specified terms.
lesson from history - guaranteed annuity options
- Equitable Life who had sold customers Guaranteed Annuity options.
- Failed to adaquetly price and provide the cost for these
- Led to collapse of institution
Brief History of derivative markets
- began in Chicago mid 1800s
- grain prices volatile each year
- farmers exposed to general harvest being better than expected - get lower price-
- purchasers at risk of poor harvest - pay higher prices
- contract “to arrive contract” - price agreed in advance for a delivery by a specified date.
- both party reduce risks
- new counterparty risk
- financial derivative used in the 1970s, grown exponentially since then.
- largest market in the world.
- difficult to measure the size, OTC derivatives are private transactions, data not collected.
- measuring size of exchange traded derivative difficult - different nominal sizes.
ISDA Master agreement for OTC
- practicalities of derivatives greatly improved .
- Is the global standard legal document for derivative trades.
- 2 versions: 1992 and 2002 version.
covers more product types and market events.
most updated to 2002.
if not then legal wording added to confirmations in order to cover the differences. - developed by market participants led by the International Swaps and Derivates Association (ISDA)
- reduced the legal + other risks in OTC derivatives
why investors use derivates
- more liquid
- traded with lower costs than the underlying physical assets they reference
- allow investment managers to quickly and efficiently overlay an exposure to the portfolio.
- allow for more efficient portfolio management
- asset transitions - target equity market exposure could be created quickly using futures, whilst a physical equity portfolio being built up in parallel by manager. Futures sold down as equities are purchased.
- currency hedging programmes - an overseas investor want to generate returns in their local currency. issue for lower risk assets, government and corporate bonds.
Currency forwards allow unintended currency exposure to be hedged- - leveraged investments - possible to create a leverage exposure without entering into financial agrememtns and hence with lower costs.
eg fund could have economic exposure to 2/3 times an equity index by entering into total return swaps on the index and holding the capital in high quality cash for margin calls and liquidity .
many more examples in notes
derivative expertise + additional stuff that has to be done
needed before an investment manager can trad derivatives.
- include suitably skilled personnel in front,mid and back office roles.
- risk, legal and compliance personnel.
-IT systems to support this activity. - fund that uses deviates needs to maintain sufficient collateral to meet margin calls. Create additional operational requirements -need to be managed.
Who do derivates tend to suit?
- shorter term positions
-or requiring the use of leverage - significantly lower costs
- more liquid than physical alternative
(provided that liquid and standard cosbtacts are used) - if held for a long time, or rolled over repeatedly, transaction costs increase.
- physical investment may be more attractive (especially if turnover is low)
What are the derivative markets, which one is recommended to be used and why?
exchange traded derivates
OTC derivates
- regulators encourage derivative market participants to use exchanges or to centrally clear transactions.
- to improve transparency
- reduce counterparty risk.
- regulators require banks to hold additional capital in respect of the OTC derivative transactions
exchange traded derivatives
- increased the no. of products offered
- focus on standardised derivates
- high levels of supply/demand + liquidity .
OTC derivative
- bileteral transaction between two counterparties. eg bank + client.
- each party exposed to credit risk of their counterpart to the trade.
- price moves - sufer gain, suffer loss,
- create risk - loss making counterparty will be unwilling or unable to make good on its obligations when the contract expires.
- mitigated through collaterisation.
- suffer loss - provide collateral to cover their loss making position with their counterpart.
- can be cleared through a clearing house - increasingly the case for standard contracts.
ISDA roles
- enforceability of netting provisions in the Master Agreement.
lobbying work - result laws passed in many countries , give legal certainty in those jurisdictions for netting in the event of default. - obtain legal opinions on the validity and scope of netting.
updating these opinions when new products are added under existing agreements.
what does netting allow
allow long and short exposure to be transacted between the same counterparties to be offset in the event of default.
future contracts
- standardised
-take place in an organised exchanged - contracts revalued daily.
- many traded between market makers in a pit on the floor of exchange.
- move away from trading in an open outcry and use electronic trading
eg NYSE life operatives exchange traded derivates markers in a number of cities.
future exchange
- corporate entity
- members elect board of directors
- decide on the t&c on which existing contracts are traded and whether to introduce new contracts.
- subject to approval by the regulatory authority
US - Commodity Futures Trading Commission (CFTC)
UK- the Financial Conduct Authority (FCA)
- set the size of each contract
-units of price quotation
-minimum price fluctuations - grade
-place of delivery
-any daily price limits
-margin requirements
-opening hours for trading
some future trading systems are order driven
buyer/seller enter their desired trades into trade queue/order book-
- matched automatically when a suitable opposing order is entered.
some future trading systems are quote driven systems
two way continues quotes offered by comeptiting market makers.
what is happening to futures trading
becoming more global
CME GLOBEX provides an “after hours” electronic trading system.
GLOBEX - does not automatically match buyers and sellers - provides price information to traders only.
OTC market in options
includes nearly all complex or exotic options.
- very large.
-tailors the option contract to the buyers spec
-secondary OTC markets exist
Expiry Dates
-fixed by exchanged
-most options traded for expiration on the third Friday of the expiry month.
-more volume in March,June, September and December expiry.
-expiry dates for options on individual stocks - entend to nine months.
-some exceptions - major market indices - 2 years or longer
Option Strike Prices
set according to agreed conventions.
-USA set at intervals of €2.50, when underlying stock price less than 25, 5 if between 25 and 200, and 10 if over 200.
-set below and above the current stock price
-as stock prices move up/down, new stock prices added
what happens if buyer exercises an ooption
broker notifies the clearing firm.
clearing firm places an exercise order with the clearing house who assigns a trader who has written a similar contract.
- may be random assignment, first in, first out rule
Advantage of buying a corporate bond vs selling a CDS
- greater range of durations is often available in CDS Market
- liquidity typically greater
- CDS are unfunded, enabling geared positions to be taken
-CDS markets are more standardised
Disadvantages of buying a corporate bond vs selling a CDS
-liquidity is dependent on the market makers making good markets - problematic during times of market stress.
-the correlation between the prices of each is not stable during times of market stress - create a basis risk
-Collateral arrnagements need to be made.
- Counterparty risk is introduced -clearing houses are typicaly being used to remove this risk.
Eg using London Clearing House
Buying a corporate bond versus selling a CDS
-capital charges in a bank usually similar.
- basis risk created when using derivates to hedge cash funds can be very significant.
eg significant rise in the Libor OAS spread during financial crisis.
Using derivatives to increase off-balance sheet lending
- banks profitability limited to the size of its balance sheet
-larger balance sheets allows more loans (increase profits),
-Derivates allows banks to create further leverage beyond balance sheet, create higher profits.
-Selling CDS can create synthetic lending, as cashflows similar to loan, but with additional credit spread in the margin.
What are structured products
- collective investment vehicles that offer investors a target return profile
Advantages of Structured investment products
- principle protection can be very attractive to some investors.
-can obtain a very tailored investment return
-can be more tax efficient than underlying investments in some cases.
-structured products usually lower volatility than the underlying assets, but with scope to participate in rising equity markets.
Disadvantages of Structured investment products
-Counterparty or credit risk (particularly if issued as an uncollateralised note)
-low liquidity - may need to unwind exposures pre-expiry, an investors cost.
- complex underlying structure, with opaque pricing.
-embedded fees can be high
Pricing and Valuation of structured products
- complex to price and value
-combine multiple asset exposures with principle protection, reference non stranded indices or include path dependent options (hard to value)
- starting point: cash or swaps curves to construct a discount rate curve.
-which will allow any principal protected component to be valued, before overlaying the additional risk exposures
-banks use various models to achieve this.
-make assumptions for correlations between exposures and potentially for volatility.
-allowance for capital charges and hedging costs will be made.
-set offer price inclusive of profit and distributions margins.
if buying a structured product what will the portfolio manager want to do?
- understand the pricing model very well
- include building model to price the product theoretically,
-get market prices for underlaying components,
-at point of execution - run a competitive process and obtain several prices from market
