Topic 7: Derivitives Market

Question 1

What is a derivative?

Answer 1

A financial asset that derives it value from some other asset.
Used to manage risk.

Question 2

What is are the 4 most basic types of derivatives?

Answer 2

1) forwards
2) futures
3) options
4) swaps

Question 3

What is a forward?

Answer 3

This is the fundamental derivative product, the others (options futures swaps) are variations.

• an agreement to buy/sell a quantity of an asset, at a set date in the future for an agreed price
• reduces risk and uncertainty ex: if you are buying a commodity like wheat (farmer cannot sell it till it’s harvested) and you know what the price is today and is exposed to the risk that the price may increase in the future. You enter in to a forward contract with the farmer to pay $7 per bushel, even though it is $6 today.
• say the price increases to $8 in the future, you have both hedged against the loss.
• the downside is that the downside. loss has been hedged but so has the ‘upside’ risk, the farmer cannot make a profit from the increased price.

Question 4

What are the advantages of the forward contract?

Answer 4

• risk is hedged
• forward contracts are negotiated directly between 2 parties so there is lots of flexibility in their structure.
• can be based on any amount, for any commodity at any specified time.

Question 5

Disadvantages of forwards?

Answer 5

• One party may be worse off (May want to enter into a FRA)
• if one party changes it’s mind then the contract is extremely difficult to get out of
• sometimes it’s difficult to find a willing counter party with the exact same needs to perfectly hedge the position
• will need a broker to negotiate costs nod this incurs a fee
  – can find a financial institution to perform the role of intermediary
• they will quote 2 way prices, the spread will be costly and make forward contracts expensive

Question 6

What is a forward rate agreement?

Answer 6

Not just for currencies and commodities but any price, rate or index. Can hedge the risk to both parties, rather than one.

• used to manage risk
• (FRA) is commonly used to lock in IR’s by an organisation looking to borrow for invest in the near future
• they can lock in the interest rate, always less than 12 months (short term)
• the FRA is quite separate to the intended borrowing or investing, it simply a compensatory payment to the party that gets the lessor deal.

Question 7

For example: FRA?

Answer 7

• company A want to borrow $1 mill, over 1 year, in 6 months
• company B wants to invest $1 mill for 1 year in 6 months
• current IR is 6%
• if IR rise by 1% the company A (borrower) will be 100 grand worse off
• if IR falls to 5% company B will be a 100 grand worse off
• if they enter into a Forward rate agreement then they lock in the IR at 6%
• the party that does not benefit gets a compensation from the party that does benefit, so the effective IR for them both is still 6%.

Question 8

What is a future?

Answer 8

Similar to forwards however they are more standardised.

• available on particular commodities (gold/wool/oil of a particular purity)
• only available for particular amounts (100oz of gold,1000 bales of wool, 1000 barrels oil etc)
• specific maturity dates (15th day of March, June,September, December)

Question 9

Advantages of futures?

Answer 9

-Because they are so standardised there is a secondary market for buying and selling futures.
This service is provided by the Sydney Futures Exchange
- because of the standardisation they are easy to unwind
- you can just sell an identical contract to get out of the position
- this will neutralise your position and you have no further obligation

Question 10

What does it mean to ‘go long’ with futures?

Answer 10

This means you are buying a contract.

You are entering into a Contract to buy the underlying asset for the agreed price on the date of maturity.

Question 11

What does it mean to ‘go short’ in a futures contract?

Answer 11

If you go short you are selling a futures contract.
You are agreeing to enter into a forward contract to sell the asset in the future.
(Remember - a future contract is a type of forward contract)

Question 12

An example of a futures contract?

Answer 12

Suppose you buy a contract on 30th April 2013, no money has changed hands but the agreement is to b 100oz of gold at the forward price of $360 on 15th Sept 2015.

1st scenario:
You buy the gold (100oz @ $360 oz) at the maturity date

2nd scenario:
You close out your position by selling a gold futures contract. You have no liability under the contract and the difference (spread) at which you bought the contract and sold it will determine your profit/loss.

Your decision to sell would be influenced by a rise or fall in gold prices.

Question 13

Uses for futures?

Answer 13

• hedging

- speculation (no existing risk present)

Question 14

What is a margin call?

Answer 14

When you buy or sell you must deposit an amount of money into a margin account.
Changes in the contract over the day will change the value of your contracts and you margin account will be adjusted accordingly.
If it drops to half it’s value you must ‘top it up’, if you fail to do so then the exchange may close out your position.

Question 15

How are futures settled?

Answer 15

In cash.
The profit or loss comes from closing out their position in the market.
You do not have to take large deliveries of commodities nor acquire them.
Less than 2% of futures contracts are settled by physical delivery.

Question 16

What are options?

Answer 16

This is a contract that gives the buyer(or holder of the option) the right but not the obligation to buy an underlying asset at the agreed price on or before a future date.

The writer (seller) of the option doesn’t have any options and must perform the contract if the option is exercised.

Question 17

What is a call option?

Answer 17

Gives the buyer of the option right to buy the underlying asset.

Question 18

What is a put option?

Answer 18

Gives the buyer the right to sell the underlying asset.

Question 19

What is a European option?

Answer 19

When the the option can only be exercised ON the MATURITY date

Question 20

What is an American option?

Answer 20

An option that can be exercised ON or BEFORE maturity date.

These are different terms for historical reasons, both types can be found in all types with American options being the most popular in Australia.

Question 21

What does it mean if an option is ‘in the money’?

Answer 21

If the difference in price of the asset and the exercise price is such that you could sell the the contract now and make a profit, then it is ‘in the money’.

Question 22

What does it mean if the option is ‘at the money’?

Answer 22

If the asset price and exercise price are equal then it is ‘at the money’.

Question 23

What if the option is ‘out of the money’?

Answer 23

Then the difference between the asset price and the exercise price, if it were to be sold immediately, would yield a loss. Therefore it is ‘out of the money’.

Question 24

Example of in, out and at the money for options?

Answer 24

You buy an option that gives you the right to sell a BHP share. The exercise price is $25 and maturity is 1sept 2013.

If the share was more than $25 this is considered out of the money. You wouldn’t sell the share for $25 if was now worth $30. You would be realising a loss of $5.

If the share dropped to $20, then you would be in the money. If you sold now you realise a $5 profit.

If the share price and the exercise price remained at $25 each you are ‘at the money’.

Question 25

Uses for options?

Answer 25

• allows the buyer to take advantage of price movements

- options can be written over commodities

Question 26

Nature of the options market?

Answer 26

• can be bought and sold over the counter OTC
• or be exchange traded options ETO

OTC are negotiated between buyer and seller
ETO are standardised and traded on secondary markets like ASX

Question 27

What is a swap?

Answer 27

It is an agreement between 2 parties to swap a series of payments to their mutual benefit.

Question 28

Name three common types of swaps?

Answer 28

• interest rate swaps
• currency swaps
• commodity swaps

Question 29

What is an interest rate swap?

Answer 29

‘Plain vanilla swap’

• one party wants to borrow at a floating rate
• another party wants to borrow at a fixed interest rate
• each party, pay to the other, what they would prefer to pay - is swapped,they swap interest payments.
• no principle is involved, just the IR payments.

Question 30

An example of swaps?

Answer 30

Company A wants to borrow at a fixed rate, but has a comparative advantage in the floating rate market

Company B want to borrow in floating rate market but has a comparative advantage in the fixed rate market.

Solution:
They construct a swap, so each can borrow in the preferred market then exchanges cash flows so they are effectively paying each other’s interest. They do not literally pay each other’s interest,,only the net difference between the payments is swapped.

This depends on the prevailing rates - LIBOR London interbank offer rate

Question 31

What is a currency swap?

Answer 31

More complex than interest rate swaps because the amounts are borrowed in different currencies.

In this case the principle must be swapped.

Each currency value will probably change over the life of the swap.

THIS IS NOT the same as an FX swap. It is an exchange of currencies and interest payments over the life of the swap.
An FX swap is the simultaneous purchase and sale of a currency in the spot and forward FX markets.

Question 32

Example of a currency swap?

Answer 32

Company A is an Aussie company wanting to borrow and invest NZD $1.5 mill in New Zealand.

Company B is a New Zealand company wanting to borrow and invest AUD$1million in Australia

The Australian company can get a cheaper IR in Australia . The NZ company can get cheaper IR in NZ but not in Australia.

Solution:
The create a swap contract so each can get access to the cheaper rate.

Step 1. - they exchange principles
Step 2. - they exchange the interest payments on the loans
Step 3. - they re-exchange principles.

Result: each company gets access to the cheaper rate

Question 33

What is a commodity swap?

Answer 33

This is used to protect against disadvantageous movements in commodity prices.

They agree to swap a fixed amount (the swap rate) for a floating amount based on a benchmark. The benchmark measures the changes in the price of the commodity.

Only the difference in the the amounts actually change hands.

Question 34

Example of a commodity swap?

Answer 34

Company E produces oil and wants the rice to be high, Company F is an airline and wants the oil prices to be low.
The 2 companies can use an oil swap to effectively fix the price for both of them.
The benchmark will be the West Texas Crude Oil price which is published daily.

The agreed swap rate may be the day the swap commences. If the price of oil rises, hurting the airline but rewarding the oil company then the oil company will compensate the airline for the amount. An vice versa.

A disadvantage of this process may be the quality if the product may not match up, known as a grade mismatch. One product may be inferior to the other.

Question 35

What is a credit default swap? CDS

Answer 35

It gives protection against credit risk.
Credit risk is the possibility that a obligor will not meet a commitment.
This may be either not meeting the interest payments or not repaying the principle.
It transfers the credit risk from the protection buyer, to the protection seller on payment of a periodic premium.
The protection seller will compensate the buyer if default occurs.

Question 36

Who provides CDO (credit default swaps)?

Answer 36

Insurance companies
Banks
Investment managers
Hedge funds

CDS figured prominently in the GFC and these derivatives have fallen not he Australian market by 50%

Question 37

How are derivatives used?

Answer 37

• these are wholesale markets
• minimum amounts begin in the $100’s of thousands
• financial institutions and corporations use these products
• usually used to hedge risk
• also used for speculation and arbitrage
• can be traded on the ASX or OTC or via a central exchange ETO’s