Week 3 Flashcards
Derivative Markets
What are Derivatives?
Derivatives are contracts whose value is derived from
the price of other asset(s) or another contract(s).
What are forwards contracts?
Forwards contracts, roughly speaking, involve buying
something in the future rather than today, but with details
agreed today.
Forward contracts are OTC instruments. Trades take
place directly (usually over the telephone) for a specific
amount and specific delivery date as negotiated between
the two parties.
What are futures contracts?
Futures contracts are essentially more standardised
versions of forwards, so are usually easier, cheaper and
more efficient to use - with some exceptions, e.g.
currency forwards are often more liquid than currency
futures.
Futures contracts are standardised (in terms of contract
size and delivery date). Trades take place in an
organised exchange and the contracts are revalued
(marked to market) daily.
Many futures contracts are traded between market
makers in a pit on the floor of the exchange, of which the
largest is the CME Group (formed from the Chicago
Mercantile Exchange and Chicago Board of Trade).
However, in recent years there has been a move away
from trading by open outcry in a pit towards electronic
trading between market makers (and, even more
recently, through direct trading platforms or brokers over
the internet).
A futures exchange is usually a corporate entity.
Members elect a Board of Directors who decide on the
terms and conditions under which existing contracts are
traded and whether to introduce new contracts. These
are usually subject to approval by the regulatory
authority, which in the US is the Commodity Futures
Trading Commission (CFTC) and in the UK the Financial
Conduct Authority (FCA).
The futures exchange sets the size of each contract, the
units of price quotation, minimum price fluctuations, the
‘grade’ and place for delivery (if the underlying asset is a
physical asset such as a commodity), any daily price
limits and margin requirements as well as opening hours
for trading.
Some futures trading systems are order driven, whereby
the buyers and sellers each enter their desired trades
into a ‘trade queue’ or ‘order book’ and are matched
automatically when a suitable opposing order is entered.
Quote driven systems operate by two-way continuous
quotes offered by competing market makers.
The futures exchanges mentioned in the previous section
also operate as option exchanges, but there are also
large options exchanges which do not trade in futures,
such as the Chicago Board Options Exchange (CBOE).
What are swaps contracts?
Swaps contracts, roughly speaking, are a series of
forward contracts packaged together.
Swap contracts are also negotiated over-the-counter.
The intermediaries in a swap transaction are usually
banks (who act as dealers). They are usually members
of the International Swaps and Derivatives Association
(ISDA) which provides some standardisation in swap
agreements via its master swap agreement. This can
then be adapted, where necessary, to accommodate
most customer requirements.
Uses of Forwards, futures, swaps and options
It is sometimes said that interest rate swaps are traded
between one party having a competitive advantage in
fixed interest rates with another who has an advantage in
floating rate contracts. This is certainly one source of
swaps, but can be only a small portion. The main use of
interest rate swaps and forward rate agreements (FRAs)
by banks and other organisations is for hedging interest
rate exposures from business conducted and the risks
arising from them.
Another significant use of such swaps
is for synthetic lending by banks and hedge funds and
other investors. This is because interest rate swaps
produce similar cash flows to normal bank lending.
A bank typically lends for relatively long terms, typically
receiving a fixed rate, while funding itself short term with
floating rates, e.g. deposits. These floating rates are
typically lower than the fixed rate. The interest rate
swaps markets are one of the biggest markets in the
world.
Financial options, roughly speaking, are like insurance,
whereby one party pays a premium for insurance against
a movement higher or lower in the price of a specified
asset.
What are Swaptions?
Swaptions are options on swaps, i.e., the option to enter
into a swap at some point in future on pre-specified
terms.
Why do investors use Derivatives?
As derivatives markets have grown in terms of the range
of instruments available and their liquidity, they have
become an essential part of the investment landscape. In
many cases, derivatives are more liquid and can be
traded with lower costs than the underlying physical
assets they reference.
Derivatives therefore allow
investment managers to quickly and efficiently overlay an
exposure to the portfolio, thereby allowing for more
efficient portfolio management in addition to more
traditional hedging or speculative positions.
Asset transitions – for example, a target equity market
exposure could be created quickly using futures whilst a
physical equity portfolio is being built up in parallel by a
manager. The futures are sold down as equities are
purchased.
Currency hedging programmes – in many cases an
overseas investor will want to generate returns in their
local currency, rather than gain unintended currency
exposure and more volatile returns. This is particularly an
issue for lower risk assets such as government and
corporate bonds. Currency forwards allow unintended
currency exposures to be hedged.
Leveraged investments – by using derivatives, it is
possible to create a leveraged exposure without entering
into financing agreements and hence with lower costs.
For example, a fund could have economic exposure to
two or three 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.
Long/short portfolios – derivatives allow a portfolio
comprising long and short exposures to be built up,
including on a leveraged basis. Many absolute return
managers isolate particular asset exposures and aim to
access these in their portfolios whilst hedging out other
risks. For example, a manager could go long the US
investment grade credit spread vs the Euro investment
grade credit spread by using credit default swaps. Such
a strategy could additionally make significant use of
derivatives to hedge currency and interest rate risks.
Nonlinear or options-based strategies – options can be
very useful for protection strategies, for example to build
an equity portfolio that is protected against losses
beyond a certain point. A tail hedge would be a more
sophisticated example, where a series of out of the
money options across various markets are held, with the
aim of offsetting losses in an investor’s portfolio in the
event of market stress.
Specialist derivatives expertise is needed before an
investment manager can trade derivatives. This will need
to include suitably skilled personnel in front, mid and
back office roles, as well as risk, legal and compliance
personnel and IT systems to support this activity.
Additionally, a fund that uses derivatives will need to
maintain sufficient collateral to meet margin calls, so this
will create additional operational requirements that need
to be managed.
Derivatives tend to be suited to shorter-term positions or
those requiring the use of leverage. In these situations,
they will usually be significantly lower cost and more
liquid than the physical alternative, provided that liquid
and standard contracts are used. Where derivatives are
held for a long time, or rolled over repeatedly, transaction
costs will increase and physical investment may be more
attractive, particularly if turnover is low.
What does the ISDA do?
Ensuring the enforceability of the netting provisions in the
Master Agreement has been an important part of ISDA’s
activity.
Netting allows long and short (or equivalently bought and
sold) exposure transacted between the same
counterparties to be offset in the event of default, such
that only the remaining net exposure is considered as a
claim against the defaulter.
Its lobbying work in this area
has resulted in a series of laws being passed in many
countries that give legal certainty in those jurisdictions for
netting in the event of default.
The other area where ISDA has been very active is in
obtaining legal opinions on the validity and scope of
netting, and updating those opinions when new products
such as credit derivatives are added under existing
agreements. ISDA’s netting opinions now cover over 50
countries, and in several of those countries there is also
now established case history from actual defaults
involving derivatives.
What are structured investment products?
Structured products are collective investment vehicles
that offer investors a target return profile, typically linked
to a combination of standard indices and often with
variable leverage or protection features. The fund
manager will then hold a collateral portfolio and a
derivative overlay to deliver the target return, which is
traded with a bank.
A common example is an equity-linked return but with a
minimum guaranteed payment of say 90% of the initial
investment after a certain period of time (e.g. 5 years).
Such a profile could be achieved by holding cash plus
long calls, or equities plus long puts. In practice the
returns are likely to be more tailored, and therefore
would be more difficult for an investor to replicate
themselves.
The underlying products tend to be illiquid, even where
they are listed on an exchange or other platform.
However, there can be secondary market liquidity or the
ability to terminate the product early (with penalty to
cover the cost of unwinding the derivatives).
How do we price structured products?
Structured products can be complex to price and value,
since they will often combine multiple asset exposures
with principal protection, reference non-standard indices
or include path-dependent options that are hard to value.
The starting point for pricing structured products will be a
cash or swaps curve to allow a discount rate curve to the
constructed. This will allow any principal protected
components to be valued, before overlaying the
additional risk exposures that will produce any excess
return received.
Banks issuing structured products will maintain various
models to achieve this and will need to make
assumptions for correlations between exposures and
potentially for volatility, particularly where non-standard
asset indices are being referenced. Allowances for
capital charges and hedging costs will also need to be
made, before setting an offer price inclusive of profit and
distribution margins.
If buying a structured product, a portfolio manager will
want to understand the pricing models as
comprehensively as possible.
This may include building a model to price the product
theoretically and also getting market prices for the
underlying components, where possible. At the point of
execution, it would be typical to run a competitive
process, and obtain several prices from the market for
similar structures. This will enable the trader to form a
view on the costs of any one structure, above its fair
value. In addition, from the buyer’s perspective, the
‘costs’ are frequently expressed as a reduction in the
level of protection or maximum return that could
otherwise be earned, rather than as a percentage of the
invested amount. This obscures the level of charges
being paid.
