DERIVATIVES MARKETS

TOPIC 1: Derivative Instruments and Markets

1.1 INTRODUCTION

The Nature of Derivatives

- Derivative products have different names such as contingent claims, forwards, or derivatives.
1. The concept of derivate comes from the fact that their value derives from the value of another
asset (the underlying asset). Per se, a derivative has no value detached from the underlying asset.
2. The concept of forward relates to the moment in which the actual transaction takes place
(purchase or sale). In the case of derivatives, it always takes place in the future, therefore the
concept of forward.

Types of derivatives
FUTURES AND SWAPS OPTIONS
FORWARD
CONTRACTS
Obligation to buy or sell Obligation to exchange cash- Right to buy or to sell
flows
Symmetrical profile of Symmetrical profile of gains Asymmetrical profile of
gains and losses and losses gains and losses
Present value equals zero Present value equals zero Present value is always
positive

The concepts of symmetry and asymmetry of gains and losses have important implications for pricing.

Examples of Underlying Assets or Goods

Financial Assets:
- Stock index
- Government bonds
- Interest rates
- Currencies
Commodities:
- Agricultural products: corn, soybeans, wheat, sugar, etc.
- Precious metals: silver, gold, platinum...
- Industrial metals: copper, aluminium...
- Energy products: crude oil, gasoline, natural gas, electricity
Other types of underlyings:
- Credit risk
- Weather
- Cryptoassets
 1.2 DERIVATIVE MARKETS

This represents the most classical structuring of financial markets, but even in this simple case there is an
important overlapping between the different market segments:

- Where are Commodities? (real, not financial assets… derivatives are financial assets)
- Money market and derivatives markets
- Insurance and derivatives

CASH AND DERIVATIVES MARKETS

- Cash or spot markets:

When an investor trades in a cash market:
 The trading price is the current spot or cash price s0;
 The transaction, payment (buyer) and delivery (seller) of the asset, takes place one or two
business days from trade date at Ts.
- Forward or derivative markets:
When an investor trades in a forward market:
 The trading price is the current forward price f0;
 The transaction, payment (buyer) and delivery (seller) of the asset, takes place in a future
pre-determined date Tf

MARKET SEGMENTATION ACCORDING TO ORGANIZATION

- Exchange markets
 In order to maximize the number or trades these markets present a high level of standardization,
transparency, liquidity and present no counterparty risk (prêt-a-porter markets).
 It is a competitive market working with an auction system, in which trading floors have been
losing importance relative to electronic platforms (e.g. NYSE vs. NASDAQ).
- Over-the-counter markets
 Contrary to ‘organized’ markets there may be a low level of standardization and as a result OTC
markets tend to be less transparent, liquid and may present counterparty risk.
 Market agents are free to negotiate directly non-standard amounts, maturities or dates (tailor-
made markets).
MARKET ORGANIZATION-CHARACTERISTICS

Exchange traded markets Over-the-counter markets

Negotiation in a centralized market Direct negotiation between the dealers
(exchange), auction system
Standardization Personalization (tailor made)
Liquidity and transparency Low liquidity
No credit risk There is some credit risk
Tradability of the instruments (there is a No tradability of the instruments (there is
secondary market) no secondary market)
Derivatives and settled daily Derivatives are usually settled once as its
expiry

MARKET ORGANIZATION-INSTRUMENTS

MARKET ORGANIZATION-SIZE

The following plot shows the size of exchange traded and OTC markets from Jun 1998 to June 2014:
- The figures for the exchange traded market represent the value of underlying assets;
- The figures for the OTC market represent total principal amounts.

MARKET ORGANIZATION-CONCLUSIONS

- The differences between the OTC and exchange traded markets are substantial and very important,
however, some of these differences are being partially eliminated.
- In the aftermath of the recent financial crisis and of the recent rate fixing scandals (i.e. Libor and FX
Markets), regulators targeted the OTC markets to try and create the conditions to prevent the
emergence of similar problems.
 Underlying the financial crisis there were several OTC derivative instruments that have triggered
a wave of defaults (e.g. AIG).
 Regulators observed that no similar events were taking place with exchange traded derivatives
due to the fact that central clearing eliminates credit risk.
- Regulators acted in forcing changes to OTC markets which had a major impact on the trading of
OTC products:
 Regulatory changes that bring OTC and Exchange traded derivatives closer
 Migration from the OTC to the exchange traded markets.

REGULATORY CHANGES TO THE OTC MARKETS

- OTC derivatives were a main target of legislation given their size, importance and role in the recent
crisis (e.g. CDSs).
- The Dodd-Frank Act (US) requires that:
o All standardized derivatives have to be cleared through central clearinghouses;
o Collateral or margin requirements have to be set on these contracts;
o Completed trades have to have their prices made public.
- In 2012, the EU adopted the European Market Infrastructure Regulation (EMIR) with the following
objectives:
o Increase transparency: reporting requirements were introduced in the OTC markets;
o Mitigate credit risk: all standardised OTC derivatives contracts must be centrally cleared
through CCPs
o Reduce operational risk: market participants need to monitor and mitigate the operational risks
such as fraud and human error.

FUTURIZATION OF SWAPS

- Recognizing the similarity between many swaps and futures contracts, major players have started
‘transforming’ swaps into futures (e.g. Intercontinental Exchange (ICE), Goldman Sachs).
- The move into the futures is explained by:
o Regulation on futures is tried and tested whereas on swaps a great part of the regulatory
body is still untested and in many cases even undefined;
o Margin requirements on futures are lower than on swap contracts;
o The regulatory and compliance obligations of swap traders are more strict than those of
futures traders;
o Reporting obligations on futures trades are more lax than those applied to swap trades (real
time for swaps vs 10m for futures);
o Pricing information is a big business for derivatives exchanges, migrating swaps into futures
will translate into higher profits;
o Swaps can be cleared in any clearinghouse, whereas futures have to be cleared on the
exchange clearinghouse.

FUTURIZATION OF SWAPS

- The central clearing requirements eliminate the risk of having a repeat of the Bailout of the US firm
AIG, however:
 Little has been done to implement most these rules apart from central clearing (e.g. see
 SwapClear and ICE Clear Credit);
 Not all the problems are solved, and new problems were created;
 Regulators are slow to act due to geographical regulatory fears.
- The futurization of swaps is not entirely unexpected and maybe was intended by regulators;
- However, further developments of regulation are expected to avoid geographical and regulatory
arbitrage and to address other problems:
 Transparency and pricing efficiency;
 Separation between exchanges and clearinghouses;
 Harmonization of margin requirements.
 1.3 FUNCTIONS AND DERIVATIVES

FUNCTIONS OF DERIVATIVES

- Derivatives have developed out of an unsatisfied need and of the existence of fundamental and basic
economic problems within businesses and the economy.
- In the chapter that addresses the determination of forward prices we analyze how some problems in
farming were mitigated by the development of forward contracts.
- Amongst the main functions of derivatives, we have:
1. Risk Management
2. Price discovery
3. Increased market efficiency and access to unavailable assets or markets
4. Reduction in the volatility of the underlying asset prices

RISK MANAGEMENT

- Risk management is one of the four main corporate financing decisions. The other three are:
 Investment decisions
 Financing decisions
 Shareholder remuneration decisions
- As with all financial decisions, the purpose of risk management is to create value, value creation with
risk management is achieved mainly through:
 Reduction of financial distress costs;
 Reduction in taxes;
 Reduction in agency costs.
- The risk mitigating role, and the process of value creation are addressed with more detail in
International Corporate Finance.

PRICE DISCOVERY

- Derivative markets serve as an important source of information about prices. Prices of derivative
instruments such as futures and forwards can be used to determine what the market expects future
spot prices to be.
- The price discovery process benefits from the existence of derivatives in the following ways:
 Derivatives markets present more investors, more information and more transparent information
about prices, when compared to most cash markets. Sometimes derivatives prices influence cash
prices and not the other way round (lead-lag relation).
 The derivative price formation mechanism:
‒ Includes all kinds or costs and benefits of holding the underlying asset, making it a complex
price, that considers a multitude of factors that are able to affect the evolution of the cash market
prices.
‒ Relies on non-arbitrage mechanisms, insuring that given current observable prices and costs
the forward price is a fair price.
- Due to these aspects, derivatives are frequently used to determine the price of the underlying asset.
For example, the spot prices of the futures can serve as an approximation of a commodity price.

INCREASED MARKET EFFICIENCY AND ACCESS TO UNAVAILABLE ASSETS

OR MARKETS
- The trading of some underlying assets is usually restricted to industry players, notably in the case of
commodities.
- If no derivatives exist, only existing industry players are able to profit from trading inthese assets.
o Without derivatives, e.g. to benefit from increases in the price of oil one would needto have
storage facilities for oil.
o With derivatives, all investors can benefit from changes in prices even if they do not belong or
have a direct interest in the industry. With derivatives, we can all invest in oil, soybeans, gold,
credit performance, etc.
- The creation of derivatives brings more investors to the market and higher volumes of trade. New
investors are attracted by different reasons:
 Investors feel safer investing in an underlying asset that has price insurance instruments.
 Short positions are easier to take with derivatives.
 Derivatives are levered instruments, therefore investors are able to achieve the same level of
exposure with lower initial investments(aspect further developed in this chapter).
 For speculators, derivatives also allow investors to profit from different expectations:
o Prices going up; o Prices going down;
o Prices becoming more volatile;
o Prices becoming less volatile;
o Differences in prices.
 For arbitrageurs, derivatives allow the identification of more arbitrage opportunities: o Between
the cash and derivatives markets; o Within the different derivative products.
- The increase in the volume of trading brings:
 ‒ Higher liquidity than most cash markets;
 ‒ Lower transaction costs when compared to cash markets;
 ‒ Higher efficiency in prices that is easily recognizable in a narrowing of bid and ask spreads.

REDUCTION IN THE VOLATILITY OF THE UNDERLYING ASSET PRICES

 The existence of derivatives is known to affect the prices of the underlying asset. They do it in
different ways.
- A direct way was previously mentioned. By attracting the attention of arbitrageurs, derivatives
increase price efficiency, reduce bid and ask spreads and bring morestable prices.
- The second way is by releasing pressure from the asset prices when investors have expectations
of future increases or decreases in prices.
 As so, assets that have derivatives trading tend to present lower volatility than assets that have no
derivatives trading.

Consider the following example:

• A fund manager currently holds a large portfolio of shares and expects the markets to go down. Two
strategies are available:

A. Expecting a decrease in the price of shares, he decides to sell part of his holdings to reduce losses and
protect himself from a market downturn. However, when he sells his holdings, by putting pressure of the
offer of the shares, he will actually drive the prices down.

B. The investor does not sell the shares, instead he sells futures on the shares or buys put options on those
shares. By acting with derivatives to protect against a possible decrease in prices, this investor did not sell
the shares and by putting pressure on the offer side, he did not push the price of his holdings down.

• Strategy A without derivatives would lead to a decrease in the price of the cash market asset. Strategy B
that uses derivatives, achieves the same level of protection without pushing the prices down.

1.4 INTERVENTION WITH DERIVATIVES

POSITIONS ON DERIVATIVE PRODUCTS
Contrary to many cash market instruments, with derivatives everyone can assume long and short
positions.

 A short position implies selling;

 A long position implies buying.

As with short-sales in cash markets, investors do not need to own an asset to be able to sell it. The
important aspect to retain is the profile of the profits that an investor is exposed to, when going short or
long.

LOW POSITION

Whenever an investor profits from increases in the price of an asset the investor is said to be long.

SHORT POSITION

Whenever an investor loses from increases in the price of an asset, the investor is said to be short.

LONG AND SHORT POSITIONS

An investor is said to be long with respect to an An investor is said to be short with respect to
asset when an asset when
It owns the asset It short-sold the asset
Bought a forward or a future on the asset Sold a forward or a future on the asset
Is currently producing or will produce the asset Has to buy the asset in the future.
Has to sell the asset in the future

TYPES OF INTERVENTION

Speculation: market intervention based on expectations (e.g. prices will go up or prices will go down),
with an aim at generating risky profits from assuming a risk exposure. Speculating implies opening a long
or a short position aimed at profiting from increases or decreases in the prices.
Arbitrage: market intervention with no expectations. It aims at generating risk free profits from exploiting
a market inefficiency (e.g. violation of the law of one price). Arbitrage implies opening a long and a
simultaneous short position and it does not imply the use of own funds.

Hedging: market intervention aimed at reducing or eliminating risks. Hedging usually implies assuming a
position contrary to an existing open speculative position (e.g. long-short, short-long), so that the loses of
the speculative position are compensated by the gains of the hedging position.

SPECULATION – ONE POSITION OPEN

ARBITRAGE-TWO SIMULTANEOUS POSITION OPEN

Investor has no expectations → Identifies that S1<S2 and goes long in S1 and short in S2 (buy cheap,
sells expensive).

HEDGING – TWO POSITIONS OPENED SEQUENTIALLY

Investor has fears of price decreases in S1 of being long → Goes short in S2 to compensate potential
losses in S1 .

TYPES OF INTERVENTION

• Arbitrage in derivatives is important because :

o It represents the basic principle of derivative pricing, arbitrage is akin to the “law of gravity” of
finance;
 o All derivatives are priced indirectly through synthetics and then non arbitrage is assumed.

• Hedging in derivatives is important because:

o It represents the purpose of why derivatives were created;

o It represents the practical application of what are essentially price insurance instruments.

• Speculation in derivatives is important because:

o Increases volumes of trade, therefore reduces bid-ask spreads and brings efficiency to the
markets;
o Allows trading in assets that are out of the reach of normal investors (e.g. derivatives on
commodities);
o Allows trading in the same asset with more security than in other markets (e.g. futures on
bitcoin).

HEDGING AND ARBITRAGE WITHIN MARKETS (INTEREST RATE DERIVATIVES)

1.5 DERIVATIVES AND RISK

• Derivative products are importantly linked with financial risk.

A. Without risky exposures there is no need for derivatives:

o Derivatives exist because of risk. Consider the case of FX products, until the early 70’s there were no
derivatives on FX products, because exchange rates were set and reviewed by the IMF.
B. Derivatives in their genesis are essentially price risk insurance products:
o They allow to mitigate or eliminate risks (hedging);
o They allow to generate profits from specific risk exposures (speculation).
C. Contrary to cash products, derivatives are a zero-sum game:
D. The profits of one party always imply equal losses for one or more parties. In cash markets all
participants may theoretically win (e.g. consider that prices keep on rising). – Most derivatives
positions are exposed to credit risk and this risk needs to be addressed. D. Speculative positions in
derivatives are riskier than speculative positions in cash market instruments due to a leverage effect.

WHAT IS RISK FOR US?

• The concept of risk can be defined as “the probability that an outcome may be different from what was
expected”.
• In terms of investment theory, risk refers to the uncertainty regarding the rate of return on a given
investment.
• Therefore, in finance, risk usually is measured by the standard deviation, or variance, of future expected
returns.
• The concept of risk does not have a negative charge per se, because it translates into potential gains and
losses:
o The realized returns may be lower than expected (downside danger);
o The realized returns may be higher than expected (upside potential)

UPSIDE POTENTIAL AND DOWNSIDE DANGER

• In the purchase of any asset (investment – long position) we are exposed to risk that the value of the
asset may change:

- The value of the asset may go up in the future (upside potential);

- The value of the asset may go down in the future (downside danger);
- The widest is the range of possible changes in the value of the asset the highest is the risk of this
asset.

RISK

The risk as we defined it previously is the most standard measure of risk, and we will be using it
extensively when dealing with financial options. However, there are several overlapping types of risks,
that can be categorized according to its nature, origin, frequency or impact:

- Market and idiosyncratic risk;

- Operational and financial risk;
- Continuous risk and event risk.

There are also different ways to measure the risks:

- Dispersion measures: standard deviation;

- Covariance measures: covariance and correlation coefficient;
- Value at Risk: dispersion measure focusing on maximum losses;
- Expected shortfall: volume of losses.

ADDRESSING THE CREDIT RISK OF DERIVATIVES

• The clearing house, the marked-to-market mechanism and the margin accounts serve as guarantors of
security:
- Trades in derivatives exchanges have no counterparty risk;
 - Potential profits and losses in the OTC or cash markets are made real in exchange traded
derivatives due to the marked-to-market mechanism.

ADDRESSING THE CREDIT RISK OF DERIVATIVES

• The margins make the mark-to-market mechanism an effective daily settlement process:

1. Need to open a margin account with the broker;

2. Make an initial margin deposit (credit letters, shares and debt instruments are allowed);
3. The margin account is debited (credited) daily as a function of the gains (losses) in the derivatives
positions (marked-to-market mechanism);
4. Make margin calls to top up the margin account to the initial margin level, whenever the margin
account balance falls bellow the maintenance margin;
5. Whenever the client does not top up the margin account the position is closed.
6. Whenever the margin account balance is above the initial margin, the trader can withdraw funds from
the margin account.

• Two levels of security: A simillar margin mechanism applies between the broker and the clearing house.

An investor acquired at $100/bu., 2 corn future contracts each for 5,000 bu. For June. The initial margin
represents 5% of the total value of the contract and the maintenance margin represents 3.75% of the total
value of the contract.

- The total value of the contract is $100 x 2 x 5,000 = $1,000,000

- The initial margin is $1,000,000 x 5% = $50,000
- The maintenance margin is $1,000,000 x 3.75% = $37,500

- Additionally, to the margin account, mark-to-market mechanism and centralized clearing we also
have:
- Intraday margin calls when volatility is very high;
- Access to a common fund built to address counterparty risk;
- Possibility of the derivatives exchange to levy taxes on its clients (was never used until today).
-
(E)DERIVATIVES ARE LEVERED ‘INVESTMENTS’
• Leverage is a general concept in Finance, most notably in Corporate Finance:
• It may refer to the combination of debt and equity that finances a firm and it is defined as financial
leverage;

• It may refer to the level of operational fixed costs and it is defined as operational leverage;

• With derivatives it refers to a similar concept in terms of the outcome, but it does not imply the use of
external funds or the existence of fixed costs;

• Leverage with financial derivatives refers to the possibility to obtain a large risk exposure than the
actual funds initially invested.

DERIVATIVES ARE LEVERED “INVESTMENTS”

- As we haver seen previously, derivative trading only implies the payment of a margin deposit, wich
is considerably lower than the economic exposure assumed
- Consider the previous example of a purchase of futures contracts where:
 The investor bought 2 futures contracts
 His economic exposure was $100*2*5000=$1000000
 For which he only paid $1000000*5%=$50000
- The leverage ratio L for this investment is calculated as:

- The leverage of this investment is equal to 20, which means that the economic exposure is equal to
20 times the investment initially committed.
- Naturally, the higher is leverage the higher are the risks of the investment.
- The leverage ratio is what explains why derivatives have higher risks (volatility) than their
underlying assets.
- We may calculate a similar leverage ratio for options, however, since options are nin linear in their
gains and losses profiles, the leverage ratio needs to be adjusted by a factor called Delta
- For the purpose of understanding leverage the delta value of an option in the ratio at which the price
of the option moves compared to the price of the underlying asset (eg)
- The leverage ratio L for options is calculated as: