Derivatives
Def. derivative
A derivative is an instrument whose value depends on or is derived from the value of another asset.
- Examples: futures, forwards, options, swaps etc.
- Underlying assets: equities, stock indicies, currencies, interest rates, commodities, debt instruments, electricity, weather
Derivatives are used for: Heding risk, speculation, arbitrage
Trading derivatives:
- Exchange traded markets:
- Trade standardized contracts that have been defined by the exchange
- Example: Chicago Board of Options Exchange (CBOE)
- Over-the-counter (OTC) markets:
- Traders contact each other & negotiate a mutually attractive deal
- Larger than the exchange traded market in terms of total volume (about ten times)
- After the financial crisis of 2007-08, some standardised derivatives contracts must now be cleared through CCPs (Central Clearing parties). CCPs do for the OTC market what exchange clearing houses do for the exchange-traded market.
- Disadvantage: Credit risk when cleared bilarterally, and worse if uncollateralised
OTC Forward Contracts
Definition
An agreement between two counter parties to buy/sell an asset at a fixed future time (maturity, ) for a fixed price (delivery price, K)
- Forward contracts can be contrasted with spot contracts
- Spot contract: An agreement between two counter parties to buy/sell an asset today for a fixed price (should equal to the price in spot makert)
- Forwards are OTC contracts (normally) between two parties
- No money changes hands when entering the contract
- The contract is settled at maturity (when money changes hands)
- Marked to market by collateratization if cleared centrally
- If uncollateralised, banks need to keep capital reserve for potential defualt and (credit) value at risk
Example
The farmer is worried that the price of wheat may fall. The bread maker is worried that the price of wheat may increase. They both want to lock in the price of wheat today.
Terminologies
- Underlying asset: The asset that underlies the agreement.
- It has a spot price
- It can be any asset (equity, stock index, bond, commodity …)
- Maturity: The future time when the transaction takes place.
- Delivery price: The fixed price at which the deal will be executed.
- It is chosen so that the initial value of the contract is zero
- Long/short position:
- Long position: The party that has agreed to buy the underlying asset
- Short position: The party that has agreed to sell the underlying asset
- Haircut:
- A haircut is the amount the market price of asset is reduced by for the purpose of determining its value for collateral purposes
- For example, a haircut of 20% means: A bond with a market value of $100 is considered to be worth $80 when used to satisfy a collateral request
Payoff function: Profits & losses
The payoff is profit/loss realized by the holder of the contract at the expiry date.
- It refers to the expiry date
- It assumes that the investor keeps the position open up to expiry
- It does not consider transaction costs and/or taxes
Exchange traded Futures Contracts
Definition
An agreement between two counter parties to buy/sell an asset at a fixed future time (maturity, ) for a fixed price (delivery price, )
While futures are similar to forward contracts, they are exchange traded contracts
Exchanges trading futures:
- Chicago Board of Trade (CBOT), Chicago Mercantile Exchange (CME), Chicago Board Options Exchange (CBOE)
- LIFFE (London), Eurex (Europe)
- BM&F (Sao Paulo, Brazil stock and futures exchange)
- TFX (Tokyo Fianncial Exchange), SGX (Singapore Exchange), HKE (Hong Kong Exchange)
Futures v.s. Forward contracts
Forwards | Futures |
OTC traded | Exchange traded |
Customised terms (some follow ISDA*) | Standardised terms (what, where, when) |
Tailored delivery date | Several choices of delivery dates |
Usually low liquidity | Usually high liquidity |
Significant counterparty risk if uncollateralised | Negligible counterparty risk |
Collaterlised or Not MtM | Marked to market (MtM) |
Delivery or cash settlement at expiry | Contracts usually closed out prior to maturity |
* ISDA: International Swap Dealers Agreement
Terminologies
- Open interest: Total number of long positions outstanding
- Equals to the total number of short positions
- Trading volume: Number of trades in one day
- Settlement price: Determined by the exchange
- Example: The trade price just before the final bell each day
- Used for the daily settlement process
Closing out a position
- To close out a futures position you enter into an offsetting trade
- Most futures contracts are closed out before maturity
- If a future contract is not closed out before maturity, it is usually settled by delivering the assets underlying the contract
- When there are alternatives about what, where, and when it is delivered, the party with the short position chooses
- A few contracts are settled in cash
- E.g. Futures on stock indices
Margin and daily mark-to-market
Clearing house
A clearing house is a financial institution formed to facilitate the exchange (i.e. clearance) of payments, securities, or derivatives transactions
The clearing house stands between two clearing firms (also known as member firms or participants). Its purpose is to reduce the risk of a member firm failing to honor its trade settlement obligations
It demands:
- The daily mark-to-market ⇒ make possible closing out the position
- The payment of the margin ⇒ Eliminates counter party risk
Margin
The cash balance (or security deposit) required from a futures trader as an insurance cushion
- The balance in the margin account is adjusted to reflect daily settlement
- Margin is used once the investor cannot pay his/her losses
- It minimizes the possibility of a loss through the default on a contract
Initial margin: The cash required from a futures trader at the time of the trade
Maintenance margin: When the balance in the trader’s margin account falls below the maintenance margin, the trader receives a margin call requiring the margin account to be topped up to the initial margin level (not the maintenance margin level).
Daily mark-to-market
At the end of the day, the accounts of the two counterparties are credited/debited to the margin account with the corresponding profits/losses
Example
An investor takes a long position in two December gold futures contracts on Day 1.
- The contract size is 100 oz.
- The futures price is US$1250.
- The initial margin is US$6000/contract (US$12000 in total).
- The maintenance margin is US$4500/contract (US$9000 in total).
Central Counterparty Clearing (Central Counterparty, CCP)
After the financial crisis of 2007-08 the G20 leaders agreed at the 2009 Pittsburgh summit that all standardised derivatives contracts should be cleared through CCPs
CCP is a highly regulated financial institution that takes on counterparty credit risk between parties to a transaction.
Novation: a trade between member firms A and B becomes two trades: A-CPP and CCP-B
- A agrees to buy an asset from B in one year for a certain price
- CCP buys the asset from B in one year for the agreed price
- CCP sells the asset to A in one year for the agreed price
- CCP takes on the credit risk of A and B
Members of the CCP have to provide both initial margin and daily variation margin, and are required to contribute to a guarantee fund.
In the event of a settlement failure, CCP:
- Ensures orderly liquidation of the defaulting firm’s positions and collateral
- Draws on its guarantee fund if necessary in order to settle trades on behalf of the failed clearing firm
In extreme circumstances, CCPs could be a source of systemic risk
Bilateral clearing
The OTC transactions not cleared though CCPs are cleared bilaterally
The two counterparties enter into a master agreement covering their trades.
- Credit support annex (CSA) requires both parties to provide a collateral
- The collateral is similar to the margin and is valued every day
CCPs and billateral clearing reduces significantly credit risk in OTC markets:
- For OTC contracts that are cleared through CPP, their credit risk is very similar to that of futures contracts
- For bilaterally collateralised OTC contracts, they still have some counterparty credit risk, but is substantially less than those that are not collateralised
- For the uncollateralised OTC contracts, the weaker party has to compensate the stronger party a CVA, credit valuation adjustment which affects the price of derivatives)
European Market Infrastructure Regulation (EMIR)
EMIR applies to any entity established in the EU that has entered into a derivatives contract, and applies indirectly to non-EU counterparties trading with EU parties
Two main categories of counterparty:
- Financial counterparties (FCs), which includes banks, insurers, investment firms and fund managers
- Non-financial couterparties (NFCs) with speculative derivatives exposure exceeds certain thresholds
For financial counterparties, contracts not cleared through a CCP will also be subject to bilateral collateral requirements.
For non-financial counterparties, it is possible that the contracts are not collateralised but adjusted for credit valuation at contract initialisation
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