WHAT ARE DERIVATIVES?
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- Derick Beasley
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1 Derivatives
2 WHAT ARE DERIVATIVES? Derivatives are contracts that derive their value from an underlying asset (e.g. equity, commodity or interest rate); the value of the derivative fluctuates with price of the underlying asset. Derivatives are forward transactions, i.e. the transaction agreement and the settlement/delivery take place at different times; with spot transactions, the agreement and settlement/delivery occur at the same time. 2
3 WHAT ARE DERIVATIVES? (DERIVATIVES VS. SHARES) Equivalent derivative contracts can be created by several entities (i.e. an exchange or a bank). Number of contracts outstanding is not limited by issuer. For shares, issuance is physical, identifiable, and unique to the issuer (i.e. a company). With derivatives, counterparties do not have to hold the underlying asset (this asset is used for reference purposes); that also means that derivative transactions are often settled in cash and not by a physical delivery of the underlying asset. The seller of a share generally owns this share and the share would be delivered to the buyer upon settlement. Conclusion of a derivative transaction may take months or years. Transactions in shares usually settle within few days. 3
4 WHAT ARE DERIVATIVES? ETD VS. OTC Derivatives Exchange Traded Derivatives (ETD) -traded on a Regulated Market * (i.e. an exchange) Over the Counter Derivatives (OTC) - traded bilaterally between entities (e.g banks) or on a trading venue that is not aregulated market Multilateral Trading Facility (MTF)* Organised Trading Facility (OTF)* *Terminology from EMIR and MiFID II/MiFIR 4
5 CHARACTERISTICS OF ETDs AND OTC DERIVATIVES ETDs are created by Regulated Markets. Execution of an ETD trade takes place in acentral multilateral market place. Historically in an exchange pit, today mostly through an electronic order book. ETDs are characterised by high degree of standardisation and liquidity. ETDs can be settled physically or in cash. ETDs are centrally cleared via CCPs (clearing houses) which reduces the systemic risks posed by derivatives. ETD market is primarily awholesale market, with the exception of equity ETDs where retail investors also participate. OTC derivatives are created by banks. OTC derivatives trades are negotiated bilaterally. The OTC derivatives market comprises an informal network of interconnected dealers, who have own client networks. Trading usually takes place through voice brokerage, over telephone. OTC derivatives are flexible and customisable. OTC derivatives are always settled in cash. Traditionally, OTC derivatives have been mostly cleared bilaterally; however, due to recent legislation, an increasing number of OTC derivatives are now cleared via CCPs. OTC derivative market is a wholesale market. 5
6 BENEFITS & DRAWBACKS OF DERIVATIVES ETDs Benefits Speed and efficiency: real time confirmation rates, with registration and central clearing occurring simultaneously, the process of give-up from an executing broker to a clearing broker is automated Easy and equitable access for and treatment of market participants Close-out opportunities (counter-trades) Transparency Liquidity and price discovery Daily margin adjustments make accumulation of losses impossible Central Clearing and risk management Stability, market confidence and resilience, even in crisis periods OTC Derivatives Benefits High degree of customisation and flexibility Drawbacks v Interconnection and leverage v Lack of transparency v Lack of Central clearing v Poor risk management Lack of stability and resilience during crises Drawbacks v Less flexibility and customisation 6
7 CATEGORISATION OF DERIVATIVES Type of Contract 1. Futures (= an unconditionalforward transaction) contract (obligation) to buy or sell asset or financial instrument at agreed price at certain point in future; buyer of contract is said to be "long and seller of the contract, is said to be "short. 2. Options (= aconditionalforward transaction) contract that gives the holder right (but not obligation) to buy (in case of a call option) or sell (in case of a put option) aparticular asset or financial instrument at agreed price ( strike price ) at certain point in the future. American option: an option that may be exercised on any trading day on or beforeexpiration. European option: an option that may only be exercised on expiry. Asset classes Interest rate Credit Equity: single stock and index FX Dividend Volatility ExchangeTraded Funds Commodities: soft commodities, non-ferrous metals, freight, energy Weather Inflation Property 3. Swaps contract through which two parties exchange financial instruments; most swaps involve cash flows based on a notional principal amount that both parties agree to; one cash flow is generally fixed, while the other is variable (i.e. based on a benchmark interest rate, floating currency exchange rate or index price). 7
8 USE OF DERIVATIVES AND THEIR FUNCTION IN THE REAL ECONOMY HEDGING AND SPECULATION: TWO SIDES OF THE SAME COIN Ø Speculating allows traders to take on risks. Ø Speculating absorbs risks in pursuit of profit. Ø When traders speculate they are investing. In other words, they are buying and selling contracts in order to make a profit when prices move. Ø Hedging allows traders to transfer risk. Ø Hedging manages risk by locking in a future price for a product thereby protecting traders from swings in the prices of that product. Ø This makes costs and profits of a business more predictable. 8
9 USE OF DERIVATIVES AND THEIR FUNCTION IN THE REAL ECONOMY HEDGING Hedging (= insurance ; a counter-position that offsets the cash or commodity market position) Tomitigate risk in underlying, by entering into aderivative contract the value of which moves in opposite direction to the underlying position, and cancels part or all of it out. Hedgers have interest in the underlying asset (tangible assets, such as commodities, as well as intangible assets, such as index or interest rate). Hedgers enter into derivatives contracts because they want protection from future price swings. They use derivatives to lock in future price for product. This makes costs and profits more predictable, which in turn makes business less risky. Traditional hedgers typically include producers and consumers of acommodity or an owner of asset subject to influences e.g. an interest rate. Less known hedgers include traders and retail participants (such as cross border businesses who are exposed to currency exchange rate fluctuations). Market participants interested in hedging positions (hedgers) frequently meet with traders who deliberately take on risk ( speculators ), and wish to establish positions in line with their expectations without large upfront capital investment. Risk is therefore transferred from hedger to speculator. 9
10 USE OF DERIVATIVES AND THEIR FUNCTION IN THE REAL ECONOMY HEDGING EXAMPLES I am worried price of wheat may go down Oh, no! I am worried price of wheat may go up Oh, no! The farmer is concerned that wheat prices will go down, and he will not make enough money to cover his costs. The baker is concerned that wheat prices will go up and he will have to raise prices to cover his costs. The farmer and baker agree in advance on a price for the wheat, regardless of the market price at harvest time. By creating a hedge, both the farmer and the baker have managed the risk of fluctuating wheat prices. Regardless of which way the price goes, the hedge has protected both against the potential for serious losses. Everyone is a winner! 10
11 USE OF DERIVATIVES AND THEIR FUNCTION IN THE REAL ECONOMY HEDGING EXAMPLES (CONT ) Equities Part of investment portfolio includes 100 shares of company AUTO, which manufactures cars. Because car industry is cyclical (AUTO usually sells more cars and is more profitable during economic booms and sells fewer cars and is less profitable during economic slumps), AUTO s shares will probably be worth less if economy starts to deteriorate. What are the hedge options? Buy aput option contract on the shares of AUTO to "lock in" aparticular sale price. Sell afutures contract, promising to sell stock at set price at certain point in future. Commodities An airline company FLY wants to hedge against rising fuel prices. What are the hedge options? Buying acall option on oil allows FLY to purchase fuel at alocked-in price within certain date range. Implement a collar hedge, which requires FLY to purchase both acall option and aput option; where call option allows FLY to purchase fuel at future date for price agreed upon today, aput option allows the FLY to do the opposite: sell fuel at afuture date for price agreed today. Boom Investor exercises put option (sells at higher price) Airline exercises call option (buys at lower price) Slump 11
12 STATISTICS FESE MEMBERS ETD TRADING 12
13 STATISTICS GLOBAL ETD TRADING % 33.1% Europe 19.3% 33.7% Asia-Pacific -0.2% 39.2% North America Percentage global market share X % Y % Growth rate *Data source: FIA 13
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