Butterflies, Condors, and Jelly Rolls: Derivatives Explained

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1 Butterflies, Condors, and Jelly Rolls: Derivatives Explained American Translators Association 47 th Annual Conference, New Orleans November 1, 2006 Ralf Lemster 1

2 Derivatives Explained What are derivatives? What are they used for? Challenges for translators Nov. 1,

3 What are derivatives? Definitions Futures/forwards Calls/puts Swaps Exchange-traded vs. OTC Underlying instruments Nov. 1,

4 Definitions A derivative is an instrument whose price is derived from the price of an underlying instrument (such as a reference asset or liability, index, basket, etc.) Nov. 1,

5 Definitions A future/forward is a binding agreement to buy/sell a specified amount [contract size] of an underlying instrument on a future date [settlement/delivery date], at a price agreed upon in advance [forward price]. Nov. 1,

6 Definitions A call option is the right (but not the obligation) to buy a specified amount of an underlying instrument on, or until a future date, at a price defined in advance. Nov. 1,

7 Definitions A call option is the right (but not the obligation) to buy a specified amount of an underlying instrument on, or until a future date, at a price defined in advance. Nov. 1,

8 Definitions A put option is the right (but not the obligation) to sell a specified amount of an underlying instrument on, or until a future date, at a price defined in advance. Nov. 1,

9 Definitions A call (put) option [option type] is the right (but not the obligation) to buy (sell) a specified amount [contract size] of an underlying instrument on, or until [option style] a future date [exercise], at a price defined in advance [exercise price / strike price]. Nov. 1,

10 Definitions A swap is a binding agreement to exchange a stream of cash flows a series of assets or receivables differences in value over a defined term Nov. 1,

11 Definitions An interest rate swap is a binding agreement to exchange a series of different interest payments defined by reference to a notional principal amount over a defined term Nov. 1,

12 Definitions An interest rate swap is a binding agreement to exchange [payer / receiver] a series of different interest payments [fixed vs. floating] [fixed vs. fixed] [cross-currency] defined by reference to a notional principal amount over a defined term Nov. 1,

13 Basic positions Long future Nov. 1,

14 Basic positions Short future Nov. 1,

15 Basic positions Long call Nov. 1,

16 Basic positions Short call Nov. 1,

17 Basic positions Long put Nov. 1,

18 Basic positions Short put Nov. 1,

19 Basic positions Straddle Nov. 1,

20 Basic positions Butterfly Nov. 1,

21 Exchange-traded vs. OTC Exchange-traded derivatives Standardised contracts traded on regulated markets Trading governed by rules and regulations Settlement takes place through a clearing house (often acting as a central counterparty) Benchmark products include contracts on interest rates, equities, equity indices, and currencies (US only) Nov. 1,

22 Exchange-traded vs. OTC Major exchanges Chicago Mercantile Exchange/Chicago Board of Trade (recently announced merger plans) Eurex Euronext.liffe Singapore Exchange Nov. 1,

23 Exchange-traded vs. OTC OTC derivatives Customised contracts traded outside regulated markets Trading governed by market conventions and standard documentation Settlement generally takes place bilaterally there is a growing trend to settle through a clearing house Nov. 1,

24 Exchange-traded vs. OTC OTC derivatives Benchmark OTC markets include contracts on interest rates (swaps, FRAs), equities, equity indices, and currencies (FX forwards) Nov. 1,

25 Underlying instruments Interest rate products Short-term interest rates Medium- to long-term bonds Synthetic swap rates Equity products Single equity issues Equity baskets Equity indices Nov. 1,

26 Underlying instruments Currency products Foreign exchange forwards Cross-currency swaps Credit products Credit default swaps Total return swaps Credit-linked securities Credit index tranches Nov. 1,

27 Underlying instruments Commodity products Precious/base metals Agricultural products Other commodities Nov. 1,

28 Underlying instruments Other products some still being developed Insurance Pollution Weather Real estate Wine Nov. 1,

29 What are derivatives used for? Hedging Trading Arbitrage Nov. 1,

30 Hedging Using derivatives to reduce, contain, or minimise existing or potential risks Selling equity index futures to hedge an existing portfolio of shares Buying fixed-income futures (or entering into a receiver IRS) to hedge the price of an anticipated portfolio purchase Buying put options to hedge the currency risk of an exporter Nov. 1,

31 Hedging Issues Availability of a suitable hedging instrument Mismatch between the maturity of the risk position and the hedge the performance of the risk position and the hedge basis risk Hedging cost Tax and accounting issues Nov. 1,

32 Trading Using derivatives to assume position risk, and to profit from anticipated market movements Benefits of using derivatives for trading: Efficient capital usage Massive liquidity in key products Quick entry and closeout Reliable market prices Nov. 1,

33 Trading Issues Reliability of liquid markets Trading controls Managing exposure Nov. 1,

34 Arbitrage Using derivatives to exploit short-term imbalances between different markets or products Generating a risk-free profit by arbitraging derivatives vs. cash (IRS vs. bonds) derivatives vs. derivatives (same contract on different markets) Nov. 1,

35 Arbitrage Issues Hidden risks (e.g. pin risk ) Trading controls Nov. 1,

36 Challenges for translators Comprehension issues Sources of information Your experience? Nov. 1,

37 Challenges some examples A synthetic short futures position is created by combining a short call with a long put option. Nov. 1,

38 Challenges some examples Option premiums are not paid or collected on sale or purchase respectively, but transferred only on exercise/assignment or on expiration of the contract. Nov. 1,

39 Challenges some examples The buyer of a Vertical Call Spread combination buys component 1, a call option, and sells component 2, a call option with the same underlying instrument and expiration month as component 1, but with a higher exercise price. Nov. 1,

40 Challenges some examples With a barrier cap the additional payment will be made if the trigger level is approached from below, whereas with a barrier floor the additional payment will be made if the trigger level is approached from above. Nov. 1,

41 Challenges some examples Essentially ABC is transferring the major part of the credit risk on the loans in the pool by purchasing credit protection via a Credit Default Swap from DEF, who then in turn purchases credit protection on the reference pool from a number of banks and institutional investors: the m non-funded Super- Senior Tranche (rated AAA/Aaa by S&P and Moody s respectively) has been insured by XYZ, the leading US monoline insurer. Nov. 1,

42 Contact details Ralf Lemster Managing Partner Ralf Lemster Financial Translations GmbH Alt-Sindlingen Frankfurt/Main, Germany Phone Fax Nov. 1,

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