Introduction to Financial Derivatives Flashcards
(25 cards)
Risk management
a competent asset manager must:
Recognise and understand risk
Exploit risk (arbitrage, speculation)
Protect against risk (hedging)
Evaluate results after allowing risk
Derivatives play a very important role in risk management. The volume of derivatives trading has grown explosively in all developed markets.
Arbitrage
Arbitrage is the practice of taking advantage of a difference in prices in two or more markets – striking a combination of matching deals to capitalize on the difference, the profit being the difference between the market prices at which the unit is traded.
Buying in advance
forward purchases in everyday life example:
Consume one bag of pasta a week, hear that there may be supply shortages, have a tight budget.
Do I buy my one bag only? Or do I buy some extra in advance of any possible price rises.
Some considerations:
Budget (current vs future) - do I have enough money to buy more now? Vs. how may prices increase? What if they do not increase?
Storage - if I buy extra now do I have space to store it?
Hedging
- invest to reduce risk of an adverse movement in asset price.
Borrowers and lenders concerned about interest rate changes,
Commodity producers and buyers concerned with price changes,
Importers and exporters concerned with exchange rate changes.
Forming diversified portfolios of assets to reduce risk. Entails a cost: premium paid or profit foregone.
Speculation
earning a profit in return for accepting risk. Hedgers pay speculators for taking on the risk.
Arbitrage
earning riskless, costless profit by trading. The action of arbitrageurs drives markets towards equilibrium.
Leverage (gearing)
borrow to increase potential return on investment. Traders can increase both risk and return by leverage.
Derivative instruments
derivatives are contracts that derive their value from the value or return of an underlying asset.
Forwards, futures, options and swaps are the most common types of derivatives - they are claims to state - contingent cash flows.
Other types e.g. credit derivatives (allows creditor to transfer the risk of default by the debtor to another party) and mortgage-backed securities (asset similar to a bond made of mortgage debt), risk transferral.
Specify a contract to trade an underlying asset, e.g. stocks, interest rates, commodities, credit risk of the underlying asset
Value of the contract is tied to the price of the underlying asset.
Hedgers and speculators can take opposite market positions with respect to cash flows.
Facts
Derivatives contracts were traditionally written on commodity prices but now you can buy contracts on equity prices, bond prices, interest rates, and more exotic underlying variables like electricity prices and temperature levels. The misuse of them can have catastrophic consequences; they’re blamed for the 2008 financial crisis.
Forward and futures
a contract to buy/sell an asset in the future at a specified price and time.
Options
gives the holder the right (option) to buy (call option) or sell (put option) an asset at a specified price.
Swaps
an agreement to exchange a series of cash flows at specified prices and times.
Derivative basics
The 2 most basic are options and forwards. We can classify derivatives in terms of:
The underlying asset, e.g. commodities, stock price, exchange rate…
The derivative type, e.g. forward, future, swap or option
Whether it is traded over-the-counter (OTC) or in an exchange
Short position
short selling, shorting, going short meaning To Sell
Long position
going long, to be long meaning To Buy
How are derivatives traded
Exchange-traded contracts
Over-the-counter (OTC) market
Over-the-counter (OTC) market
traders working for banks, fund managers and corporate treasurers contact each other directly to negotiate and agree terms. These OTC derivatives contracts are traded directly between the two parties, where each party takes on the credit risk of the other (default risk).
Forwards and swaps are traded OTC
Options can be traded OTC or in an exchange
Exchange-traded contracts
are traded on an organised exchange, e.g. Chicago Board Options Exchange (CBOE. largest options exchange in the US) the identities of the parties are usually unknown.
The exchange guarantees the contract and thus bears the credit risk of the parties.
Futures are exchange traded
Options can be traded OTC or in an exchange
The OTC Market prior to 2008
largely unregulated. Banks acted as market markers quoting bids and offers. Master agreements usually defined how transactions between two parties would be handled. But some transactions were handled by central counterparties (CCPs). A CPP stands between the two sides to transaction in the same way that an exchange does.
Since the GFC of 2008
“All of the securities and derivatives involved in the financial turmoil that began with a 2007 breakdown in the U.S. mortgage market were traded in OTC markets.”
The OTC market has become regulated. Objectives: reduce systemic risk & increase transparency. In the U.S and some other countries, standardized OTC products must be traded on swap execution facilities (SEFs) which are similar to exchanges. Central counterparties must be used for standardized transactions between dealers in most countries. All trades must be reported to a central registry.
Derivatives and underlying assets
These are the most common types of derivative instruments. Many other instruments exist but we will not cover them in this module.
Forwards: commodities, forward rate agreements, foreign exchange
Futures: bonds, short-term interest rates, stock index
Swaps: interest rate, currency
Options: stocks, stock index
Why are derivatives used
To hedge risks
To speculate-take a view on the future direction of the market
To lock in an arbitrage profit
To change the nature of a liability
To change the nature of an investment without incurring the costs of selling one portfolio and buying another
How to reduce risk
tools available:
Insurance
Diversification
Match duration of assets and liabilities / Match sales and expenses
Futures, forwards, options, and swaps
Forward contracts
An agreement to trade a specified asset at a specified future time and place, at an agreed price. The most basic types of contract are:
Commodity
FRA (Forward rate agreement)
Foreign exchange
A forward contract is created between two parties (counterparties)
Long position (agrees to buy in the future, expect price to increase in the future).
Short position (agrees to sell in the future, expect price to decrease)
The contract specifies:
The asset to be traded
The delivery date
The price to be paid for the underlying asset (the forward price)
Other features:
There are no cash flows before delivery, in general
The contract is fair to both parties
There is a zero-sum pay-off to the contract
Both parties are committed to trade
Instrument for hedging
Settlement:
Contracts can be settled by delivery of the asset
Contracts are often settled by cash
