Volume 5 - Derivatives Flashcards
Derivative Instrument and Derivative Market Features
define a derivative and describe basic features of a derivative instrument
describe the basic features of derivative markets, and contrast over-the-counter and exchange-traded derivative markets
Counterparties to a derivatives contract exchange cash flows based on the performance of the underlying. The contract buyer has long exposure to the price of the underlying and the seller has a short position.
Key features of derivatives include:
- Contracts can be structured as forward commitments (e.g., forwards, futures, and swaps) or contingent claims (e.g., options).
- Derivatives can be used to pursue strategies (e.g., short positions) that would be more difficult to execute in the cash market.
- Index-based derivatives can help investors quickly and easily diversify their portfolios.
- Large exposures can be achieved with relatively small cash outlays.
- Transaction costs are typically lower and liquidity is generally higher compared to trading underlying assets in the spot market.
- Derivatives are critical to the risk management process because they can be used to adjust, hedge, or eliminate exposure to certain risks.
Commodities :
Can be classified as hard or soft. Hard commodities include natural resources (e.g., oil, gold) that are used to sustain life or support economic activity. Soft commodities include agricultural products, such as corn and cattlte.
Other “assets” that serve as the underlying for derivatives contracts include weather, cryptocurrencies, and longevity risk related to insurance policies and defined benefit pension plans. These relatively new derivatives are more difficult to price than better-known instruments such as commodity futures and interest rate swaps.
Embedded derivatives are part of other assets, such as callable bonds, and cannot be traded separately in derivatives markets.
OTC derivative markets are driven by dealers, also known as market makers, which are typically financial intermediaries (e.g., banks). Market participants, such as investors and companies, are seeking to hedge their risks or to take speculative positions and dealers are willing to act as counterparties.
Exchange-Traded Derivative (ETD) Markets :
Unlike OTC derivatives, these contracts have standardized terms with respect to matters such as contract size, delivery method, definition of the underlying, and maturity date. ETD markets are also highly transparent, with details of all trades being recorded by exchanges and disclosed to regulators.
ETD markets are characterized by efficient clearing and settlement operations. Clearing is the process of verifying the identities of counterparties and confirming trade execution, while settlement refers to ensuring that final payments are made and delivery terms are met
ETD markets compared to OTC :
- Liquidity: Typically higher for ETD markets
- Trading costs: Lower for ETD markets
- Transparency: Greater for ETD markets
- Standardization: Higher for ETD markets
- Flexibility/Customization: Lower for ETD markets
- Counterparty credit risk: Lower for ETD markets due to margin requirements
A central counterparty (CCP) is mandated to bear the credit risk of each party to a contract, as well as to provide clearing and settlement services. This change in the nature of the OTC derivative market has not eliminated risk, but rather concentrated it in one entity. So safeguards are necessary to ensure that the central counterparty’s risk is properly managed.
The central clearing process for interest rate swaps, which is also used for other OTC derivatives, involves three steps:
Step 1: Two parties (typically financial intermediaries) reach a swap agreement through a swap execution facility (SEF), which is an online trading platform used by dealers.
Step 2: The details of the SEF transaction are submitted to the CCP.
Step 3: The CCP replaces the existing trade and enters into two separate swaps with each of the parties based on the terms of their agreement. This step, known as the novation process eliminates bilateral credit risk by having the CCP act as the counterparty to each of the parties to the original transaction. The CCP also provides clearing and settlement services.
Which of the following comments about over-the-counter (OTC) derivatives and exchange-traded derivatives is least accurate?
A
All exchange traded derivatives are more liquid than OTC derivatives
B
19%
Compared to exchange traded derivatives, OTC derivatives are less regulated
C
Both exchange traded derivatives and OTC derivatives can be used to hedge ris
Like exchange traded derivatives, OTC derivatives are also used to hedge risk. OTC derivatives have the same function as the exchange traded derivatives, but trade in the less regulated OTC market where investors are considered to be sufficiently aware of the risks they take. Derivatives that trade on organized exchanges are not necessarily more liquid than those that trade in the OTC market. Ultimately, liquidity is a function of trading interest. There are heavily-traded OTC derivatives and very illiquid exchange traded derivatives.
Forward Commitment and Contingent Claim Features and Instruments
- define forward contracts, futures contracts, swaps, options (calls and puts), and credit derivatives and compare their basic characteristics
- determine the value at expiration and profit from a long or a short position in a call or put option
- contrast forward commitments with contingent claims
Derivatives can be classified as forward commitments or contingent claims. Forward commitments are an obligation to trade, while contingent claims provide the buyer with the right to trade.
A forward contract is an agreement to make a trade at a future date. One party agrees to pay the forward price for an underlying asset and the other party agrees to sell at that price on a specific date.
Futures :
A futures contract is similar to a forward contract in that there is an agreement to purchase an underlying asset for a specific price on a specified date.
Differences between forwards and futures include:
- Futures contracts are standardized, while forward contracts are customized terms.
- Futures contracts trade on a public exchange with a clearinghouse that guarantees the performance of all traders. Forward contracts trade OTC with no performance guarantees, so traders must do their own assessment of counterparty credit risk.
- Futures contracts are marked to market, which allows traders to realize gains or losses at the end of each day. By contrast, gains and losses for forward contracts are not realized until expiration.
- Futures contracts are highly liquid instruments because it is much easier to take offsetting positions when trading standardized contracts. By contrast, forward contracts are usually held to maturity.
Futures exchanges limit their exposure to default risk by requiring an initial margin deposit (typically less than 10% of the futures price) from both parties upon initiation. Cover any future losses
Daily settlement, all contracts are marked to the end-of-day settlement price.
At the end of the day, clearinghouse credits gains and debits loss from one party to the other
A margin call is made if an account balance drops below the maintenance margin. After receiving a margin call, a party must deposit sufficient funds to bring the account balance back to the initial margin level.
The amount required to bring an account back up to the initial margin level is known as the variance margin. A party that fails to meet a margin call will be required to close out its contract and cover any of its losses.
Futures exchanges retain the right to change margin requirements depending on market conditions.
Exchanges may also impose price limits that require trades to occur within a specified range of the previous day’s settlement price. If the spot price breaches these limits, a circuit breaker is triggered and trading is paused.
The number of outstanding contracts for a particular underlying and settlement day is known as the open interest. As the settlement date approaches, parties may close out their positions by either buying out their counterparty before maturity or by taking an offsetting position in another contract
A futures contract with the same settlement price as a forward contract on the same underlying will provide the same overall payoff, but the timing will be different. Forward contracts realize the full amount at maturity, while returns to futures contracts are accumulated incrementally over time through the daily settlement process.
A swap can be thought of as a series of forward contracts, meaning that cash flows are exchanged on more than one date. OTC transactions and each party is exposed to the risk that the other party will default.
Because a swap has the same value to both parties at inception, no money is exchanged when the contract is signed. The periodic payments are a percentage of the contract’s notional principal, although the principal amount is typically not exchanged.
Obligations are typically netted so that only one payment is made per period. The floating-rate obligation is reset after each payment period.
Which of the following terms of a futures contract is least likely to be specified by the exchange?
A
Price
B
Quantity
C
Underlying asset
Price is the only negotiated term of a futures contract and it is agreed upon by the two parties at initiation.
In order to function efficiently, futures exchanges can only have a limited number of standardized contracts. Investors seeking more customized terms would be better served by the forward market.
A swap is an over-the-counter forward commitment.
It is over-the-counter and not exchange-traded because it is a private, customizable transaction and not a public, standardized good.
Options can be settled by physical delivery of the underlying asset or with a cash payment based on the difference between the spot price of the underlying and the strike price.
European-style options can only be exercised at maturity, while American-style options can be exercised any time after initiation.
- Buyers of calls and puts have limited loss potential.
-Sellers of call options are exposed to unlimited potential losses.
Sellers of put options can incur substantial (but not unlimited) losses.
Time value based on the potential for price movements that benefit the owner. This time value is always positive during the option’s lifetime before falling to zero at maturity.
Credit default swap (CDS) contracts are the most common type of credit derivative. These instruments are insurance-like contingent claims based on an underlying issue or index, with the buyer getting protection against adverse credit events (e.g., bankruptcy, failure to pay, involuntary restructuring). The credit protection buyer makes a series of cash payments in return for compensation from the credit protection seller if a defined loss event occurs.
The pricing of CDS contracts is based on a credit spread (CDS spread), which reflects the probability of default (POD) and the loss given default (LGD).
Another way to acquire an asset is to sell a put option. This can be particularly attractive for investors who want to avoid overpaying.
Derivative Benefits, Risks, and Issuer and Investor Uses
describe benefits and risks of derivative instruments
compare the use of derivatives among issuers and investors
Risk Allocation, Transfer, and Management :
Achieve price certainty now rather than waiting until later to trade in the cash market. For example;
- An airline can use futures contracts to lock in a price for fuel.
- A mining company can use a currency forward contract to lock in an exchange rate for converting the proceeds of a large export sale into domestic currency units.
Overcome timing issues. For example, investors who do not currently have sufficient funds to trade in the cash market can gain exposure to the price of an underlying asset with little or no upfront payment required in the derivatives market.
Information Discovery :
Provide information beyond the cash market.
- Equity futures prices give an indication of investors’ expectations about where the market is going.
- Interest rate futures contracts reflect expectations about central bank monetary policies.
- Commodity futures prices reveal information about the dynamics of the relationships between producers and consumers.
- Options prices imply assumptions about the volatility of the underlying assets.
Operational Advantages :
- Lower transaction costs
- Lower cash requirements
- Greater liquidity due to lower capital requirements
- The ability to easily take short positions
Market Efficiency : Asset prices can adjust more quickly to new information as it becomes available. Additionally, the ability to take short positions forces assets to trade closer to their intrinsic value.
Derivative Risks
Potential for Speculative Use : take very risky, highly leveraged speculative positions.
Lack of Transparency :
Market participants may not fully understand the full implications of derivative trading. Compared to stand-alone derivatives, these instruments can be more costly, less liquid, and less transparent.
Basis Risk ;
Basis risk is incurred when the derivative underlying does not match the exposure being hedged.
Liquidity Risk :
Mismatches in the timing of cash flows create exposure to liquidity risk. For example, an investor who is expecting a large cash inflow in six months may choose to enter a futures contract rather than waiting to trade the underlying in the cash market. However, the investor is exposed to the risk of receiving a margin call before the expected payment is received.
Counterparty Credit Risk ;
Forward contracts are over-the-counter derivatives that leave both parties fully exposed to the possibility that their counterparty will fail to meet its obligations.
Futures exchanges seek to eliminate counterparty credit risk by requiring margin deposits and marking positions to market at the end of each day. These requirements may be changed at the exchange’s discretion based on market and credit conditions.
Destabilization and Systemic Risk :
Derivatives have played a role in contributing to crises that have been felt throughout the global economy.
Since 2008; reforms have included standardizing swap contracts and mandating a central counterparty (CCP) with the ability to require margin deposits.
Individual derivatives market participants are least likely to be able to manage their exposure to:
A
liquidity risk.
B
61%
systemic risk.
C
counterparty credit risk.
Derivatives have been cited as contributing to increased systemic risk, which is the threat of destabilizing events that have a negative impact throughout the global economy. Because systemic risk stems from the cumulative impact of the activities of all derivatives market participants, it cannot be mitigated by any one individual. Rather, the responsibility for mitigating systemic risk belongs to regulators.
Individual market participants can manage their exposure to liquidity risk and counterparty credit risk through their choices related to, for example, which derivative instruments are best suited for their specific objectives and constraints.
