Chapter 9 derivatives futures options and swaps
Derivatives are more common in the modern era, but their origins trace back several centuries. One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century. Derivatives may broadly be categorized as "lock" or "option" products. Lock products such as swaps , futures , or forwards obligate the contractual parties to the terms over the life of the contract. Option products such as interest rate swaps provide the buyer the right, but not the obligation to enter the contract under the terms specified.
Derivatives can be used either for risk management i. This distinction is important because the former is a prudent aspect of operations and financial management for many firms across many industries; the latter offers managers and investors a risky opportunity to increase profit, which may not be properly disclosed to stakeholders.
Along with many other financial products and services, derivatives reform is an element of the Dodd—Frank Wall Street Reform and Consumer Protection Act of The Act delegated many rule-making details of regulatory oversight to the Commodity Futures Trading Commission CFTC and those details are not finalized nor fully implemented as of late Still, even these scaled down figures represent huge amounts of money.
And for one type of derivative at least, Credit Default Swaps CDS , for which the inherent risk is considered high [ by whom? It was this type of derivative that investment magnate Warren Buffett referred to in his famous speech in which he warned against "financial weapons of mass destruction".
Lock products are theoretically valued at zero at the time of execution and thus do not typically require an up-front exchange between the parties. Based upon movements in the underlying asset over time, however, the value of the contract will fluctuate, and the derivative may be either an asset i.
Importantly, either party is therefore exposed to the credit quality of its counterparty and is interested in protecting itself in an event of default. Option products have immediate value at the outset because they provide specified protection intrinsic value over a given time period time value.
One common form of option product familiar to many consumers is insurance for homes and automobiles. The insured would pay more for a policy with greater liability protections intrinsic value and one that extends for a year rather than six months time value. Because of the immediate option value, the option purchaser typically pays an up front premium. Just like for lock products, movements in the underlying asset will cause the option's intrinsic value to change over time while its time value deteriorates steadily until the contract expires.
An important difference between a lock product is that, after the initial exchange, the option purchaser has no further liability to its counterparty; upon maturity, the purchaser will execute the option if it has positive value i. Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another.
For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: However, there is still the risk that no wheat will be available because of events unspecified by the contract, such as the weather, or that one party will renege on the contract. Although a third party, called a clearing house , insures a futures contract, not all derivatives are insured against counter-party risk.
From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they sign the futures contract: The miller, on the other hand, acquires the risk that the price of wheat will fall below the price specified in the contract thereby paying more in the future than he otherwise would have and reduces the risk that the price of wheat will rise above the price specified in the contract.
In this sense, one party is the insurer risk taker for one type of risk, and the counter-party is the insurer risk taker for another type of risk. Hedging also occurs when an individual or institution buys an asset such as a commodity, a bond that has coupon payments , a stock that pays dividends, and so on and sells it using a futures contract.
The individual or institution has access to the asset for a specified amount of time, and can then sell it in the future at a specified price according to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset, while reducing the risk that the future selling price will deviate unexpectedly from the market's current assessment of the future value of the asset. Derivatives trading of this kind may serve the financial interests of certain particular businesses.
The corporation is concerned that the rate of interest may be much higher in six months. The corporation could buy a forward rate agreement FRA , which is a contract to pay a fixed rate of interest six months after purchases on a notional amount of money. If the rate is lower, the corporation will pay the difference to the seller. The purchase of the FRA serves to reduce the uncertainty concerning the rate increase and stabilize earnings. Derivatives can be used to acquire risk, rather than to hedge against risk.
Thus, some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset.
Speculators look to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is less.
Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset. Speculative trading in derivatives gained a great deal of notoriety in when Nick Leeson , a trader at Barings Bank , made poor and unauthorized investments in futures contracts. The true proportion of derivatives contracts used for hedging purposes is unknown,  but it appears to be relatively small.
In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in the market:. According to the Bank for International Settlements , who first surveyed OTC derivatives in ,  reported that the " gross market value , which represent the cost of replacing all open contracts at the prevailing market prices, Because OTC derivatives are not traded on an exchange, there is no central counter-party.
Therefore, they are subject to counterparty risk , like an ordinary contract , since each counter-party relies on the other to perform. An "asset-backed security" is used as an umbrella term for a type of security backed by a pool of assets—including collateralized debt obligations and mortgage-backed securities Example: An empirical analysis" PDF.
Retrieved July 13, Asset-backed securities, called ABS, are bonds or notes backed by financial assets. Typically these assets consist of receivables other than mortgage loans, such as credit card receivables, auto loans, manufactured-housing contracts and home-equity loans. The CDO is "sliced" into "tranches" , which "catch" the cash flow of interest and principal payments in sequence based on seniority.
The last to lose payment from default are the safest, most senior tranches. As an example, a CDO might issue the following tranches in order of safeness: Separate special-purpose entities —rather than the parent investment bank —issue the CDOs and pay interest to investors. CDO collateral became dominated not by loans, but by lower level BBB or A tranches recycled from other asset-backed securities, whose assets were usually non-prime mortgages.
A credit default swap CDS is a financial swap agreement that the seller of the CDS will compensate the buyer the creditor of the reference loan in the event of a loan default by the debtor or other credit event. The buyer of the CDS makes a series of payments the CDS "fee" or "spread" to the seller and, in exchange, receives a payoff if the loan defaults. In the event of default the buyer of the CDS receives compensation usually the face value of the loan , and the seller of the CDS takes possession of the defaulted loan.
If there are more CDS contracts outstanding than bonds in existence, a protocol exists to hold a credit event auction ; the payment received is usually substantially less than the face value of the loan. CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency. In addition to corporations and governments, the reference entity can include a special-purpose vehicle issuing asset-backed securities.
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or to sell an asset at a specified future time at a price agreed upon today, making it a type of derivative instrument.
The party agreeing to buy the underlying asset in the future assumes a long position , and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price , which is equal to the forward price at the time the contract is entered into. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes.
The forward price of such a contract is commonly contrasted with the spot price , which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit , or loss, by the purchasing party. Forwards, like other derivative securities, can be used to hedge risk typically currency or exchange rate risk , as a means of speculation , or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive.
A closely related contract is a futures contract ; they differ in certain respects. Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized assets. However, being traded over the counter OTC , forward contracts specification can be customized and may include mark-to-market and daily margin calls. Hence, a forward contract arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain.
In finance , a 'futures contract' more colloquially, futures is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed upon today the futures price with delivery and payment occurring at a specified future date, the delivery date , making it a derivative product i. The contracts are negotiated at a futures exchange , which acts as an intermediary between buyer and seller.
The party agreeing to buy the underlying asset in the future, the "buyer" of the contract, is said to be " long ", and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be " short ".
While the futures contract specifies a trade taking place in the future, the purpose of the futures exchange is to act as intermediary and mitigate the risk of default by either party in the intervening period. For this reason, the futures exchange requires both parties to put up an initial amount of cash performance bond , the margin. Margins, sometimes set as a percentage of the value of the futures contract, need to be proportionally maintained at all times during the life of the contract to underpin this mitigation because the price of the contract will vary in keeping with supply and demand and will change daily and thus one party or the other will theoretically be making or losing money.
To mitigate risk and the possibility of default by either party, the product is marked to market on a daily basis whereby the difference between the prior agreed-upon price and the actual daily futures price is settled on a daily basis. This is sometimes known as the variation margin where the futures exchange will draw money out of the losing party's margin account and put it into the other party's thus ensuring that the correct daily loss or profit is reflected in the respective account.
If the margin account goes below a certain value set by the Exchange, then a margin call is made and the account owner must replenish the margin account. This process is known as "marking to market". Thus on the delivery date, the amount exchanged is not the specified price on the contract but the spot value i. Upon marketing the strike price is often reached and creates lots of income for the "caller".
A closely related contract is a forward contract. A forward is like a futures in that it specifies the exchange of goods for a specified price at a specified future date.
However, a forward is not traded on an exchange and thus does not have the interim partial payments due to marking to market. Nor is the contract standardized, as on the exchange. Unlike an option , both parties of a futures contract must fulfill the contract on the delivery date.
The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position can close out its contract obligations by taking the opposite position on another futures contract on the same asset and settlement date.
The difference in futures prices is then a profit or loss.. A mortgage-backed security MBS is a asset-backed security that is secured by a mortgage , or more commonly a collection "pool" of sometimes hundreds of mortgages.
The mortgages are sold to a group of individuals a government agency or investment bank that " securitizes ", or packages, the loans together into a security that can be sold to investors. The structure of the MBS may be known as "pass-through", where the interest and principal payments from the borrower or homebuyer pass through it to the MBS holder, or it may be more complex, made up of a pool of other MBSs.
Other types of MBS include collateralized mortgage obligations CMOs, often structured as real estate mortgage investment conduits and collateralized debt obligations CDOs. The shares of subprime MBSs issued by various structures, such as CMOs, are not identical but rather issued as tranches French for "slices" , each with a different level of priority in the debt repayment stream, giving them different levels of risk and reward.
The total face value of an MBS decreases over time, because like mortgages, and unlike bonds , and most other fixed-income securities, the principal in an MBS is not paid back as a single payment to the bond holder at maturity but rather is paid along with the interest in each periodic payment monthly, quarterly, etc.
This decrease in face value is measured by the MBS's "factor", the percentage of the original "face" that remains to be repaid. In finance , an option is a contract which gives the buyer the owner the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on or before a specified date. The seller has the corresponding obligation to fulfill the transaction—that is to sell or buy—if the buyer owner "exercises" the option.
The buyer pays a premium to the seller for this right. An option that conveys to the owner the right to buy something at a certain price is a " call option "; an option that conveys the right of the owner to sell something at a certain price is a " put option ". Both are commonly traded, but for clarity, the call option is more frequently discussed. Options valuation is a topic of ongoing research in academic and practical finance.
In basic terms, the value of an option is commonly decomposed into two parts:. Although options valuation has been studied since the 19th century, the contemporary approach is based on the Black—Scholes model , which was first published in Options contracts have been known for many centuries.
However, both trading activity and academic interest increased when, as from , options were issued with standardized terms and traded through a guaranteed clearing house at the Chicago Board Options Exchange. Today, many options are created in a standardized form and traded through clearing houses on regulated options exchanges , while other over-the-counter options are written as bilateral, customized contracts between a single buyer and seller, one or both of which may be a dealer or market-maker.
Options are part of a larger class of financial instruments known as derivative products or simply derivatives. A swap is a derivative in which two counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument.
The benefits in question depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds , the benefits in question can be the periodic interest coupon payments associated with such bonds.
Specifically, two counterparties agree to the exchange one stream of cash flows against another stream. These streams are called the swap's "legs". The swap agreement defines the dates when the cash flows are to be paid and the way they are accrued and calculated.
Usually at the time when the contract is initiated, at least one of these series of cash flows is determined by an uncertain variable such as a floating interest rate , foreign exchange rate , equity price, or commodity price. The cash flows are calculated over a notional principal amount. Contrary to a future , a forward or an option , the notional amount is usually not exchanged between counterparties.
Consequently, swaps can be in cash or collateral. Swaps can be used to hedge certain risks such as interest rate risk , or to speculate on changes in the expected direction of underlying prices. Swaps were first introduced to the public in when IBM and the World Bank entered into a swap agreement. In a nutshell, there is a substantial increase in savings and investment in the long run due to augmented activities by derivative market participant.
For exchange-traded derivatives, market price is usually transparent often published in real time by the exchange, based on all the current bids and offers placed on that particular contract at any one time.
Complications can arise with OTC or floor-traded contracts though, as trading is handled manually, making it difficult to automatically broadcast prices. In particular with OTC contracts, there is no central exchange to collate and disseminate prices.
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