Financial Derivatives

Welcome to:

LEARNING UNIT 1 | BASIC CONCEPTS

‘Forwards, Futures, Options and Swaps’

What are Derivatives?

A derivative is a financial instrument whose price is derived from the price/value of another asset, known as the Underlying Asset.

Most common Derivatives are Forwards, Futures, Options & Swaps.

Most common Asset Classes are FX, Interest Rates, Fixed Income thenEquities and Commodities would follow.

Derivatives are traded on Exchanges and/or Over-the-Counter (OTC).

Swaps are the most traded derivative for both Interest Rate Swaps and Cross Currency Swaps.

For instance, the value of a Gold Futures Contract is derived from the value of the underlying asset reflected by the Gold Spot Price.

Investor Profiles

HEDGERA hedger is someone who faces risk associated with price movement

and who uses derivatives to manage the level of portfolio risk.

SPECULATOR

Uses futures and options contracts to get extra leverage in betting on price direction of an asset in pursuit of profits.

ARBITRAGEUR

Take advantage of gaps between the prices of one asset quoting in several markets. Discrepancies arise from different time zones, base currencies and regulations of those specific markets.

The contract between the two parties is privately negotiated.

Non-standard products are traded in the so-called OTC derivatives

markets. The most common being Forwards and Swaps.

OTC main players are Investment Banks and SwapDealers and include

Financial (hedge funds, commercial banks, etc. ) and Non Financial

Institutions like governments, municipalities or corporations.

Main advantages of OTC compared with regulated exchanges are that

contract specifications are tailor made and reduced costs.

OTC vs. Exchange Traded Derivatives

Over the counter (OTC) or off-exchange trading is to trade financialinstruments such as stocks, bonds, commodities or derivatives directlybetween two parties without going through an exchange or otherintermediary.

I. OTC Markets

A derivatives exchange is a market for investors that trade standardized

contracts originally predefined by the exchange.

The exchange acts as an intermediary in all related transactions. It takes an

initial margin from both counterparties minimizing counterparty risk (It alsocharges an exchange fee).

OTC vs. Exchange Traded Derivatives

USA hosts the world's largest derivative exchanges as CME, CBOT, NYMEX, etc.

II. Exchange Traded Derivatives

OTC (Over the counter ) trading

Exchange Traded Derivatives Future Contracts

Forward Contracts

Options

Swaps

Most common Derivative Products

Enhance liquidity of the underlying asset

Lower transaction costs

Improve the price discovery process

Upgrade portfolio management capabilities

Allow risk management thru hedging & leverage

Provide signals of market movements

Facilitate financial markets integration

Derivatives, advantages for Markets……from an academic approach

A forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today.

It is a customized and tailor made contract in the sense the terms of the contract are agreed by both counterparties.

Hence, it is an OTC derivative product as no exchange is involved.

What is a Forward?

Forward Contract Example

I agree to sell 500kgs Wheat at

40€/kg after 3 months.

FarmerBread Maker

Then 3 months later…

FarmerBread Maker

500 Kgs. of wheat

20,000 €

At the starting point,

Credit Risk – Does the other party have the means to pay?

Operational Risk – Will the other party make delivery? Will the other party accept delivery?

Liquidity Risk – In case either party wants to opt out of the contract, how easy is to find another counterparty?

Classical Risks in Forward Contracts

Long Position

Short Position

Spot Price

Delivery|Fwd Price

Maturity Date

Investor ‘is more of a buyer in an asset (x)’.

Asset (x) in net terms is short in a portfolio.

Price of the underlying asset in the spot market.

Price of the asset at the delivery date.

It’s the date when a future expires and dies.

Forward Specifications

A Future is a STANDARDIZED “Forward” contract.

It’s traded in an ORGANIZED EXCHANGE.

Standardizations involve:

Quantity of underlying asset

Quality of underlying (mostly in commodities futures)

Delivery dates and type of settlement (cash|delivery)

Price quotes, ticks and symbols are predefined

What are Futures?

Situation AWent Long at $10

Sold @ $10Bought @ $14

S $14

Profit $2

Loss $4 Profit $2

Situation B Situation C

Went Short at $12

L $12

Futures Contract Example

INTEREST RATES (Below 2YR) Ex: 3month EURIBOR, 3mEURODOLLAR

FIXED INCOME (Above 2YR) Ex: US 10YR Note, Bund, BTP, JGB

FOREIGN EXCHANGE Ex: Eur/dol, eur/gbp, dol/yen

EQUITY (Stock|Equity Index Futs) Ex: SP500, Dow, Nasdaq, Dax, IBEX

COMMODITIES Ex: Gold, Crude Oil, Wheat, Copper

Asset Classes & Futures Contracts

Differences between… …Forwards vs. Futures

No

No

No

No

No

No

No

No

Yes

Yes

Yes

Yes

Yes

Yes

Mostly

Yes

Trade on organized exchanges

Use standardized contract terms

Use associate clearinghouses toguarantee contract fulfillment

Require margin payments and daily settlements

Markets are transparent

Marked to market daily

Closed prior to delivery

Profits or losses realized daily

Contract size -> The amount of the underlying asset that has to be delivered per (one) contract. Ex, a BMW future represents 100 lots of its underlying asset which is BMW shares.

Expiry date -> Defines the date that ends the life period of a futures contract. For european equity derivatives it’s common to be set the 3rd

Friday of each quarter.

Maturity -> Usually refers to the month in which the expiry of the future will take place. Ex, Eurostoxx50 future shows quarterly maturities (or expiries) in months Mar, Jun, Sep & Dec.

Futures Specifications

Generally, futures positions are not held until the expiry date and are closed out earlier in order to avoid:

Diminished liquidity as the expiry date comes nearer.

Delivery obligation when the 1st notice date is reached.

Usual way for investors to do so is by ROLLING OVER their positions,

WHAT HOW

WHEN

CASH SettlementMost common, daily

settlement

DELIVERY SettlementMostly for commodities and

governments debt

vs.

Closing & Settlement of Futures

Keep bets on market direction without any delivery issues.

Closing up the position in the present expiry and (re)opening it up in

the next one. In this way the bet is protracted.

Before the expiry and/or the 1st notice date is reached.

A margin is an amount of money that must be deposited with the clearing house as a requirement to execute futures contracts.

Both sides of the trade, buyer and seller, have to make this deposit in their their respective margin accounts.

Big picture, marging accounts help to reduce OTC markets overall

counterparty risk.

In case a counterparty defaults there is already money put aside, thus, the aggregated margin accounts, to honor the contracts.

Margin Concepts

Initial Margin -> It’s an OTC concept, refers to the Deposit that an investor must make when trading futures contracts. Usually amounts 10% of the contract nominal size.

Maintenance Margin -> As time goes by, the margin can reach its ‘minimum maintenance level’. Then the investor is required (by its CCP or Counterparty) to bring the margin back to its IM level. On average happens when margin drops below 75% of the IM.

Margin call -> When the margin account falls below the maintenance level, a ‘Margin Call’ is made to fill the gap.

Variation Margin -> Additional margins can be required to bring an account up to the required level under special market conditions.

Margins, more in detail (I)

Marking to Market is the practice of periodically adjusting the money deposited in the margin account,

ORIGIN From increased regulation and public scrutiny after Lehman Crash in 2008 this practice Mtm is extending from solely

exchange traded derivatives into OTC accountancy.

HOW

GOALMinimize counterparty default risk.

Margins, more in detail (II)

By adding|subtracting funds based on changes in the market price. Thus, reflecting daily the investor ’s gain|loss.

This leads to changes in margin accounts on a daily basis.

Contracts that give the holder the option…

The word “option” means that the holder has the RIGHT but not the obligation to buy (or sell) the underlying asset.

An example of language flow in the trading of options:

The option to buy (or sell)a specified

quantity of the underlying asset,

At a particular price,

On (or before) a specified time period,

“Please quote me the DEC19 3500 PUT EUROSTOXX50 Tks.”

What are Options?

WHAT

HOWWHEN

CALLOption that gives the buyer the RIGHT (but not the obligation) TO

BUY a given quantity of the underlying asset, at a given price on (orbefore) a particular date by paying a premium.

PUTOption give the buyer the RIGHT (but not the obligation)TO SELL a given quantity of the underlying asset, at a given priceon (or before) a particular date by paying a premium.

Option Types

EUROPEAN Can be exercised ONLY on the maturity date of the option. Also known as the expiry date.

AMERICAN Can be exercised ANY TIME either before or on the expiry date, thus, at any time during its life time.

Chart showing the execution possibilities of:

OPTION LIFE TIME

An AMERICAN OPTION

An EUROPEAN OPTION =

Option Styles

Right to buy 100 BMW shares,at a price of 300 € per share,

after 3 months Strike Price

BMW spot price = 250 €Option Premium = 2,500 €

BMW spot price is 400 €,Then the option IS EXERCISED

And the hundred shares are bought

PROFIT =40,000-30,000-2,500= 7,500

Expiry date

Calculation, this involves a premium per share of 25 €

Scenario 1, a month later Scenario 2, a month later

BMW spot price is 200 €,Then the option is NOT exercised

The premium paid is lost

LOSS = 2,500 € = Premium paid

Call Option, BMW example

Right to sell 100 IBM shares,At a price of 35 $ per share,

after 3 months Strike Price

IBM spot price = 40 $Option Premium = 400 $

IBM spot price is 30 $,Then the option IS EXERCISED

And the hundred shares are sold

PROFIT = 3,500-3,000-400 = 100 $

Expiry date

Calculation, this involves a premium per share of 4 $

Scenario 1, a month later Scenario 2, a month later

IBM spot price is 50 $,Then the option is NOT exercised

The premium paid is lost

LOSS = 400 $ = Premium paid

Put Option, IBM example

Underlying

Premium

Strike

Expiry date

Exercise date

Option holder

Option writer

Open interest

Options Specifications

Specific security or asset.

Price of the option.

Exercise price.

Date on which option expires.

Option is exercised (can be the expiry date).

One who buys options.

One who sells options.

Total number of a specific option contract that have NOT yet been…

closed out|delivered|expired

…on a particular day.

Option Pay Off

Strike Price vs. Spot Price

Intrinsic Value of an option comes out comparing Strike|Spot price.

Therefore, for a given STRIKE and SPOT,The value of an option position is quite different

when its Calls or Puts | Long or Short.

It’s a concept that refers to the potential profit (or loss) derived from the eventual exercise of a specific option position.

In option pricing the reference price is the spot price of the underlying asset.

Moneyness

We see now the TWO COMPONENTS involved in a PREMIUM,namely TIME and INTRINSIC value.

Premium & Time to Expiry

Swaps are contractual agreements to exchange or swap a series of cash

flows.

These cash flows are most commonly the interest payments associated with

debt service:

If the agreement is for one party to swap its fixed interest rate

payments for the floating interest rate payments of another, it is termed an interest rate swap (IRS).

If the agreement is to swap currencies of debt service obligation, it is termed a currency swap (CCS).

A single swap may combine elements of both IRSs and CCSs.

What are SWAPS? (I)

The swap itself is not a source of capital, but rather an alteration of the

cash flows associated with debt service payments.

What is often termed the plain vanilla swap is an agreement between two parties to exchange fixed-rate for floating-rate financial obligations.

Swaps are the top traded single derivative product in the world.

What are SWAPS? (II)

I. A corporate borrower has an existing debt service obligation. Based on their

interest rate predictions they want to swap to another exposure (e.g. change from paying fixed to paying floating).

II. Two borrowers can work together to get a lower combined borrowing

cost by utilizing their comparative borrow profiles,

The Quality Spread Differential (QSD) represents the potential gains from the swap that can be shared between the counterparties and the swap bank.

There is no reason to presume that the gains will be shared equally.

In the next slide we show an example where Company B is less credit-worthy than Bank A, so they probably would have gotten less of the QSD, in order to compensate the swap bank for the default risk.

Main reasons for using swaps

A company agrees to pay a pre-determined fixed interest rate on a

notional principal for a fixed number of years.

In return, receives interest at a floating rate on the same notional for the same period of time.

The Principal is NOT EXCHANGED. Hence, It’s called NOTIONAL amount.

IRS is the most traded of all swaps. Therefore, IRSs are the most relevant financial derivative in the world.

What is an Interest Rate Swap?

LIBOR

+ ½%

10 3/8 %

LIBOR – 1/8%LIBOR – ¼%

10 ½%

B saves ½ %

Bank

A

Swap

Bank

Company

B

A saves ½ %

The swap bank makes ¼ %

10%

Note that the total savings ½

+ ½ + ¼ = 1.25 % = QSD

COMPANY B BANK A DIFFERENTIAL

Fixed rate 11.75% 10% 1.75%

Floating rate LIBOR + 0.50% LIBOR 0.50%

QSD = 1.25%

IRS example,

Working together to get alower combined borrowing cost

Since all swap rates are derived from the yield curve in each major

currency, the fixed-to-floating IRS existing in each currency allows firms swap across currencies.

The usual motivation for a currency swap is to replace cash flowsscheduled in an undesired currency with flows in a desired currency.

The desired currency is probably the currency in which the firm’s future operating revenues (inflows) will be generated.

Firms often raise capital in currencies in which they do not possess significant revenues for investments and/or logistics purposes.

What is a Currency Swap?

INITIALLY Company A which is US based wants to finance a £10,000,000 expansion of a British plant. Alternatives,

BETTER SOLUTION for Company A would be to find a British MNC with mirror financing needs and do a CCS.

For this example, let’s assume this and also that both firms wish to finance a project of the same size in each other’s country.

Data, £10M and $16Mwith exchange rate $/£ = 1.60

I. To borrow $’s in the U.S. where they are well known and exchange dollars for pounds. This results in exchange rate risk.

II. To borrow £’s in the international bond market, but pay a lot since they are not well known abroad.

CCS example (I)

A is the more credit-worthy of the two. A pays 2% less to borrow in dollars than B. A pays 0.4% less to borrow in pounds than B.

B has a comparative advantage in borrowing in £. B pays 2% more to borrow in dollars than A. B pays only 0.4% more to borrow in pounds than A.

Potential Savings or Gains,

2.0 - 0.4 = 1.6%

CCS example (II)

If Swap Bank takes 0.4% and A&B split the rest:“A” improves paying 11.6% - 0.6% = 11%“B” improves paying 10% - 0.6% = 9.4%

Company A

SwapBank

i$=8%

i$=8%

i£=11%i£=12%

i$=9.4%

CompanyB

i£=12%

A’s net position is to borrow at i£=11%

A saves i£=0.6%

B’s net position is to borrow at i$=9.4%

B saves i$=0.6%

The Swap Bank makes money too:

1.6% - (0.6 - 0.6) = 0.4%

The swap bank faces exchange rate

risk, but they could avoid it hedging

that amount.

CCS example (III)

Derivative products are Forwards, Futures, Options and Swaps.

Asset classes are FX, Interest Rates, Fixed Income, Equities and Commodities.

All above can be traded either taylor made at OTC markets orstandardized in Exchange derivative markets.

Settlement can be done by cash or by delivery.

Premium on option valuation involve two components which are Time value and Intrinsic value.

Swaps are widely used as they allow debtors to improve its paymentconditions.

SUMMARY and Q&A

Financial Derivatives

Fonetic Trading Unit

LEARNING UNIT 1 | BASIC CONCEPTS

‘Forwards, Futures, Options and Swaps’

End of presentation,

Thank you.