Derivatives

Derivative

a security that derives its value from an underlying, typically a price or interest rate

OTC Markets

• customizable

• less liquid and transparent

• higher trading costs

• many required to have central clearing party and collateral

• Forward Contracts

Exchange-Traded

• standardized

• more transparent and liquid

• lower costs

• central clearing minimizes counterparty risk (more efficient)

• Futures Contract

Forward Contract

• customized, no active secondary market (OTC)

• long gains if asset price > forward

• short gains if asset price < forward

Futures Contract

• standardized, active secondary market (exchange-traded)

• requires margin deposit

• no counterparty default risk

Settlement Price

average of trades during closing period, used to calculate margin

Spot Price

price of underlying asset for immediate delivery

Marking to Market

prices of adjusting margin balance each day for change in future prices

Swaps

agreements to exchange a series of payments on mulitple settlement dates over a specific period

• payments are typically netted

• may or may not require margin

• equivalent to a series of forwards

Credit Default Swaps

protection buyer makes periodic payments (short credit risk)

Protection seller pays only if credit event occurs (long credit risk)

Call Option

Long has right to buy underlying at exercise price

Short has obligation to sell/deliver asset

Put Option

Long has the right to sell the underlying at the exercise price

Short has obligation to purchase at exercise

European Options

can be exercised only at expiration

American Options

can be exercised any time prior to expiration

Basis Risk

underlying mismatch w/ hedged risk; mismatch of expiration date and date of hedged transaction

Systemic Risk

excessive speculation may have negative impact on financial markets / institution

Counterparty Risk

depending on derivative position and margin requirements

Hedge Accounting

gains / losses on derivatives offset changing asset/ liability values

Cash Flow Hedge

Fixed Rate payer swap to reduce uncertainty about future floating rate interest payments

Currency forward to reduce uncertainty about value of foreign currency payment

Fair Value Hedge

value of gold miner’s inventory hedged by selling forward contracts on gold

floating-rate payer swap to offset changes in balance sheet value of fixed-rate bond liability

Net Value/ Investment Hedge

hedging the value of a foreign subsidiary’s equity on a parent’s balance sheet w/ currency forwards

Arbitrage

two assets have the same future payoffs, but different prices, buy the lower-priced asset & sell higher-priced asset to risk-free gain

actions of arbitrageurs will reduce the price difference to zero (no-arbitrage price)

Forward Rate Agreement (FRA)

fixed rate payer (long) will pay the forward rate on a notional amount of principal

Long FRA

pay fixed, receive floating rate

Short FRA

pay floating rate, receive fixed rate

Forward Price / Value changes

after initiation, price does not change however value will fluctuate w/ changes in value of underlying (convexity bias)

Futures Price / Value changes

price and value both change with daily mark to market gains/losses are settled

price resets to settlement price and value returns to zero daily

Forward Convexity Bias

just like bond convexity, it has value to investors

just like bonds, convexity effect increases for longer periods

Swap Price

a fixed rate price, at initiation swap value is zero

Hedge Ratio

number of units of long stock needed per 1 short call option to create risk neutral portfolio