Chapter 6 - Derivatives

Futures, Options, IR Swaps, Credit Default Swaps and Derivative and Commodity Markets

What is a derivative?

An asset that derives value based on the value of another asset or contract.

What are commodity markets?

• The trading of agricultural products.

• They are where raw or primary products are exchanged or traded on regulated exchanges. They are bought and sold in standardised contracts – a standardised contract is one where not only the amount and timing of the contract conforms to the exchange’s norm, but also the quality and form of the underlying asset – for example, the dryness of wheat or the purity of metals.

Who participates in commodity markets?

• Commodities are sold by producers (eg, farmers, mining companies and oil companies) and purchased by consumers (eg, food manufacturers and industrial goods manufacturers).

• Much of the buying and selling is undertaken via commodity derivatives, which also offer the ability for producers and consumers to hedge their exposure to price movements.

• However, there is also substantial trading in commodities (and their derivatives) undertaken by financial firms and speculators seeking to make profits by correctly predicting market movements.

Why do people use derivatives?

• A derivative is a financial instrument whose price is based on the price of another asset, known as the underlying asset or simply ‘the underlying’, and pre-agreed contract terms.

• This underlying asset could be a financial asset or a commodity.

• Derivatives are often based around time and the uncertainty of future prices.

How can derivatives be traded?

• OTC - directly between counterparties

• Organised exchange - such as ICE Europe, exchange-traded

What is hedging?

A technique employed by portfolio managers to reduce the impact of adverse price movements on a portfolio’s value; this could be achieved by selling a sufficient number of futures contracts or buying put options.

What is anticipating future cash flows?

Closely linked to the idea of hedging; if a portfolio manager expects to receive a large inflow of cash to be invested in a particular asset, then futures can be used to fix the price at which it will be bought and offset the risk that prices will have risen by the time the cash flow is received.

What are asset allocation changes?

These are changes to the asset allocation of a fund, whether to take advantage of anticipated short-term directional market movements or to implement a change in strategy; can be made more swiftly and less expensively using derivatives such as futures than by actually buying and selling securities within the underlying portfolio.

What arbitrage?

The process of deriving a risk-free profit from simultaneously buying and selling the same asset in two different markets, when a price difference between the two exists. If the price of a derivative and its underlying asset are mismatched, then the portfolio manager may be able to profit from this pricing anomaly.

What is a future?

• An agreement between a buyer and seller.

• A futures contract is a legally binding obligation between two parties:

  • The buyer agrees to pay a prespecified amount for the delivery of a particular prespecified quantity of an asset at a prespecified future date.

  • The seller agrees to deliver the asset at the future date, in exchange for the prespecified amount of money.

What are the two distinct features of a future?

• It is exchange-traded – for example, on derivatives exchanges such as ICE Europe in London or the Chicago Mercantile Exchange (CME) in the US.

• It is dealt on standardised terms – the exchange specifies the quality of the underlying asset, the quantity underlying each contract, the future date and the delivery location – only the price is open to negotiation.

  • In the above example, the oil quality will be based on the oil field from which it originates (eg, Brent crude – from the Brent oil field in the North Sea), the quantity is 1,000 barrels, the date is three months ahead and the location might be the port of Rotterdam.

What is specific futures terminology?

• Long – the term used for the position taken by the buyer of the future. The person who is ‘long’ of the contract is committed to buying the underlying asset at the pre-agreed price on the specified future date.

• Short – the position taken by the seller of the future. The seller is committed to delivering the underlying asset in exchange for the pre-agreed price on the specified future date.

• Open – the initial trade. A market participant ‘opens’ a trade when it first enters into a future. It could be buying a future (opening a long position), or selling a future (opening a short position).

• Close – the physical assets underlying most futures that are opened do not end up being delivered: they are ‘closed-out’ instead. For example, an opening buyer will almost invariably avoid delivery by making a closing sale before the delivery date. If the buyer does not close-out, they will pay the agreed sum and receive the underlying asset. This might be something the buyer is keen to avoid, for example, because the buyer is actually a financial institution simply speculating the price of the underlying asset using futures.

• Covered – when the seller of the future has the underlying asset that will be needed if physical delivery takes place.

• Naked – when the seller of the future does not have the asset that will be needed if physical delivery of the underlying commodity is required. The risk could be unlimited.

What is an option?

• An option gives a buyer the right, but not the obligation, to buy or sell a specified quantity of an underlying asset at a pre-agreed exercise price, on or before a prespecified future date or between two specified dates. The seller, in exchange for the payment of a premium, grants the option to the buyer.

• A key difference between a future and an option is, therefore, that an option gives the right to buy or sell, whereas a future is a legally binding obligation between counterparties.

How can options be traded?

• When options are traded on an exchange, they will be in standardised sizes and terms. From time to time, however, investors may wish to trade an option that is outside these standardised terms and they will do so in the OTC market.

• Options can, therefore, also be traded off-exchange, or OTC, where the contract specification determined by the parties is bespoke.

What are the two main classes of options?

• A call option is when the buyer has the right to buy the asset at the exercise price, if they choose to.

  • The seller is obliged to deliver if the buyer exercises the option.

• A put option is when the buyer has the right to sell the underlying asset at the exercise price.

  • The seller of the put option is obliged to take delivery and pay the exercise price if the buyer exercises the option.

Who are the holders and writers of options?

• The buyers of options are the owners of those options. They are also referred to as holders.

• The sellers of options are referred to as the writers of those options.

  • Their sale is also referred to as ‘taking for the call’ or ‘taking for the put’, depending on whether they receive a premium for selling a call option or a put option.

How are options done on organised exchanges?

• Both buyers and sellers settle the contract with a clearing house that is part of the exchange, rather than with each other.

• The exchange needs to be able to settle bargains if holders choose to exercise their rights to buy or sell. Since the exchange does not want to be a buyer or seller of the underlying asset, it matches these transactions with deals placed by option writers who have agreed to deliver or receive the matching underlying asset, if called upon to do so.

What is the premium of an option?

The money paid by the buyer/holder to the exchange (and then by the exchange to the seller/writer) at the beginning of the option contract; it is not refundable.

How do options work in practice?

• Staying with that example, we can look at the terms ‘covered’ and ‘naked’ in relation to options.

• The writer of the option is hoping that the investor will not exercise his right to buy the underlying shares and then he can simply pocket the premium.

• This obviously presents a risk because if the price does rise then the writer will need to find the shares to meet his obligation.

• He may not have the shares to deliver and may have to buy these in the market, in which case his position is referred to as being naked (ie, he does not have the underlying asset – the shares).

• Alternatively, he may hold the shares, and his position would be referred to as covered.

What are Swaps?

• An agreement to exchange one set of cash flows for another. They are most commonly used to switch financing from one currency to another or to replace floating interest with fixed interest.

• Swaps are a form of OTC derivative and are negotiated between the parties to meet the different needs -of customers, so each tends to be unique.

• Interest rate swaps are the most common form of swaps.

What are IR Swaps?

• They involve an exchange of interest payments and are usually constructed whereby one leg of the swap is a payment of a fixed rate of interest and the other leg is a payment of a floating rate of interest.

• They are often used to hedge exposure to interest rate changes.

How do IR Swaps work?

• The two exchanges of cash flow are known as the legs of the swap and the amounts to be exchanged are calculated by reference to a notional amount.

• The notional amount in the above example would be the amount that Company A has borrowed to fund its project.

• It is referred to as the notional amount as it is needed in order to calculate the amounts of interest due, but is never exchanged.

• Typically, one party will pay an amount based on a fixed rate to the other party, who will pay back an amount of interest that is variable and usually based on a market reference rate such as the Secured Overnight Funding Rate (SOFR).

• The variable rate will usually be set as a market reference rate plus, say, 0.5%, and will be reset quarterly.

• The variable rate is often described as the floating rate.

What are CDSs?

• Credit derivatives are instruments whose value depends on agreed credit events relating to a third-party company, for example, changes to the credit rating of that company, or an increase in that company’s cost of funds in the market, or credit events relating to it.

• Credit events are typically defined as including a material default, bankruptcy, a significant fall in an asset’s value, or debt restructuring, for a specified reference asset.

What is the purpose of CDSs?

The purpose of credit derivatives is to enable an organisation to protect itself against unwanted credit exposure, by passing that exposure on to someone else. Credit derivatives can also be used to increase credit exposure, in return for income.

What do CDSs do?

• Although a CDS has the word ‘swap’ in its name, it is not like other types of swaps, which are based on the exchange of cash flows.

• A CDS is actually more like an option. In a CDS, the party buying credit protection makes a periodic payment (or pays an up-front fee) to a second party, the seller. In return, the buyer receives an agreed compensation if there is a credit event relating to some third party or parties.

• If such a credit event occurs, the seller makes a predetermined payment to the buyer, and the CDS then terminates.

• So, a CDS can be thought of as a type of insurance – in simple terms, the holder of a bond (ie, the CDS buyer) can take out protection on the risk of the issuer of the bond (the debt issuer) defaulting by paying a premium to a counterparty, the CDS seller.

• An investment fund might take out a CDS to protect its holding of a bond in case of default, while other market participants might use one to speculate on changes in credit rating.

What exactly are derivatives?

• A financial instrument whose price is derived from that of another asset.

• Derivatives are often thought of as dangerous instruments that are impenetrably complex.

• While derivatives can be complex and present systemic risks, they are chiefly designed to be used to reduce the risk faced by organisations and individuals, a process known as hedging.

• Equally, many derivatives are not particularly complex.

What is an example of a derivative?

As an example, imagine that you wanted to purchase a large amount of wheat from a wholesale supplier. You contact the supplier and see that it will cost the sterling equivalent of $5 a bushel. But you discover that the wheat is currently out of stock in the warehouse. However, you can sign a contract to accept delivery of the wheat in one month’s time (when the stock will be replenished), and at that stage, the store will charge $5 for each bushel you order now. If you sign, you have agreed to defer delivery for one month – and you have purchased into a derivative.

How do commodities fit in with derivatives?

• The physical trading of commodities takes place side by side with the trading of derivatives.

• The physical market concerns itself with procuring, transporting and consuming real commodities by the shipload on a global basis.

• This trade is dominated by major international trading houses, governments, and the major producers and consumers.

• The derivatives markets exist in parallel and serve to provide a price-fixing mechanism whereby all stakeholders in the physical markets can hedge market price risk.

• Another aspect of commodity markets, more recent in origin but highly developed, is the use of commodities as an investment asset class in its own right.

What are OTC derivatives?

• They are negotiated and traded privately between parties without the use of an exchange.

• Products such as interest rate swaps, forward rate agreements and other exotic derivatives are mainly traded in this way.

• The OTC market is the larger of the two in terms of value of contracts traded daily.

• Trading takes place predominantly in Europe and, particularly, in the UK (note that there is considerable activity taking place at the moment to move OTC trading on-exchange in response to regulatory concerns about the risks posed by OTC derivative trading).

What are Exchanged-traded Derivatives (ETDs)?

• ETDs have standardised features and can, therefore, be traded on an organised exchange, such as single stock or index derivatives.

• The role of the exchange is to provide a marketplace for trading to take place, but also to stand between each party to a trade to provide a guarantee that the trade will eventually be settled. It does this by acting as an intermediary (central counterparty) for all trades and by requiring participants to post a margin, which is a proportion of the value of the trade, for all transactions that are entered into.

What are examples of commodity markets?

• Agricultural markets

• Base and precious metals

• Energy markets

• Power markets

• Plastics markets

• Emissions markets

• Freight and shipping markets

What is ICE Futures Europe?

• In 2001, Euronext purchased a derivatives exchange in London called LIFFE (pronounced ‘life’) and renamed it Euronext.liffe.

• LIFFE was originally an acronym for the London International Financial Futures and Options Exchange, set up in 1982.

• It is now part of ICE following the takeover of NYSE Euronext.

• ICE Futures Europe is the main exchange for trading financial derivative products in the UK, including

  • futures and options on:

  • interest rates and bonds

  • equity indices (eg, FTSE), and

  • individual equities (eg, BP, HSBC).

• It also trades derivatives on soft commodities, such as sugar, wheat and cocoa. Additionally, it also runs futures and options markets in Amsterdam, Brussels, Lisbon and Paris.

What is Eurex?

• Eurex is the world’s leading international derivatives exchange and is based in Frankfurt. Its principal products are German bond futures and options, the most well-known of which are contracts on the Bund (a German bond). It also trades index products for a range of European markets.

• Eurex was created by Deutsche Börse AG and the Swiss Exchange. Trading is on the fully computerised Eurex platform, and its members are linked to the Eurex system via a dedicated wide-area communications network (WAN). This enables members from across Europe and the US to access Eurex outside Switzerland and Germany.

What is Intercontinental Exchange (ICE)?

• Intercontinental Exchange (ICE) operates the electronic global futures and OTC marketplace for trading energy commodity contracts. These contracts include crude oil and refined products, natural gas, power and emissions.

• The company’s regulated futures and options business, formerly known as the International Petroleum Exchange (IPE), now operates under the name ICE Futures. ICE acquired the London-based energy futures and options exchange in 2001 and completed the transition from open outcry to electronic trading in April 2005.

Is ICE Futures Europe part of ICE?

• ICE Futures Europe is the leading energy futures and options exchange and is a subsidiary of ICE.

• ICE’s products include derivative contracts based on key energy commodities: crude oil and refined oil products, such as heating oil and jet fuel and other products, like natural gas and electric power.

• With the acquisition of LIFFE, its range of tradeable products expanded to include futures and options on bonds, equities and indices.

Where else is ICE located?

ICE’s other markets are centred in North America and include trading of agricultural, currency and stock index futures and options. It also took over NYSE Euronext and, as a result, by acquiring LIFFE, became the world’s largest derivatives exchange operator.

What is the London Metal Exchange (LME)?

• The London Metal Exchange (LME) is the world’s premier non-ferrous metals market and has been operating for over 130 years.

• Although it is based in London, it is a global market with an international membership and with more than 95% of its business coming from overseas.

• Futures and options contracts are traded on a range of metals, including aluminium, copper, nickel, tin, zinc and lead.

• More recently, it has also launched the world’s first futures contracts for plastics.

• Trading on the LME takes place in three ways: through open outcry trading in the ‘ring’, through an inter-office telephone market and through LME Select, the exchange’s electronic trading platform.

What are the advantages of investing in the derivatives market?

• Enables producers and consumers of goods to agree the price of a commodity today for future delivery, which can remove the uncertainty of what price will be achieved for the producer and the risk of lack of supply for the consumer.

• Enables investment firms to hedge the risk associated with a portfolio or an individual stock.

• Offers the ability to speculate on a wide range of assets and markets to make large bets on price movements using the geared nature of derivatives.

What are the disadvantages of investing in the derivatives market?

• Some types of derivatives investment can involve the investor losing more than their initial outlay and, in some cases, facing potentially unlimited losses.

• Derivatives markets thrive on price volatility, meaning that professional investment skills and experience are required.

• In the OTC markets, there is a risk that a counterparty may default on their obligations, and so it requires great attention to detail in terms of counterparty risk assessment, documentation and the taking of collateral.