Econ2050 Money and Finance Topic 8: Derivatives Markets Notes

Introduction to Financial Derivatives

• Financial derivatives are instruments that derive their value from movements in an underlying security, commodity, or specific event.

• Because derivatives are based on external benchmarks, there is virtually no limit to their creation, allowing for a vast and complex marketplace.

• Primary Purpose: Derivatives are intended to allow firms to alter their risk profile. They serve as a guard against fluctuations in:

  • Interest rates.

  • Exchange rates.

  • Commodity prices.

  • Default risk.

  • Other diverse sources of financial market risk.

• Growth and Market Volume: In the decade leading up to 2007, the "over the counter" (OTC) derivatives market grew ten-fold. In 2007 alone, the volume of OTC derivatives bought and sold reached $\$700\text{trn}$.

• The Shift in Perception:

  • Prior to the Global Financial Crisis (GFC), many believed derivatives could effectively banish risk from the financial system.

  • Conversely, Warren Buffet famously described certain derivatives as "financial weapons of mass destruction."

  • Rather than just mitigating risk, derivatives can exacerbate the troubles a corporation faces due to unrelated fundamental issues.

  • These instruments create a "daisy-chain risk," which is functionally similar to the risks faced by insurers regarding interconnected liabilities.

Forwards and Futures

• Definition: Forwards and Futures are contracts where two parties agree to engage in a financial transaction at a future date at a price specified today.

• Terminology:

  • Long Position ("Going Long"): This refers to the buyer of the asset forward.

  • Short Position ("Shorting"): This refers to the seller of the asset forward.

• Market Structure:

  • Futures: Traded on organized exchanges. In Australia, this is the Sydney Futures Exchange ($SFE$), which is part of the $ASX$.

  • Forwards: Sold "over the counter" ($OTC$) rather than on a formal exchange.

• Contractual Specifics:

  • Futures Contracts: These are highly standardized. Standardized items include quantities, qualities (for deliverables), and timing.

  • Forward Contracts: Features such as quantity and timing are negotiable between the parties.

• Historical Evolution: For over a century, US futures exchanges focused exclusively on commodity futures. In the 1970s, a revolution occurred with the introduction of financial futures.

• Applications:

  • Foreign exchange markets are the most active arena for forward contracts. Exporters and importers use them to seek protection against exchange rate movements.

  • Market participants include both "hedgers" (who use derivatives to mitigate risk) and "speculators" (who seek to profit from price movements).

Risk Management and Exchange Mechanics in Futures Markets

• Default Risk Protection: In futures markets, the contract is between the buyer/seller and the exchange itself. This design eliminates much of the default risk (the risk that a counterparty fails to deliver, which equals the "price gap" created by spot price movements).

• The Clearing House: The futures exchange provides a clearing house that stands between counterparties. This ensures players can lose money due to price movements (a "bad deal"), but not due to their choice of counterparty.

• Safeguards for the Exchange: Considering the vast volumes, exchanges protect themselves via:

  • Initial Margins: Deposits that counterparties must lodge with the clearing house.

  • Marking to Market: Daily price movements are transferred to the "winning" counterparty. This process is "zero-sum," meaning one party's gain is the other's loss.

• Margin Calls:

  • Determined by the exchange based on contract size, nature, and historical volatility projections.

  • If the initial margin falls below a specific threshold, a top-up of new cash is required.

  • This prevents the buildup of large unrealized losses.

  • The Sydney Futures Exchange typically announces margin calls at $7.00am$ based on the previous day’s prices. During high volatility, "intraday" margin calls may occur.

• Default and Position Limits:

  • If a margin call is not met, the exchange will "close out" the position (taking out an opposite contract) and take action to recover losses from the defaulter.

  • Position Limits: Many exchanges limit the size of positions held by traders to prevent speculators from "cornering" the market.

Share Index Futures Contracts

• Definition: Share Index Futures derive their value from movements in a specific share index.

• SFE SPI 200: In Australia, the most significant and widely reported share index future is the $SFE\,SPI\,200$, commonly referred to as the "spi."

• Hedging Systematic Risk: Investors sell $SPI$ futures contracts to offset potential downward movements in their share portfolios.

  • Cost of Insurance: While this offsets losses, it also offsets potential gains during systematic market upswings.

• Index Arbitrage: A form of arbitrage has emerged to exploit price differences between index futures and the movements of the underlying shares.

Options: Call and Put Mechanics

• Definition: Options give the purchaser the right—but not the obligation—to buy or sell a security at a predetermined price, known as the "strike price" or "exercise price," within a specific timeframe.

• Buyer vs. Writer:

  • The buyer has the choice to exercise.

  • The writer (seller) has no choice and must fulfill the contract if the buyer chooses to exercise.

• Option Premium: The buyer pays a premium to the seller. The seller keeps this premium regardless of whether the option is exercised.

• Option Types:

  • Call Options: Right to buy a security at the strike price.

  • Put Options: Right to sell a security at the strike price.

• Profitability States:

  • In the Money: For a Call Option, this is when the market price is above the strike price. For a Put Option, it is when the market price is below the strike price.

  • Out of the Money: For a Call Option, this is when the market price is below the strike price. For a Put Option, it is when the market price is above the strike price.

• Exercise Timing:

  • American Options: Can be exercised anytime before the expiry date.

  • European Options: Can only be exercised at the maturity date.

• Risk Profile: In options, the buyer's loss is limited to the premium paid (plus commissions). In futures or forwards, potential losses can be unlimited.

• Sub-categories of Options Writers:

  • Covered Options: The writer already owns the underlying security or has hedged the exposure.

  • Naked Options: The writer does not own the security and has not arranged a hedge.

Option Pricing and the Black-Scholes Model

• The Black-Scholes Model: Formulated in the early 1970s, this model revolutionized the options market.

• Impact: Before this model, options writers faced high risks of capital loss and consequently wrote small amounts with high premiums. The formula allowed dealers to calculate desirable option prices based on the past behavior of asset prices, limiting seller losses.

• Expansion: Following the model's introduction, new options were developed for interest rates ($IRs$), credit ratings, weather, energy, and commodities.

• Limitations: The model relies on certain assumptions, most notably that markets are efficient.

Swaps: Interest Rate and Currency

• Definition: Swaps are contracts obligating parties to exchange a series of payments. The two most common types are "interest rate swaps" and "currency swaps," often called "plain vanilla" swaps.

• Economic Incentive: Swaps are driven by the principle of "comparative advantage" or gains from trade.

• Currency Swaps: These align income and expense flows for businesses operating in multiple countries (e.g., $BHP\,Billiton$ receiving Yen from operations but having A\ debt, swapping with $Toyota$ which has the inverse situation).

• Interest Rate (IR) Swaps:

  • Used to obtain cheaper financing than local banks or bond issues.

  • Example: A small company might pay a fixed rate (e.g., $5\%$) to a blue-chip company, while the blue-chip company pays a floating rate (e.g., $LIBOR + 4\%$) back to the small company.

  • Notional Amount: The principal is not exchanged; payments are calculated based on a "notional" amount.

  • Netting: Only the net interest payment is transferred between parties.

• Characteristics:

  • Can be used for speculation (e.g., if you expect interest rates to rise, you want to be the fixed-rate payer).

  • Swaps are mostly $OTC$ transactions, meaning there is no central clearing house and therefore they carry counterparty/default risk.

  • Investment banks often act as intermediaries or counterparties in these deals.

Credit Default Swaps (CDS)

• Overview: A $CDS$ is essentially an insurance contract against the default of an underlying security issuer. It swaps default risk with an insurer (the $CDS$ seller).

• Note on Coverage: A $CDS$ does not insure against interest rate risk, only default risk.

• Mechanics: The bondholder pays a premium to the insurer. If the bond issuer defaults, the insurer pays the bondholder the bond’s face value.

• Speculation and De-coupling:

  • A party does not need to own the underlying bond to buy a $CDS$.

  • Speculators buy $CDSs$ if they believe market doubts regarding a bond issuer will increase. If doubts grow, the $CDS$ price rises, and the speculator is "in the money."

  • Because ownership is not required, the volume of $CDSs$ can be significantly greater than the actual volume of the underlying assets; their issue is virtually unlimited.

• Market Risks and the GFC:

  • In contrast to traditional insurance, the $CDS$ market was largely unregulated (no capital or asset quality ratios).

  • Prior to GFC: $CDSs$ were cheap, even for exotic assets.

  • During/Post GFC: $CDS$ prices soared as defaults increased. They became the primary vehicle for transmitting subprime write-downs throughout the financial sector.

  • When firms like Bear Stearns and Lehman Brothers failed, $CDS$ sellers faced massive bills for full-face value compensation.

  • Systemic Failure: Many unregulated $CDS$ sellers (and some regulated ones who oversold) could not honor their commitments, leaving buyers uninsured.

• The Case of AIG: The US Federal Reserve bailed out $AIG$ (despite letting Lehman fail) because $AIG$ was a massive seller of $CDSs$. If $AIG$ had failed, the systemic risk to the global financial system would have been immediate.

Quantitative Data: CDS Market Trends

• A provided chart tracks Five-year US dollar $CDS$ prices (in basis points) from $Q1\,20$ to $Q1\,23$.

• Participating Institutions Includes: Barclays, Deutsche Bank, Citigroup, JPMorgan, and Credit Suisse.

• Trend Detail: While most banks remained between $0$ and $200$ basis points, Credit Suisse's $CDS$ prices soared dramatically, reaching near $1,000$ basis points by $Q1\,23$, far exceeding the prices of its peers.