Econ2050 Money and Finance Topic 8: Derivatives Markets Notes
Introduction to Financial Derivatives
Definition and Value Source: Financial derivatives are named because their value is 'derived' from the movement in an underlying security, commodity, or event.
Potential for Creation: Because their value can be tied to almost any underlying event or asset, there is virtually no limit to the creation of new derivative products.
Primary Function: Derivatives are intended to be instruments that allow firms to alter their risk profile. They serve as a guard against movements in:
Interest rates.
Exchange rates.
Commodity prices.
Default risk.
Other general sources of financial market risk.
Market Expansion: The market underwent massive growth in the decade leading up to .
'Over the counter' (OTC) derivatives alone grew ten-fold during this period.
In , approximately worth of derivatives were bought and sold.
Case Study: Credit Suisse CDS: A chart provided in the materials illustrates that Credit Suisse's Credit Default Swap (CDS) prices soared far above other major banks (Barclays, Deutsche Bank, Citigroup, and JPMorgan) between and , peaking near .
Risks and the Global Financial Crisis (GFC)
Perception of Risk: Prior to the Global Financial Crisis (GFC), there was a widespread belief that derivatives could effectively banish risk itself from the financial system.
Financial Weapons of Mass Destruction: Warren Buffett evocatively described certain derivatives as 'financial weapons of mass destruction' because of their potential to cause widespread economic ruin.
Exacerbation of Trouble: Derivatives can worsen the difficulties a corporation faces, even if those troubles initially stemmed from unrelated fundamental issues.
Daisy-Chain Risk: These instruments create a 'daisy-chain' risk similar to that experienced by insurers, where the failure of one party leads to a series of subsequent failures throughout the financial system.
Forwards and Futures Contracts
Core Definition: Both are contracts where two parties agree to engage in a financial transaction at a future date at a price specified today.
Key Terminology:
Long Position ('Going Long'): The buyer of an asset via a forward or futures contract.
Short Position ('Shorting'): The seller of an asset via a forward or futures contract.
Forwards Characteristics:
Sold 'over the counter' (OTC).
Contractual items (quantities, qualities, timing) are negotiable between the specific parties.
Futures Characteristics:
Traded on organized exchanges. In Australia, this is the Sydney Futures Exchange (SFE), which is part of the ASX.
Standardized contracts regarding quantities, quality of deliverables, and timing.
Market Evolution: For over a century, US futures exchanges focused exclusively on commodity futures. A revolution began in the with the introduction of financial futures.
Foreign Exchange (FX): FX markets are the most active arena for forward contracts, particularly for exporters and importers seeking protection against exchange rate fluctuations.
Market Participants: These markets consist of counterparties using forwards to hedge against risk and speculators seeking to profit from price movements.
Mechanics of Futures Exchanges and Clearing Houses
Default Risk Mitigation: A critical difference between futures and forwards is that futures eliminate much of the default risk. In a futures contract, the agreement is technically between the buyer/seller and the exchange itself, rather than directly between two private parties.
The Clearing House: The exchange provides a clearing house that stands between counterparties. This ensures players can lose money due to a 'bad deal' (price movement) but not due to the choice of a counterparty who fails to deliver.
Protection Mechanisms:
Initial Margins: Deposits lodged with the clearing house at the start of a contract.
Mark to Market: Daily price movements are transferred to the 'winning' counterparty of a deal. This is a zero-sum process.
Margin Calls: Determined by the exchange based on the size and nature of the contract and projected volatility.
Top-Ups: If an initial margin deposit falls below a specified value (maintenance margin), the exchange requires a top-up of new cash. This prevents large unrealised losses from accumulating.
Sydney Futures Exchange (SFE) Protocols:
Margin calls are normally announced at , based on the previous day's price movements.
In times of high volatility, 'intraday' margin calls may be announced.
If calls are not met, the exchange will 'close out' the position by taking an opposite contract (buying to cancel a sell, or selling to cancel a buy) and taking action to recover losses.
Position Limits: Exchanges impose limits on the size of positions to ensure speculators cannot 'corner' the market.
Specific Financial Futures: Share Index Futures
Definition: Share Index Futures Contracts derive their value from movements in a specific share index.
Australian Context: The most significant contract is the SFE SPI 200, commonly known as the 'SPI'.
Hedging Systematic Risk: These contracts allow investors to hedge against the systematic risk of share portfolios.
Process: An investor sells an SPI futures contract to offset potential downward movements in their portfolio value.
Trade-off: This insurance costs the investor the potential gains they might have made in a systematic upswing.
Index Arbitrage: Arbitrageurs exploit price differences between the index futures and the movements of the underlying shares upon which the futures are based.
Options: Call, Put, and Sub-Categories
Definition: An option gives the purchaser the right—but not the obligation—to buy or sell a security at a predetermined price, known as the 'strike' or 'exercise' price, within a specific timeframe.
Buyer vs. Writer:
Buyer: Has the choice of whether to exercise the option.
Writer (Seller): Has the obligation to fulfill the contract if the buyer exercises it. The writer receives a premium which they keep regardless of whether the option is exercised.
Types of Options:
Call Option: The right to buy a security at the strike price.
Put Option: The right to sell a security at the strike price.
Moneyness:
In the Money: For a call option, when the market price > strike price. For a put option, when the market price < strike price.
Out of the Money: For a call option, when the market price < strike price. For a put option, when the market price > strike price.
Exercise Timing:
American Options: Can be exercised anytime before the expiry date.
European Options: Can only be exercised on the maturity date.
Writer Categories:
Covered Options: The writer owns the underlying security or has hedged their exposure.
Naked Options: The writer does not own the underlying security and has no hedge in place.
Risk Comparison: In options, the buyer's loss is limited to the premium paid (plus commissions). In futures and forwards, losses can be theoretically unlimited.
Options Pricing and the Black-Scholes Model
Historical Context: The options market grew significantly in the early following the Black-Scholes model formulation. Previously, writers faced high risks and thus charged high premiums.
The Formula: The Black-Scholes model allows dealers to calculate a desirable option price based on the past behavior of asset prices, effectively limiting seller losses.
Expanded Asset Classes: This model facilitated options for interest rates, credit ratings, weather, energy, and various commodities.
Limitations: The model relies on certain assumptions, most notably that markets are efficient.
Swaps: Interest Rate and Currency
Definition: A contract obligating parties to exchange ('swap') one series of payments for another.
Plain Vanilla Swaps:
Interest Rate (IR) Swaps: Exchange of interest rate payments (typically fixed for floating) based on a notional amount. The principal is NOT exchanged; only the net interest payment is transferred.
Currency Swaps: Exchange of income/expense flows across different currencies to better align business operations.
Incentive: Based on the economic principle of 'comparative advantage' or gains from trade.
Usage:
Hedging against interest rate or exchange rate risk.
Speculation: If an entity believes interest rates will rise, they would prefer to be the fixed-rate payer in a swap.
Market Structure:
No central clearing house; mostly OTC transactions.
Involves counterparty risk (default on interest payments).
High search and negotiation costs; investment banks frequently act as intermediaries or counterparties.
Credit Default Swaps (CDS)
Definition: An insurance contract against the default of an underlying security issuer. The CDS holder 'swaps' the risk of default with a seller.
Protection: The bondholder pays a premium; if the issuer defaults, the insurer pays the bondholder the bond’s face value.
Speculation: One does not need to own the underlying bond to buy a CDS. A speculator can buy a CDS if they believe market doubts about a bond issuer will increase. If the CDS price rises, the holder is 'in the money'.
Systemic Implications:
CDS can be issued in quantities far exceeding the volume of the underlying assets (unlimited issue).
Regulation: Unlike traditional insurance, the CDS market was largely unregulated before the GFC. Sellers did not have to meet standard capital or asset quality ratios.
The GFC and Transmission:
Post-subprime crisis, CDS prices soared, and defaults increased.
CDS acted as the primary vehicle transmitting subprime write-downs throughout the financial sector.
When firms like Bear Stearns and Lehmans failed, CDS sellers faced massive bills for full-face value compensation.
AIG Case Study: Many CDS sellers were unable to honor commitments. The US Federal Reserve bailed out AIG because it was a massive seller of CDS; its failure would have triggered catastrophic systemic risk, even though the Fed had allowed Lehman Brothers to fail just days prior.
Questions & Discussion
Video Resource: The lecture references a video explaining the GFC and CDS mechanics: https://www.youtube.com/watch?v=Q89eZka94NU
Summary of Counterparty Risk: The transcript emphasizes that in OTC markets (like swaps and forwards), the lack of a clearing house makes the choice of counterparty a vital source of risk, unlike in exchange-traded futures.