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COURS TITLE
Derivatives Markets
dr Krzysztof SPIRZEWSKI
Wydział Nauk Ekonomicznych
Uniwersytetu Warszawskiego
Assesment criteria and evaluation methods
Final assessment criteria will consist from three parts:
1. written assessment project - the description of:
a.
one scientific paper focusing on verification of models and theories presented during the lectures or
b.
one focusing on press article covering current macroeconomic situation (hand written by student).
2. mid-term exam,
3. final exam.
The student has to pass the mid-term exam and give back the project in order to be admitted to final exam.
Class presence according to common University of Warsaw rules.
Compulsory readings:
Hull J.C., 2008, Options, Futures and Other Derivative Securities, Prentice-Hall.
Supplementary readings:
1. Whaley R. E., Derivatives: Markets, Pricing and Risk Management; John Wiley & Sons 2006
2. McDonald R.L., Derivatives Markets; Addison Wesley, 2006
3. Wilmott P., Paul Wilmott., On Quantitative Finance, 2nd Edition, John Wiley & Sons, Chichester 2006.
4. Wilmott P., The Best of Wilmott 1 and 2 , John Wiley & Sons, 2004, 2006.
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Cours description
Derivatives Markets
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Forward and Futures
SWAPS
OPTIONS I
Pricing an options
Securitization
Managing the risk
Management of credit risk
Nonstandard derivatives
Interest rate derivatives
Energy and Commodity Derivatives
Real Options
Derivatives markets
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Lecture 1
Introduction to Derivatives Markets
I.
II.
Introduction
Types of markets and derivatives
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Introduction
The financial systems are created and developed under certain environment (different and unique for each
country):
- Economic,
- Law,
- Politic system, - Society.
The financial system structure is based on three main pillars :
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Financial institution (banks, insurance company and pension funds),
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Financial markets (FX market, Stock exchange, Money market, Derivatives market),
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Financial market infrastructure:
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Institutional (regulatory board and authority)
Technical (local settlements system)
Table 1.1 Comparison of bank assets and market capitalization for selected countries. Data for 2012 in
billion of USD.
country
USA
JAPAN
Germany
GDP
GDP per
capita
16 163
5 954
3 539
45 008
37 595
39 274
Banks Balance
Sheets
BAS/GDP
13 061
9 401
11 161
80,81%
157,89%
315,37%
Source: Authors' own based on data of Trading Economics.
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Market
Capitalization
(EMC)
18 668
3 680
1 486
EMC/GDP
115,50%
61,81%
41,99%
I Introduction
Part I:
In the last 30 years, derivatives have become increasingly important in finance. Futures and options are
actively traded on many exchanges throughout the world. Many different types of forward contracts,
swaps, options, and other derivatives are entered into by financial institutions, fund managers, and
corporate treasurers in the over-the-counter market.
Derivatives are added to bond issues, used in executive compensation plans, embedded in capital
investment opportunities, used to transfer risks in mortgages from the original lenders to investors, and
so on. It is important for those who work in finance, need to understand how derivatives work, how they
are used, and how they are priced.
The derivatives market is huge - much bigger than the stock market when measured in terms of underlying
assets. The value of the assets underlying outstanding derivatives transactions is several times the
world gross domestic product. As we shall see, derivatives can be used for hedging or speculation or
arbitrage. It could be good or bad depends on context. In this case the context is everything.
A derivative can be defined as a financial instrument whose value depends on (or derives from) the values
of other, more basic, underlying variables. Very often the variables underlying derivatives are the prices
of traded assets. A stock option, for example, is a derivative whose value is dependent on the price of a
stock. However, derivatives can be dependent on almost any variable, from the price of live cattle to
the amount of snow falling at a certain ski resort.
Recently there have been many developments in derivatives markets. There is now active trading in credit
derivatives, electricity derivatives, weather derivatives, and insurance derivatives.
Many new types of interest rate, foreign exchange, and equity derivative products have been created.
There have been many new ideas in risk management and risk measurement. Capital investment
appraisal now often involves the evaluation of what are known as real options.
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I Introduction
Derivatives markets have come under a great deal of criticism because of their role in the credit crisis that
started in 2007. Derivative products were created from portfolios of risky mortgages in the United States
using a procedure known as securitization. Many of the products that were created became worthless
when house prices declined. Financial institutions, and investors throughout the world, lost a huge
amount of money and the world was plunged into the worst recession it had experienced for many
generations. Securitization might work in such a way that such big losses occurred. As a result of the
credit crisis, derivatives markets are now more heavily regulated than they used to be. For example,
banks are required to keep more capital for the risks they are taking and to pay more attention to liquidity,
and new regulation came into force (EMIR in EU and Dodd-Frank Act in US).
Part II:
The concept of risk is at the heart of investment management. Financial analysts and portfolio managers
continually identify, measure, and manage risk. In a simple world where only stocks and bonds exist, the
only risks are the fluctuations associated with market values and the potential for a creditor to default.
Measuring risk often takes the form of standard deviations, betas, and probabilities of default. In the
above simple setting, managing risk is limited to engaging in stock and bond transactions that reduce or
increase risk. For example, a portfolio manager may hold a combination of a risky stock portfolio and a
risk-free bond, with the relative allocations determined by the investor's tolerance for risk. If for some
reason the manager desires a lower level of risk, the only transactions available to adjust the risk
downward are to reduce the allocation to the risky stock portfolio and increase the allocation to the riskfree bond.
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I Introduction
But we do not live in a simple world of only stocks and bonds, and in fact investors can adjust the level of risk
in a variety of ways. For example, one way to reduce risk is to use insurance, which can be described as
the act of paying someone to assume a risk for you. The financial markets have created their own way of
offering insurance against financial loss in the form of contracts called derivatives. A derivative is a
financial instrument that offers a return based on the return of some other underlying asset. In this sense,
its return is derived from another instrument - hence, the name.
As the definition states, a derivative's performance is based on the performance of an underlying asset. This
underlying asset is often referred to simply as the underlying1. It trades in a market in which buyers and
sellers meet and decide on a price; the seller then delivers the asset to the buyer and receives payment.
The price for immediate purchase of the underlying asset is called the cash price or spot price. A
derivative also has a defined and limited life: A derivative contract initiates on a certain date and
terminates on a later date. Often the derivative's payoff is determined and/or made on the expiration
date, although that is not always the case. In accordance with the usual rules of law, a derivative contract
is an agreement between two parties in which each does something for the other. In some cases, as in
the simple insurance analogy, a derivative contract involves one party paying the other some money and
receiving coverage against potential losses. In other cases, the parties simply agree that each will do
something for the other at a later date. In other words, no money need change hands up front.
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On behalf of the financial world, we apologize to all English teachers. "Underlying" is not a noun, but in the world of derivatives it is
commonly used as such. To be consistent with that terminology, we use it in that manner here.
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I Introduction
The world of finance and capital markets has undergone a stunning transformation in the last 30 years.
Simple stocks and bonds now seem almost quaint alongside the dazzling, and seemingly arcane world
of futures, options, swaps, and other "new" financial products. (The word "new" is in quotes because it
turns out that some of these products have been around for hundreds of years.)
Frequently this world pops up in the popular press:
Procter & Gamble lost $150 million in 1994, Barings bank lost $1.3 billion in 1995, Long-Term Capital
Management lost $3.5 billion in 1998, AIB lost $0.7 million in 2002, SocGen’s lost EUR 4.9 billion
($7.3) in 2008
What is not in the headlines is that, most of the time, for most companies and most users, these financial
products are an everyday part of business. Just as companies routinely issue debt and equity, they
also routinely use swaps to fix the cost of production inputs, futures contracts to hedge foreign
exchange risk, and options to compensate employees, to mention just a few examples.
OTC derivatives were brought to the attention of regulators following the 2008 financial crisis. In US DoddFrank Act (DFA), in EU the EMIR regulation are aiming at increasing the transparency and stability of
OTC derivatives and Exchange Traded derivatives markets by acting on a large number of post trade
process: mandatory clearing for certain products, the application of risk mitigation techniques to the
transactions that cannot be centrally cleared and transaction/position reporting. The EMIR is one of the
outputs of the G20 resolution taken in Pittsburgh in September 2009 regarding the derivatives. It
intends to increase transparency, reduce operational risk and minimize counterparty risks through a
series of new rules.
The European Market Infrastructure Regulation (“EMIR”) entered into force on 16 August 2012 and is
becoming effective gradually from 2013 through 2015. But reporting transactions to Trade Repositories
on 12 February 2014 is a major milestone.
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I Introduction
EMIR only applies to European Economic Area (“EEA”) counterparties and their branches worldwide But
 Contagion to counterparties outside of the EEA when dealing with through a branch of EEA’s bank
 Extraterritoriality, “substituted compliance” and “equivalence” rules not finalised yet
The obligations under EMIR are dependent on the nature of the counterparties involved but few clients are
really out of scope.
90% of OTC derivative transactions banks enter into globally and 100% of listed derivatives are affected by
EMIR.
EMIR impacts banks and clients: there are changes, at Pre-Trade, Trade and Post-Trade levels
ENTITIES IMPACTED:
EMIR applies to all EEA entities
 Financial Counterparties (FC)
 Non Financial Counterparties (NFC): Any undertaking established in the EEA which is not an FC
 Exemptions
o Full: ECB, national central banks in the EU, Bank for International Settlements (BIS), EU public bodies in charge of the
management of the public debt
o Partial: multilateral development banks, public sector entities owned by central governments which benefit from explicit
guarantee arrangements by the central governments, the EFSF, the ESM
o Temporary: pension funds are temporarily exempted from clearing for 3 years
o Under conditions: Intragroup transactions (subject to conditions and upon prior notification to or authorization from
regulators) are exempted from clearing & collateral
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What Is a Derivative?
Options, futures, and swaps are examples of derivatives. A derivative is a financial instrument (or more
simply, an agreement between two people) that has a value determined by the price of something else.
Derivatives can be thought of as bets on the price of something.
Example
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A bushel of corn is not a derivative; it is a commodity with a value determined by the price of corn.
However, you could enter into an agreement with friend that says: If the price of a bushel of corn in one
year is greater than $3, you will pay the friend $1. If the price of corn is less than $3, the friend will pay
you $1. This is a derivative in the sense that you have an agreement with a value depending on the
price of something else (corn, in this case).
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But don't automatically think the term "bet" is pejorative. Suppose your family grows corn and your
friend's family buys corn to mill into cornmeal. The bet provides insurance: You earn $1 if your family's
corn sells for a low price; this supplements your income. Your friend earns $1 if the corn his family buys
is expensive; this offsets the high cost of corn. Viewed in this light, the bet hedges you both against
unfavorable outcomes. The contract has reduced risk for both of you.
Investors could also use this kind of contract simply to speculate on the price of corn. In this case the
contract is not insurance. And that is a key point: It is not the contract itself, but how it is used, and who
uses it, that determines whether or not it is risk-reducing.
Context is everything.
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II Types of markets and derivatives
The bet is interesting particularly in the environment where the change in price move up and dawn. See
the figure with changes in oil price and exchange rate
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II Types of markets and derivatives
EXCHANGE-TRADED MARKETS
A derivatives exchange is a market where individual’s trade standardized contracts that have been defined
by the exchange. Derivatives exchanges have existed for a long time.
The Chicago Board of Trade (CBOT) was established in 1848 to bring farmers and merchants together. A
rival futures exchange, the Chicago Mercantile Exchange (CME), was established in 1919. CME and
CBOT have merged to form the CME Group, which also includes the New York Mercantile Exchange.
The Chicago Board Options Exchange started trading call option contracts on 16 stocks in 1973. Options
had traded prior to 1973, but the CBOE succeeded in creating an orderly market with well-defined
contracts. Put option contracts started trading on the exchange in 1977. The CBOE now trades options
on over 2,500 stocks and many different stock indices. Like futures, options have proved to be very
popular contracts. Many other exchanges throughout the world now trade options. The underlying
assets include foreign currencies and futures contracts as well as stocks and stock indices.
Electronic Markets
Traditionally derivatives exchanges have used what is known as the open outcry system. This involves
traders physically meeting on the floor of the exchange, shouting, and using a complicated set of hand
signals to indicate the trades they would like to carry out. Exchanges are increasingly replacing the
open outcry system by electronic trading. This involves traders entering their desired trades at a
keyboard and a computer being used to match buyers and sellers. The open outcry system has its
advocates, but, as time passes, it is becoming less and less used.
Electronic trading has led to a growth in algorithmic trading (also known as black-box trading, automated
trading, high-frequency trading, or robot trading). This involves the use of computer programs to initiate
trades, often without human intervention.
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II Types of markets and derivatives
TABLE 1.1
Examples of futures contracts traded on the:
Chicago Board of Trade (CBT),
Chicago Mercantile Exchange (CME), and
the New York Mercantile Exchange (NYMEX).
CBT
30-day Average
Federal Funds
CME
S&P 500 index
NYMEX
Crude oil
10-year U.S. Treasury NASDAQ 100 index
bonds
Natural gas
Municipal Bond Index Eurodollars
Corn
Nikkei 225
Soybeans
Pork bellies
Heating oil
Gasoline
Gold
Wheat
Oats
Heating and cooling degree-days Copper
Japanese yen
Electricity
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II Types of markets and derivatives
OVER-THE-COUNTER MARKETS
Not all trading of derivatives is done on exchanges. The over-the-counter market is an important
alternative to exchanges and, measured in terms of the total volume of trading, has become much
larger than the exchange-traded market. It is a telephone-and computer-linked network of dealers.
Trades are done over the phone and are usually between two financial institutions or between a
financial institution and one of its clients (typically a corporate treasurer or fund manager).
Financial institutions often act as market makers for the more commonly traded instruments. This means
that they are always prepared to quote both a bid price (a price at which they are prepared to buy)
and an offer price (a price at which they are prepared to sell).
Telephone conversations in the over-the-counter market are usually taped. If there is a dispute about
what was agreed, the tapes are replayed to resolve the issue. Trades in the over-the-counter market
are typically much larger than trades in the exchange-traded market. A key advantage of the overthe-counter market is that the terms of a contract do not have to be those specified by an exchange.
Market participants are free to negotiate any mutually attractive deal. A disadvantage is that there is
usually some credit risk in an over-the-counter trade (i.e., there is a small risk that the contract will
not be honored). Exchanges have organized themselves to eliminate virtually all credit risk.
Lehman Brothers was a very active trader of over-the-counter derivatives. Its bankruptcy in 2008 provided
a dramatic test for the market.
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II Types of markets and derivatives
Market Size
Both the over-the-counter and the exchange-traded market for derivatives are huge. Although the
statistics that are collected for the two markets are not exactly comparable, it is clear that the overthe-counter market is much larger than the exchange-traded market.
Figure 1.1 compares (a) the estimated total principal amounts underlying transactions that were
outstanding in the over-the counter markets between June 1998 and December 2009 and (b) the
estimated total value of the assets underlying exchange-traded contracts during the same period.
Using these measures, we see that, by December 2009, the over-the-counter market had grown to
$614.7 trillion and the exchange-traded market had grown to $73.1 trillion.
In interpreting these numbers, we should bear in mind that the principal underlying an over-the-counter
transaction is not the same as its value.
An example of an over-the-counter contract is an agreement to buy 100 million US dollars with British
pounds at a predetermined exchange rate in 1 year. The total principal amount underlying this
transaction is $100 million. However, the value of the contract might be only $1 million.
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II Types of markets and derivatives
Figure 1.1 Size of over-the-counter and exchange-trade derivatives
markets.
Size of market (USD milion)
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OTC
.....
Exchange
II Types of markets and derivatives
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II Types of markets and derivatives
Types of derivatives.
1. FORWARD CONTRACTS
2. FUTURES CONTRACTS
3. OPTIONS
FORWARD CONTRACTS
A relatively simple derivative is a forward contract.
Definition:
It is an agreement to buy or sell an asset at a certain future time for a certain price. It can be contrasted
with a spot contract, which is an agreement to buy or sell an asset today. A forward contract is traded
in the over-the-counter market - usually between two financial institutions or between a financial
institution and one of its clients.
One of the parties to a forward contract assumes a long position and agrees to buy the underlying asset
on a certain specified future date for a certain specified price. The other party assumes a short
position and agrees to sell the asset on the same date for the same price.
Forward contracts on foreign exchange are very popular. Most large banks employ both spot and forward
foreign-exchange traders. Spot traders are trading a foreign currency for almost immediate delivery.
Forward traders are trading for delivery at a future time. Forward contracts can be used to hedge
foreign currency risk.
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II Types of markets and derivatives
FUTURES CONTRACTS
Like a forward contract, a futures contract is an agreement between two parties to buy or sell an asset
at a certain time in the future for a certain price. Unlike forward contracts, futures contracts are
normally traded on an exchange. To make trading possible, the exchange specifies certain
standardized features of the contract. As the two parties to the contract do not necessarily know
each other, the exchange also provides a mechanism that gives the two parties a guarantee that
the contract will be honored.
The largest exchanges on which futures contracts are traded are the Chicago Board of Trade (CBOT)
and the Chicago Mercantile Exchange (CME), which have now merged to form the CME Group.
On these and other exchanges throughout the world, a very wide range of commodities and
financial assets form the underlying assets in the various contracts. The commodities include pork
bellies, live cattle, sugar, wool, lumber, copper, aluminum, gold, and tin. The financial assets
include stock indices, currencies, and Treasury bonds.
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OPTIONS
Options are traded both on exchanges and in the over-the-counter market. There are two types of
option. A call option gives the holder the right to buy the underlying asset by a certain date for a
certain price. A put option gives the holder the right to sell the underlying asset by a certain date
for a certain price. The price in the contract is known as the exercise price or strike price; the date
in the contract is known as the expiration date or maturity.
American options can be exercised at any time up to the expiration date.
European options can be exercised only on the expiration date itself.
Most of the options that are traded on exchanges are American. In the exchange-traded equity option
market, one contract is usually an agreement to buy or sell 100 shares. European options are
generally easier to analyze than American options, and some of the properties of an American
option are frequently deduced from those of its European counterpart.
It should be emphasized that an option gives the holder the right to do something. The holder does
not have to exercise this right. This is what distinguishes options from forwards and futures,
where the holder is obligated to buy or sell the underlying asset. Whereas it costs nothing to
enter into a forward or futures contract, there is a cost to acquiring an option.
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At this stage we note that there are four types of participants in options markets:
1.
Buyers of calls
2.
Sellers of calls
3.
Buyers of puts
4.
Sellers of puts.
Buyers are referred to as having long positions; sellers are referred to as having short positions.
Selling an option is also known as writing the option.
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Introduction to derivatives markets
SUMMARY
One of the exciting developments in finance over the last 30 years has been the growth of derivatives
markets. In many situations, both hedgers and speculators find it more attractive to trade a derivative on
an asset than to trade the asset itself. Some derivatives are traded on exchanges; others are traded by
financial institutions, fund managers, and corporations in the over-the-counter market, or added to new
issues of debt and equity securities.
A forward or futures contract involves an obligation to buy or sell an asset at a certain time in the future for a
certain price. There are two types of options: calls and puts. A call option gives the holder the right to
buy an asset by a certain date for a certain price. A put option gives the holder the right to sell an asset
by a certain date for a certain price. Forwards, futures, and options trade on a wide range of different
underlying assets.
Derivatives have been very successful innovations in capital markets. Three main types of traders can be
identified: hedgers, speculators, and arbitrageurs. Hedgers are in the position where they face risk
associated with the price of an asset. They use derivatives to reduce or eliminate this risk. Speculators
wish to bet on future movements in the price of an asset. They use derivatives to get extra leverage.
Arbitrageurs are in business to take advantage of a discrepancy between prices in two different
markets. If, for example, they see the futures price of an asset getting out of line with the cash price,
they will take offsetting positions in the two markets to lock in a profit.
A very high proportion of the futures contracts that are traded do not lead to the delivery of the underlying
asset. Traders usually enter into offsetting contracts to close out their positions before the delivery
period is reached. However, it is the possibility of final delivery that drives the determination of the
futures price. For each futures contract, there is a range of days during which delivery can be made and
a well-defined delivery procedure. Some contracts, such as those on stock indices, are settled in cash
rather than by delivery of the underlying asset.
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Introduction to derivatives markets
The specification of contracts is an important activity for a futures exchange. The two sides to any contract
must know what can be delivered, where delivery can take place, and when delivery can take place.
They also need to know details on the trading hours, how prices will be quoted, maximum daily price
movements, and so on. New contracts must be approved by the Commodity Futures Trading
Commission before trading starts.
Margins are an important aspect of futures markets. An investor keeps a margin account with his or her
broker. The account is adjusted daily to reflect gains or losses, and from time to time the broker may
require the account to be topped up if adverse price movements have taken place. The broker either
must be a clearing house member or must maintain a margin account with a clearing house member.
Each clearing house member maintains a margin account with the exchange clearing house. The
balance in the account is adjusted daily to reflect gains and losses on the business for which the
clearing house member is responsible.
Information on futures prices is collected in a systematic way at exchanges and relayed within a matter of
seconds to investors throughout the world. Many daily newspapers such as the Wall Street Journal
carry a summary of the previous day's trading.
Forward contracts differ from futures contracts in a number of ways. Forward contracts are private
arrangements between two parties, whereas futures contracts are traded on exchanges. There is
generally a single delivery date in a forward contract, whereas futures contracts frequently involve a
range of such dates. Because they are not traded on exchanges, forward contracts do not need to be
standardized. A forward contract is not usually settled until the end of its life, and most contracts do in
fact lead to delivery of the underlying asset or a cash settlement at this time.
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Introduction to derivatives markets
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A derivative contract is a financial instrument with a return that is obtained from or "derived" from the
return of another underlying financial instrument.
Exchange-traded derivatives are created, authorized, and traded on a derivatives exchange, an
organized facility for trading derivatives.
Exchange-traded derivatives are standardized instruments with respect to certain terms and conditions
of the contract. They trade in accordance with rules and specifications prescribed by the derivatives
exchange and are usually subject to governmental regulation.
Exchange-traded derivatives are guaranteed by the exchange against loss resulting from the default of
one of the parties. Over-the-counter derivatives are transactions created by any two parties off of a
derivatives exchange. The parties set all of their own terms and conditions, and each assumes the
credit risk of the other party.
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