Derivatives market and instruments
Introduction
Derivatives derive their values from the performance of underlying assets
They transform the performance of the underlying asset before paying it out
They transfer risk between parties
A put is the most common to be seen as insurance against risk
The buyer is known as long and the seller is known as short
Some lock the price known as forward commitments- forwards, futures and swaps.
Contingent claims- Provide the right but not the obligation. Known as an option
Derivatives usually have lower transaction costs that comparable spot transactions and are often
more liquid
Exchange traded derivatives markets
These are standardised unlike the OTC which makes the market more liquid
Two types: market makers and spectators
Market makers buy at one price and sell at a higher one. This is almost done instantaneous and
known as scalping
Standardisation also facilitates the creation and settlement operations
Clearing is what is referred to as the process by which the exchange verifies the execution of a
transaction and records a participant’s identification
Settlement refers to related parties exchanging money. T+2
Use the clearinghouse to ensure the winner is paid. This is by acquiring credit guarantees by cash
deposit usually called the margin bond or performance boned
Exchange traded are said to have transparency however the loss of privacy
Regulation means the loss of flexibility and privacy
Over the counter
Dealers are usually the banks who are usually members of a group called the ISDA
Usually called dealer markets
Acting as principal the dealers informally agree to buy and sell various derivatives- however are
not obliged to
These dealers also hedge the risk by running similar transactions to alternative participants
More privacy, lower transparency, and less liquidity
Forwards
Obligated to engage in a transaction
Provide a linear payoff
Forward commitments- establish the identity and quantity of the underlying and how the
contract will be settled
Forward contract- OTC where the buyer will purchase the underlying asset at a future date at a
fixed price
Either counterparty can default
Non-deliverable forwards (NDF’s), cash settled forwards or CDF’s- exchange cash not the asset
Futures
Are specialised derivative contracts that have been standardised versions of forwards contracts
and trade on the futures exchange
Offers liquidity and protection against loss by default
, There is a daily settlement of gains/losses known as mark to market or daily settlement
The clearinghouse determines the average of the final futures trades of the day and designates
this as the settlement price
This is known as a margin account- winner gets £2 losers has £2 taken off them
Have the initial margin and maintenance margin
Margin call is when fall below the maintenance margin
When fall below this must deposit enough to raise back to the initial margin
At any given time the number of outstanding contracts is known as open interest
The future price converges to the spot price at expiration
Unlike forward markets future markets are highly regulated
Swaps
Two parties exchange a series of cash flow. One set is variable and is set by the underlying
asset/rate the other set can be fixed/variable
These are OTC. Only one party can default at a particular time. Subject to default
Is a bit like a forward as private and negotiable? Subject to default
Notional principal isn’t exchanged in the case of IR swaps
Fixed for floating is known as a plain vanilla swap- must common is the 180-day LIBRO as
underlying for a vanilla swap
Has no principal but instead has a balance called notional principal which ordinarily matches the
loan balances
Only one party pays the other for the difference in the swap
Use a swap if need some sort of cash flow series
Contingent claims- Options
Right but not obligation
Right to buy- call
Right to sell- put
American- can be exercised early
European- only exercised at expiration date
Exercise price/strike price
The buyer payers the writer a sum of money known as the option premium
When ST>X called in the money
Only the short can default
Credit derivatives
Total return swap- underlying is a bond/loan. The credit protection buyer offers to pay the
credit protection seller the total return on the bond. In return the credit protection seller pays
either fixed or floating rate of interest. If the bond defaults the seller must continue to pay the
promised IR while receiving a small return/none from the buyer. If a default occurs the seller
pays the buyers
Credit spread option- Bond yield spread vs benchmark. Essentially a call option with underlying
as the credit spread
Credit linked note- The credit protection buyer holds a loan that is subject to default risk and
issues its own security (CLN) with the condition if there is a default the principal payoff on the
CLN is reduced accordingly
Credit default swap- Most successful. Credit protection buyer seeks credit protection against a
third party making a series of regularly scheduled payments to the other party- credit protection
, seller. The credit seller makes no payment until the credit event occurs. The CDS seller bets on
them no defaulting
Options payoffs are non-linear related to the payoffs of the underlying
Derivatives pricing and valuation
Pricing the underlying
Formation of the expectations- assume no divy
Required rate of return- convert to PV
Risk aversion of the investor
Pricing of risky assets
Benefits and costs of holding an asset- convenience
yield 0
The net of costs and benefits if often referred to as
cost of carry
Replication
A long asset and a short derivative can be combined to produce a risk-free bond equivalent
But why would you do this unless there is arbitrage opportunities
Risk-neutral pricing is that arb through underlying and derivatives guarantees the risk-free rate
Arbitrage pricing- assumes the market if free arb
Derivatives are priced via a hedged portfolio to eliminate opportunities
Future contracts
Are priced each day with gains/losses ignoring TVM are equal to forwards
A swap is priced as equivalent to a series of forward contracts created at the swap price
What effects options
Value of underlying
Exercise price
Time- Long term should be worth more than SR. Value of a European put can be either directly
or inversely related to the time to expiration. Direct more common but inverse more can prevail
with a put the longer the time to expiry, higher rf rate and deeper it is in the money. Value of
European call is directly related to Rf IR. Value of European put is inversely related to Rf IR
Volatility- Put and call are directly affected by volatility
Cost of carry- Call is worth less the more benefits from holding the underlying. It is worth more
the more costs of carrying the underlying. Put is worth more the more benefits that are paid by
the underlying and worth less the more costs incurred by the underlying
Loss in the value of option as it moves closer to expiry known as time value decay
American style
Can never sell for less than the European
Might exercise a call option before ex-div drop in price of the underlying.
If there is significant carrying costs the motivation for early exercise is weakened
When a put is so deep in the money worth exercising- has a limit to its overall value. Can’t go
any further until stock goes to 0
A call there is no upper limit to the price
The value of a European call option is directly related to time to expiry
European call is directly related to RF rate. Put is inverse
European call/put are both directly related to the volatility of the expiry
Introduction
Derivatives derive their values from the performance of underlying assets
They transform the performance of the underlying asset before paying it out
They transfer risk between parties
A put is the most common to be seen as insurance against risk
The buyer is known as long and the seller is known as short
Some lock the price known as forward commitments- forwards, futures and swaps.
Contingent claims- Provide the right but not the obligation. Known as an option
Derivatives usually have lower transaction costs that comparable spot transactions and are often
more liquid
Exchange traded derivatives markets
These are standardised unlike the OTC which makes the market more liquid
Two types: market makers and spectators
Market makers buy at one price and sell at a higher one. This is almost done instantaneous and
known as scalping
Standardisation also facilitates the creation and settlement operations
Clearing is what is referred to as the process by which the exchange verifies the execution of a
transaction and records a participant’s identification
Settlement refers to related parties exchanging money. T+2
Use the clearinghouse to ensure the winner is paid. This is by acquiring credit guarantees by cash
deposit usually called the margin bond or performance boned
Exchange traded are said to have transparency however the loss of privacy
Regulation means the loss of flexibility and privacy
Over the counter
Dealers are usually the banks who are usually members of a group called the ISDA
Usually called dealer markets
Acting as principal the dealers informally agree to buy and sell various derivatives- however are
not obliged to
These dealers also hedge the risk by running similar transactions to alternative participants
More privacy, lower transparency, and less liquidity
Forwards
Obligated to engage in a transaction
Provide a linear payoff
Forward commitments- establish the identity and quantity of the underlying and how the
contract will be settled
Forward contract- OTC where the buyer will purchase the underlying asset at a future date at a
fixed price
Either counterparty can default
Non-deliverable forwards (NDF’s), cash settled forwards or CDF’s- exchange cash not the asset
Futures
Are specialised derivative contracts that have been standardised versions of forwards contracts
and trade on the futures exchange
Offers liquidity and protection against loss by default
, There is a daily settlement of gains/losses known as mark to market or daily settlement
The clearinghouse determines the average of the final futures trades of the day and designates
this as the settlement price
This is known as a margin account- winner gets £2 losers has £2 taken off them
Have the initial margin and maintenance margin
Margin call is when fall below the maintenance margin
When fall below this must deposit enough to raise back to the initial margin
At any given time the number of outstanding contracts is known as open interest
The future price converges to the spot price at expiration
Unlike forward markets future markets are highly regulated
Swaps
Two parties exchange a series of cash flow. One set is variable and is set by the underlying
asset/rate the other set can be fixed/variable
These are OTC. Only one party can default at a particular time. Subject to default
Is a bit like a forward as private and negotiable? Subject to default
Notional principal isn’t exchanged in the case of IR swaps
Fixed for floating is known as a plain vanilla swap- must common is the 180-day LIBRO as
underlying for a vanilla swap
Has no principal but instead has a balance called notional principal which ordinarily matches the
loan balances
Only one party pays the other for the difference in the swap
Use a swap if need some sort of cash flow series
Contingent claims- Options
Right but not obligation
Right to buy- call
Right to sell- put
American- can be exercised early
European- only exercised at expiration date
Exercise price/strike price
The buyer payers the writer a sum of money known as the option premium
When ST>X called in the money
Only the short can default
Credit derivatives
Total return swap- underlying is a bond/loan. The credit protection buyer offers to pay the
credit protection seller the total return on the bond. In return the credit protection seller pays
either fixed or floating rate of interest. If the bond defaults the seller must continue to pay the
promised IR while receiving a small return/none from the buyer. If a default occurs the seller
pays the buyers
Credit spread option- Bond yield spread vs benchmark. Essentially a call option with underlying
as the credit spread
Credit linked note- The credit protection buyer holds a loan that is subject to default risk and
issues its own security (CLN) with the condition if there is a default the principal payoff on the
CLN is reduced accordingly
Credit default swap- Most successful. Credit protection buyer seeks credit protection against a
third party making a series of regularly scheduled payments to the other party- credit protection
, seller. The credit seller makes no payment until the credit event occurs. The CDS seller bets on
them no defaulting
Options payoffs are non-linear related to the payoffs of the underlying
Derivatives pricing and valuation
Pricing the underlying
Formation of the expectations- assume no divy
Required rate of return- convert to PV
Risk aversion of the investor
Pricing of risky assets
Benefits and costs of holding an asset- convenience
yield 0
The net of costs and benefits if often referred to as
cost of carry
Replication
A long asset and a short derivative can be combined to produce a risk-free bond equivalent
But why would you do this unless there is arbitrage opportunities
Risk-neutral pricing is that arb through underlying and derivatives guarantees the risk-free rate
Arbitrage pricing- assumes the market if free arb
Derivatives are priced via a hedged portfolio to eliminate opportunities
Future contracts
Are priced each day with gains/losses ignoring TVM are equal to forwards
A swap is priced as equivalent to a series of forward contracts created at the swap price
What effects options
Value of underlying
Exercise price
Time- Long term should be worth more than SR. Value of a European put can be either directly
or inversely related to the time to expiration. Direct more common but inverse more can prevail
with a put the longer the time to expiry, higher rf rate and deeper it is in the money. Value of
European call is directly related to Rf IR. Value of European put is inversely related to Rf IR
Volatility- Put and call are directly affected by volatility
Cost of carry- Call is worth less the more benefits from holding the underlying. It is worth more
the more costs of carrying the underlying. Put is worth more the more benefits that are paid by
the underlying and worth less the more costs incurred by the underlying
Loss in the value of option as it moves closer to expiry known as time value decay
American style
Can never sell for less than the European
Might exercise a call option before ex-div drop in price of the underlying.
If there is significant carrying costs the motivation for early exercise is weakened
When a put is so deep in the money worth exercising- has a limit to its overall value. Can’t go
any further until stock goes to 0
A call there is no upper limit to the price
The value of a European call option is directly related to time to expiry
European call is directly related to RF rate. Put is inverse
European call/put are both directly related to the volatility of the expiry
