CHAPTER 5:

DERIVATIVE SECURITY MARKETS

Dr. LINH DUY NGUYEN

FACULTY OF FINANCE
BANKING UNIVERSITY OF HCMC
 CONTENTS
2

I. Introduction
II. Types of derivatives
III. Derivatives markets in the world
 I. INTRODUCTION
3

1. Definitions
2. Roles of derivatives
 1. DEFINITION
4

 Derivatives are financial contracts whose values are

derived from the values of underlying assets.
 The derivative itself is a contract between two or more
parties, and the derivative derives its price from
fluctuations in the underlying asset.
 The most common underlying assets for derivatives are
stocks, bonds, commodities, currencies, interest rates, and
market indexes.
DEFINITION
5
 2. ROLES OF DERIVATIVES
6

 Hedging
 Speculation
 Arbitrage
 ROLES OF DERIVATIVES
7

 Hedging
 Hedging is a market mechanism by which investors can reduce
their risks due to an adverse price movement by using
derivatives
 Hedgers want to avoid exposure to adverse movements in the
price of an asset
 Speculation
 Speculation involves trying to make a profit from a security's
price change. In particular, either speculators are betting that
the price of the asset will go up or they are betting that it will
go down.
 ROLES OF DERIVATIVES
8

Speculators Hedgers
 Seek to profit from price  Seek protection from
movement price movement
• Long — believe price • Long hedge — protecting
will rise against a rise in purchase
price
• Short hedge — protecting
• Short — believe price
against a fall in selling
will fall
price
 ROLES OF DERIVATIVES
9

 Arbitrage
 Arbitrage involves locking in a riskless profit by
simultaneously entering into transactions in two or more
markets.
 The main objective of an arbitrageur is to exploit the price
differentials in different markets.
 II. TYPES OF DERIVATIVES
10

1. Forwards contract
2. Futures contract
3. Option contract
4. Swaps
 1. FORWARDS CONTRACT
11

A. Definition
B. Characteristics
C. Roles
 A. DEFINITION
12

 A forward contract is an agreement to buy or sell an

asset at a certain future time for a certain price.
 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.
A 6 months forward contract:
 Today: Buyer (Long Seller (Short
position) £1 million position
an exchange rate of 1.4561

 6 months later
$ 1,456,100
Buyer (Long Seller (Short
position) £1,000,000 position
 B. CHARACTERISTICS
13

 Privatecontract between two parties  highly

customizable or not standardized
 Usually one specified delivery date
 Settled at end of contract
 Delivery or final cash settlement usually takes place
 Some credit risk or counterparty risk
 C. ROLES
14

 Hedging
 An importer will have to pay $1 million in next 6 months from
now. To hedging against a potential increase in the exchange
rate (VND/USD), what should the importer do?
 An exporter will receive $1 million in next 6 months from now.
To hedging against a potential decrease in the exchange rate
(VND/USD), what should the exporter do?
 C. ROLES
15

 Speculation
 A speculator expects that the exchange rate (VND/USD) will
strongly increase in the next 6 months. What should he do?
 A speculator expects that the exchange rate (VND/USD) will
strongly decrease in the next 6 months. What should he do?
 2. FUTURES CONTRACT
16

A. Definition
B. Daily settlement
C. Delivery
D. Trading mechanics
E. Forward vs. futures contracts
 A. DEFINITION
17

 A futures contract is a legal agreement to buy or sell a

particular commodity asset, or security at a
predetermined price at a specified time in the future.
Futures contracts are standardized for quality and
quantity to facilitate trading on a futures exchange.
 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.
 B. DAILY SETTLEMENT
18

 Marking to Market — Each day the profits or losses from

the new futures price are paid over or subtracted from the
account
 Convergence of Price — As maturity approaches the spot
and futures price converge
 Initial Margin — funds or interest-earning securities
deposited to provide capital to absorb losses
 Maintenance margin —level at which the account must be
replenished or position reduced
 Margin call — when the maintenance margin is reached,
broker will ask for additional margin funds
 B. DAILY SETTLEMENT
19

Ví dụ:
 On 27/02/200x, investor buy a futures contract of 100
stock XYZ, the future price = VND 80,000/stock
 Initial margin: 1,000,000đ.
 Maintenance margin: 800,000đ.
 The daily settlement from 27/02 to 12/05 is as follows:
 Settlement Contract Marked to Margin A/c Deposit Margin A/c
Date 20
price value Market balance (Withdraw) balance
27/2 80,000 8,000,000 - 1,000,000 1,000,000
28/2 85,000 8,500,000 500,000 1,500,000
2/3 89,000 8,900,000 400,000 1,900,000
3/3 90,000 9,000,000 100,000 2,000,000
4/3 80,000 8,000,000 (1,000,000) 1,000,000
5/3 77,000 7,700,000 (300,000) 700,000 300,000 1,000,000
6/3 70,000 7,000,000 (700,000) 300,000 700,000 1,000,000
9/3 77,800 7,780,000 780,000 1,780,000
10/3 77,600 7,760,000 (20,000) 1,760,000
11/3 88,600 8,860,000 1,100,000 2,860,000
12/3 98,400 9,840,000 980,000 3,840,000 (2,840,000) 1,000,000
Chương 5: Thị trường phái sinh
 22

Chương 1: Hệ thống tài chính

 B. DAILY SETTLEMENT
23

Trade Settlement Daily gain Cumulative Margin account Margin call

• Operation of margin Day
price ($) price ($) ($) gain ($) balance ($) ($)
account for a long
1 1,250.00 12,000.00
position in two gold 1 1,241.00 -1,800.0 -1,800.0 10,200.0
futures contracts. 2 1,238.30 -540.0 -2,340.0 9,660.0
• The initial margin is 3 1,244.60 1,260.0 -1,080.0 10,920.0
$6,000 per contract, or 4 1,241.30 -660.0 -1,740.0 10,260.0
$12,000 in total; 5 1,240.10 -240.0 -1,980.0 10,020.0
• The maintenance 6 1,236.20 -780.0 -2,760.0 9,240.0
7 1,229.90 -1,260.0 -4,020.0 7,980.0 4,020.0
margin is $4,500 per
8 1,230.80 180.0 -3,840.0 12,180.0
contract, or $9,000 in 9 1,225.40 -1,080.0 -4,920.0 11,100.0
total. 10 1,228.10 540.0 -4,380.0 11,640.0
• The contract is entered 11 1,211.00 -3,420.0 -7,800.0 8,220.0 3,780.0
into on Day 1 at $1,250 12 1,211.00 0.0 -7,800.0 12,000.0
and closed out on Day 13 1,214.30 660.0 -7,140.0 12,660.0
14 1,216.10 360.0 -6,780.0 13,020.0
16 at $1,226.90.
15 1,223.00 1,380.0 -5,400.0 14,400.0
16 1,226.90 780.0 -4,620.0 15,180.0
 C. DELIVERY
25

 Most futures contracts are closed out early by reversing

trades: If you are currently long, you simply instruct
your broker to enter the short side of a contract to close
out your position.
 Only 1-3% of contracts result in actual delivery of the
underlying commodity
 C. DELIVERY
26

 There are three critical days for a contract.

 The first notice day is the first day on which a notice of
intention to make delivery can be submitted to the exchange.
 The last notice day is the last such day.

 The last trading day is generally a few days before the last
notice day.
 To avoid the risk of having to take delivery, a trader
with a long position should close out his or her contracts
prior to the first notice day.
 D. TRADING MECHANICS
27

 The exchange acts as a clearing house and counterparty to

both sides of the trade

 The net position of the clearing house is zero

D. TRADING MECHANICS
28
 E. FORWARD VS. FUTURES CONTRACTS
29

Forward Futures
Private contract between two parties
Not standardized
Usually one specified delivery date
Settled at end of contract
Delivery or final cash settlement
usually takes place
Some credit risk
 3. OPTION CONTRACT
31

A. Definition
B. Types of option
C. Option positions
D. Profit from an option position
 A. DEFINITION
32

 An option is a contract between two parties—a buyer and

a seller—that gives the buyer the right, but not the
obligation, to purchase or sell something at a later date at
a price agreed upon today.
 The option buyer pays the seller a sum of money called
the price or premium. The option seller stands ready to
sell or buy according to the contract terms if and when the
buyer so desires.
 B. TYPES OF OPTION
33

 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.
 The date specified in the contract is known as the
expiration date or the maturity date.
 The price specified in the contract is known as the
exercise price or the strike price.
 B. TYPES OF OPTION
34

 Options can be either American or European, a

distinction that has nothing to do with geographical
location.
 A European option can be exercised only on the maturity
date;
 An American option can be exercised at any time during its
life.
 B. TYPES OF OPTION
CALL OPTION
36

 Call buyer
 Expect an increase of underlying assets
If right: exercise the call option
If wrong: not to exercise, loss the premium

 Call seller
 Expecta decrease of underlying assets
 Have an obligation to sell underlying assets.
 B. TYPES OF OPTION
PUT OPTION
37

 Put buyer
 Expect a decrease of underlying assets
If right: exercise the put option
If wrong: not to exercise, loss the premium

 Put seller
 Expectan increase of underlying assets
 Have an obligation to buy underlying assets.
 C. OPTION POSITIONS
38

 S is the market price of the underlying assets; K is the strike

price
Option positions Call option Put option
In The Money – ITM S>K S<K
At the money – ATM S=K S=K
Out of The Money – OTM S<K S>K

 At a specified market price, if call option is ITM, put option is

OTM and vice versa.
 An option will be exercised only when it is in the money.
 D. PROFIT FROM AN OPTION POSITON
39

 A long position in a call option

 A short position in a call option
 A long position in a put option
 A short position in a put option

 We call:
 K : The strike price
 S : The market price of the underlying assets
 I : Premium
 4. SWAPS
46

A. Definition
B. Types of swaps
 A. DEFINITION
47

 A swap is an over-the-counter derivatives agreement

between two companies to exchange cash flows in the
future.
 The agreement defines the dates when the cash flows are
to be paid and the way in which they are to be calculated.
 Usually, the calculation of the cash flows involves the
future value of an interest rate, an exchange rate, or other
market variable.
 B. TYPES OF SWAPS
48

 Interest rate swaps

 Currency swaps
 Credit default swaps
 Equity swaps
 B. TYPES OF SWAPS
INTEREST RATE SWAPS: INTRODUCTION
49

 In an interest rate swap, a company agrees to pay cash

flows equal to interest at a predetermined fixed rate on a
notional principal for a number of years.
 In return, it receives interest at a floating rate on the
same notional principal for the same period of time.
 B. TYPES OF SWAPS
INTEREST RATE SWAPS: ILLUSTRATION
50

 Consider a hypothetical three-year swap initiated on March 8,

2017, between Apple and Citigroup.
 Apple agrees to pay to Citigroup an interest rate of 3% per
annum on a notional principal of $100 million  the fixed-rate
payer
 Citigroup agrees to pay Apple the six-month LIBOR rate on the
same notional principal  the floating-rate payer.
 Assume the agreement specifies that payments are to be
exchanged every six months and that the 3% interest rate is
quoted with semiannual compounding.
 B. TYPES OF SWAPS
INTEREST RATE SWAPS: ILLUSTRATION
51

Interest rate swap between Apple and Citigroup:

a notional principal of $100 million

3.0%

Citigroup Apple
LIBOR
 B. TYPES OF SWAPS
INTEREST RATE SWAPS: ILLUSTRATION
52

The swap cash flows from the perspective of Apple

Floating cash Fixed cash
LIBOR rate Net cash flow
Date flow received flow paid
(%) ($ million)
($ million) ($ million)
Mar. 8, 2017 2.20
Sept. 8, 2017 2.80 1.10 -1.50 -0.40
Mar. 8, 2018 3.30 1.40 -1.50 -0.10
Sept. 8, 2018 3.50 1.65 -1.50 0.15
Mar. 8, 2019 3.60 1.75 -1.50 0.25
Sept. 8, 2019 3.90 1.80 -1.50 0.30
Mar. 8, 2020 1.95 -1.50 0.45
 B. TYPES OF SWAPS
INTEREST RATE SWAPS: ILLUSTRATION
54

The swap cash flows from the perspective of Apple

Floating cash Fixed cash
LIBOR rate Net cash flow
Date flow received flow paid
(%) ($ million)
($ million) ($ million)
Mar. 8, 2017 2.20
Sept. 8, 2017 2.80 1.10 -1.50 -0.40
Mar. 8, 2018 3.30 1.40 -1.50 -0.10
Sept. 8, 2018 3.50 1.65 -1.50 0.15
Mar. 8, 2019 3.60 1.75 -1.50 0.25
Sept. 8, 2019 3.90 1.80 -1.50 0.30
Mar. 8, 2020 1.95 -1.50 0.45
 B. TYPES OF SWAPS
INTEREST RATE SWAPS
55

 Purpose of using interest rate swaps

 Using the swap to transform a liability
 Using the swap to transform an asset
 B. TYPES OF SWAPS
CURRENCY SWAPS
56

 A “fixed-for-fixed” currency swap involves exchanging

principal and interest payments at a fixed rate in one currency
for principal and interest payments at a fixed rate in another
currency.
 A currency swap agreement requires the principal to be
specified in each of the two currencies. The principal amounts
in each currency are usually exchanged at the beginning and at
the end of the life of the swap.
 B. TYPES OF SWAPS
CURRENCY SWAPS: ILLUSTRATION
57

 Consider a hypothetical five-year currency swap agreement

between British Petroleum and Barclays entered into on
February 1, 2017.
 We suppose that British Petroleum pays a fixed rate of interest
of 3% in dollars to Barclays and receives a fixed rate of
interest of 4% in British pounds (sterling) from Barclays.
Interest rate payments are made once a year and the principal
amounts are $15 million and £10 million.
 This is termed a fixed-for-fixed currency swap because the
interest rate in both currencies is fixed.
 B. TYPES OF SWAPS
CURRENCY SWAPS: ILLUSTRATION
58

A currency swap

Dollars 3.0%
British
Barclays
Petroleum
Sterling 4.0%
 B. TYPES OF SWAPS
CURRENCY SWAPS: ILLUSTRATION
59

Cash flows to British Petroleum in currency swap

Dollar cash flow Sterling cash flow

Date
(millions) (million)
February 1, 2017 15.00 -10.00
February 1, 2018 -0.45 0.40
February 1, 2019 -0.45 0.40
February 1, 2020 -0.45 0.40
February 1, 2021 -0.45 0.40
February 1, 2022 -15.45 10.40
 B. TYPES OF SWAPS
CURRENCY RATE SWAPS
61

 Purpose of using currency rate swaps

 Using the swap to transform a liability
 Using the swap to transform an asset
 B. TYPES OF SWAPS
CREDIT DEFAULT SWAPS
62

 A privately negotiated contract that protects investors against

the risk of default on particular debt securities.
 One party is the buyer, who is willing to provide periodic
(usually quarterly) payments to the other party, the seller.
 The seller receives the payments from the buyer but is
obligated to reimburse the buyer if the securities specified in
the swap agreement default.
 The buyer of a CDS is protected if the securities specified in
the CDS contract default.
 B. TYPES OF SWAPS
CREDIT DEFAULT SWAPS
63

 A CDS is like an insurance contract that pays off if a particular

company or country defaults. The company or country is
known as the reference entity.
 The buyer of credit protection pays an insurance premium,
known as the CDS spread, to the seller of protection for the
life of the contract or until the reference entity defaults.
 B. TYPES OF SWAPS
CREDIT DEFAULT SWAPS
64

$1,000
Bondholder Bond issuer (Y)
CDS buyer Reference entity
4.0% p.a
Insurance
against Quarterly
default of Y CDS spread

CDS seller
 B. TYPES OF SWAPS
CREDIT DEFAULT SWAPS: EXAMPLE
65

 Firm X purchased bonds (issued by firm Y – reference entity)

with a par value of $30 million. Concern the default probability
of Y, X purchases a CDS on these bonds for 5 years
 AIG sells the CDS contract for these bonds over the five years for
a premium of 2 percent of the value per year ($600,000)
 If at any time over the next five years, Y is bankruptcy and the
bonds become worthless, X would not make any additional
payments, and AIG would be obligated to pay X $30 million
 In contrast, if the bonds do not default, AIG receives $600,000
annually for five years because it was willing to insure the bonds.
 B. TYPES OF SWAPS
EQUITY SWAPS
66

 An equity swap is a swap in which the two parties agree

to exchange a series of payments, at least one of which is
determined by the return on a stock, stock portfolio, or
stock index.
 The equity swap payment is determined by the return on the
stock  can be negative.
 The upcoming equity payment is never known because the
equity return is not determined until the end of the settlement
period.
 B. TYPES OF SWAPS
EQUITY SWAPS: EXAMPLE
67

 Firm X wants to enter into an equity swap to pay the return on the
S&P 500 Total return index and to receives a fixed rate. The
notional principal will be $25 million.
 On the day the swap is arranged, the index is at 2,710.55.

 The swap will call for payments every 90 days for a 360-day
period. Bank Y, the dealer, offers X a fixed rate of 3.45% with
payments calculated on the basis of 90 days divided by 360.
 Let us treat the payment dates as day 90, day 180, day 270, and
day 360. The initial day is day 0.
 B. TYPES OF SWAPS
EQUITY SWAPS: EXAMPLE
68

Fixed Interest S&P Total S&P Payment Net Payment

Day
Payment ($) Return Index ($) ($)
0 2,710.55
90 215,625 2,764.90 501,282.03 -285,657.03
180 215,625 2,653.65 (1,005,913.41) 1,221,538.41
270 215,625 2,805.20 1,427,750.46 -1,212,125.46
360 215,625 2,705.95 (884,518.04) 1,100,143.04

The fixed component of the payment

will be:

The equity payment would be:

 III. DERIVATIVES MARKETS IN THE WORLD
70

 How Derivatives Are Traded

 The OTC Market Prior to 2008
 Since 2008…
 Size of OTC and Exchange-Traded Markets
 III. DERIVATIVES MARKETS IN THE WORLD
71

 How Derivatives Are Traded:

 On exchanges such as the Chicago Board Options Exchange
(CBOE)
 In the over-the-counter (OTC) market where traders working
for banks, fund managers and corporate treasurers contact
each other directly
 III. DERIVATIVES MARKETS IN THE WORLD
72

 The OTC Market Prior to 2008

 Largely unregulated
 Banks acted as market makers quoting bids and offers

 Master agreements usually defined how transactions

between two parties would be handled
 But some transactions were cleared through central
counterparties (CCPs). A CCP stands between the two sides
to a transaction in the same way that an exchange does
 III. DERIVATIVES MARKETS IN THE WORLD
73

 Since 2008…
 OTC market has become regulated. Objectives:
 Reduce systemic risk (see Business Snapshot 1.2, page 5)
 Increase transparency

 In the U.S and some other countries, standardized OTC

products must be traded on swap execution facilities (SEFs)
which are electronic platforms similar to exchanges
 CCPs must be used to clear standardized transactions
between financial institutions in most countries
 All trades must be reported to a central repository
 III. DERIVATIVES MARKETS IN THE WORLD
74

 Size of OTC and Exchange-Traded Markets

75