Derivatives Series

When investing, there are different avenues that an investor can use to enhance their portfolios, they can either choose to place their funds on the less risky money market and bond market or they can place their funds on high risk markets like the stock market and the derivatives market. In this series of research work, the researcher aims to expose the different types of investment vehicles that an investor can make use of on the stock market and the derivatives market. The rst chapter concentrates on gold investment with chapter 2 explaining Exchange Traded Funds(ETFs) as one of the ways of investing in gold. Concentration on derivative instruments commences in chapter 3 and the rest of the chapters.

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Chapter 1 Gold

1.1 Background
Gold is one of the most precious stones that one can get in the world and in its purest form it exhibits a bright yellow colour. Gold has over the years been considered as a valuable and precious metal sought after for coinage, jewellery and artistic purposes amongst other uses. Throughout the world, gold has been used for monetary exchange primarily by the issuance of gold coins. The question comes when we think of how the price of this metal has behaved over the past years, the volatility characterised by the metal showed positive and negative disturbances on the environment it thrives in.

With the largest economies i.e. United States of America and Europe, in the world faced with a destructive debt crisis, one can only wonder if at this moment it will be best to invest in any currency. Investors pose a question such as how have commodities such as gold, silver, platinum and oil behaved in comparison to world currencies? are they worth investing in? As at 29 June 2011, the total outstanding

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public debt for USA was US$14.46 trillion with countries such as China, Japan, United Kingdom and Brazil being the largest holders.

1.2 Gold Production

As at 28 June 2011, the largest producers of gold in the world were China and Australia, with production levels of 345 tonnes and 255 tonnes respectively for the year 2010. Until 2006, South Africa was the largest producer of gold in the world but due to decline in production levels its now the fourth largest producer, this follows after a century of hegemony. As of 2010, the total gold produced in the world stood at 166 600 metric tonnes.

It is important that we specify the difference between investing and speculating because the word investor has been wrongly used when people at times mean speculative activities.

1.3 Investor
When we talk of an investment operation, there has to be an act of thorough analysis before any action is taken by the investor on the company or commodity to be invested in, this analysis must prove that there is a promise of safety of the principal invested and an appropriate return. If a person is willing to go the extra mile as stated above, then one can be termed an investor. It is important to note that when one expects extraordinary returns on an investment, it ceases to be an investment operation, it becomes a speculative operation. This implies that not everyone who places funds on a commodity or stock market is an investor.

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1.3.1 Speculator
When we desire quick returns from fund placement on either the commodities or stock market, we generally tend to look at the performance of the stock or commodity on the market it is listed, if we anticipate that the price will increase or decrease in the short to medium term, we place our funds accepting the high risk of the tables turning the other way, this in simple terms is speculation. If players on a market are driven by speculative views, this can make people engage in high risk contracts such as options. With options, most people tend to be involved in short selling i.e. trading with borrowed shares, without enough knowledge leading to heavy loses being realised. Most fund managers choose to partition their funds such that, a small proportion is set aside for speculative operations. It must be noted that it is not advisable to place all your funds in speculative operations, at times neither is it a good idea to place all your funds in long term investments.

1.4 Gold returns vs Stock returns

Where should I put my money to get the best return on my investment?. This is a question investors from novice to expert ponder with regularity. In light of gold price performance over the past few years it is important for an investor to be up to date with the performance information to act accordingly in decision making processes. Commodities have an inverse relation with stocks, over the past years, in many occassions, when there is a bull run in the stock market, the opposite is true for the commodities market. This implies that an investor must know the goings on in both markets and know when to enter and exit either of the markets in order to maximise on the promising returns in either markets. Investing in a commodity like gold has been considered as a way to hedge ones funds from the hand of ination and a negative economy.

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Gold prices and Stock prices both are not predictable, we can not guess with absolute certainty how a commodities market will perform or how a stock market will perform, in light of this investors use different strategies to get better returns on their investments.

1.4.1 Gold Price

As at 09 August 2011, the price of gold per ounce stood at US$ 1,734.42, representing almost 165% increment from its price 5 years ago of US$603.46. For the past 30 days to 09 July 2011 the price of gold has risen by about 10.4%, if extrapolated to the next 1 year, gold could rise by about 124.8%, this can only be necessitated by a surge in demand for the metal. If the world economy continues to be under stress we can see gold prices going past the US$2,500 mark in the next 5 to 6 months as investors seek a safe haven.

1.5 Safe haven currencies

During these recessionary periods, investors are looking for alternative investment opportunities other than the stock markets where intense volatility is the order of the day due to uncertainties in the underlying economies. The demand for currencies such as the Japanese yen and the Swiss franc have been on the increase as investors neglect the United States dollar, which has over the years been considered as a traditional safe haven currency, owing to mounting pressure by the downgrading of the United States by the S&P . This has created major problems for Japan and Switzerland with both countries intervening heavily in the foreign exchange markets as their currencies continue to appreciate. The increase in volatility has seen daily swings as large as 8% making it highly risky to trade in the currencies even though they are appreciating.

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1.6 How to invest in gold

Investing in gold tends to be more difcult for investors than investing in stocks and bonds, this is due to the fact that stocks and bonds are readily transferable and easily accessible to the average investor. One way to trade in gold involves the futures and the options market but due to their complex nature, it tends to be difcult for the investor as well. Gold is more accessible to the average person in bullion form (gold in its physical form) but with the advent of advanced nancial instruments, gold has become much more easier to invest in without having to buy the physical metal. The introduction of Exchange Traded Funds (ETF) gives investors direct exposure since they replicate the movement of the underlying commodity i.e. gold. In general, investors looking to invest in gold have roughly three choices: Purchasing the physical asset. Make use of an ETF. Trade futures and options on the commodities market. These may not be the only options one can choose to invest in gold but they are the most common.

Chapter 2 Exchange Traded Funds (ETFs)

2.1 Introduction
In the preceeding chapter we talked about investing in gold through the use of ETFs, these securities offer a cheap way to invest in gold with promise of good return on your investment. ETFs can be a valuable component of an investors portfolio, some investors use ETFs to implement sophisticated investment strategies, but for one to be able to use them, there is need to understand what they are and how they function. Usually investors tend to compare the performance of an ETF with a mutual fund, thus in this chapter much comparison is made between the two.

2.1.1 Denitions
A mutual fund is a professionally managed investment scheme that pools money from investors to buy stocks, bonds, short term money market instruments and/or other securities. An index fund is a type of a mutual fund such that the portfolio is constructed

Exchange Traded Funds (ETFs) to match or track the components of a market index such as the S&P.

An exchange traded fund is a security that tracks an index, a commodity or a basket of assets like an index fund but trades like a stock on an exchange. An ETF exhibits the diversication of a mutual fund with the exibility of a stock. There already exists ETFs that follow established exchanges like the S&P and NYSE and these are listed on the respective exchanges, some track commodities but not all commodities have ETFs, hence when one buys an ETF, they are investing in a conglomerate of companies rather than a single company. The primary trading venue for Gold ETFs is the American Stock Exchange (AMEX) but they can be traded on other established exchanges in the world.

2.2 Features of an ETF

Buying and selling ETFs can be good for the small investor - since ETFs can be traded on a stock exchange throughout the day like stock, they can be sold short thereby enhancing the scope of an investors strategies, whereas a mutual funds are traded based on their Net Asset Value(NAV) at the end of the day. ETFs are traded at the price reecting on the stock exchange, which resemble the underlying NAV but are independent of it. Though an investor can buy one share of an ETF, most buy in board lots to cut the costs for the investor. An ETF can be bought anywhere in the world, irrespective of the country in which it was registered.

Transparency - With an ETF, investors know exactly what they are buying and can see exactly what consitutes the ETF, e.g. gold, an investor who wishes to invest in gold keeps track of the price of gold and can evaluate how the fund is performing without even approaching the broker to nd out its performance.

Exchange Traded Funds (ETFs)

Fees and commisions - One of the main features on an ETF is its low annual fee when compared with a mutual fund. The passive nature of index investing , reduced marketing and distribution and accounting charges contribute to the low fees.

2.3 How Gold ETFs work

The way an ETF operates is easy to understand, especially if it is tracking a commodity like gold, to check on its performance, an investor has to keep track of the price of gold in the comfort of their home. A Gold ETF Fund purchases a large amount of gold, maintaining the physical metal in storage and then issue shares in baskets, the idea here being that the value of the shares will increase with the price of gold. Thus if the price of gold goes up by 20%, then individual shares will increase by 20%.

2.4 Advantages of an ETF

Diversication - A single ETF can give exposure to a set of stocks or a sector hence offering diversication within the set other than following a single stock. Lower fees - Compared to managed funds, ETFs have lower expense ratios. Trades like a stock - Though an ETF offers diversication, it has the advantage of trading on an exchange as a listed entity, where it further enjoys the following benets; 1. It can be purchased on margin and sold short. 2. It trades at a price that is updated throughout the day unlike index and mutual funds which are priced at the end of the day. 3. ETFs allow one to manage risk by trading futures and options just like a stock.

Exchange Traded Funds (ETFs) Dividends are reinvested immediately

Lower discount or premium in price - the chances of an ETF being overvalued or undervalued are minimal putting into consideration the fact that their price is not too different from that of the underlying security, if it so happens that they are mispriced, arbitrage will bring its price to equilibrium.

2.5 Disadvantages of an ETF

May be limited to larger companies - In some countries investors are limited to large cap counters, hence their portfolios lack exposure to small and mid cap companies. This could leave potential growth opportunities out of reach of ETF investors. Intraday pricing might be overkill - Long term investors may not benet from intraday pricing changes whereas some investors may trade more due to these price swings and enjoy good returns. Costs could be higher with ETFs - If one compares an ETF and investing in a specic stock, the costs are high, the commission paid to the broker might be the same but there is no management fee for a stock. Dividend yield - There are dividend paying ETFs, but the yields may not be as high as owning a high yield stock or groups of stocks. The risk associated with an ETF is usually lower but if an investor can take on the risk, the yield is higher with the correct stock.

2.6 Some Gold ETFs in USA

SPDR Gold Trust (GLD) ProShares Ultra Gold (UGL) Market Vectors Gold Miners fund (GDX)

Chapter 3 Introduction to Futures and Options

3.1 Introduction
We shall begin by introducing the term derivatives, these are securities whose value is based on that of an underlying asset e.g. a stock. There are many types of derivatives, futures and options are examples of derivatives. Trading on the derivatives market offers diversity to an investors portfolio hence it is important that an investor is equiped with the necessary knowledge to attain considerable return on their investment.

Derivatives markets can facilitate the management of nancial risk exposure, since they allow investors to unbundle and transfer nancial risk. In principle, such markets could contribute to a more efcient allocation of capital and crossborder capital ow, facilitate risk transfer, price discovery, and more public information (Tsetsekos and Varangis, 1997; Ilyina, 2004).

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In Sub-Saharan Africa, futures and options are traded on the Johannesburg Stock Exchange (JSE) and we shall focus this research on the derivatives market on the JSE. The derivatives market was created to enhance the nancial system of South Africa, enhance liquidity and meet the challenges of being a global economy. The market consists mainly of two broad categories, futures and options, within these, instruments such as warrants, equity futures and options, agricultural commodity futures and options, interest rate futures and options, currency futures and xed income derivatives are found.

3.1.1 Futures
A futures contract is a standardised contract between two parties to buy or sell a specied asset e.g. stock, of standardised quantity and quality at a specied future date at a price agreed today (the futures price), the parties are under obligation to exercise the contract at maturity. The contracts are traded on a futures exchange and it is the responsibility of the respective market to standardise the futures contracts. If a party agrees to buy the underlying asset in the future at a price agreed upon today, they are said to have taken a long position with the party willing to sell taking a short position.

3.1.2 Features of a futures contract

A futures contract is standadised in such a way that it species the following: The underlying asset or instrument e.g. a stock. The type of settlement, either cash settlement or physical settlement. The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a xed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc.

Introduction to Futures and Options The currency in which the futures contract is quoted.

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The grade of the deliverable. In the case of bonds, this species which bonds can be delivered. In the case of physical commodities, this species not only the quality of the underlying goods but also the manner and location of delivery. The delivery month. The last trading date. Depending on the exchange, some include the minimum acceptable price uctuation.

3.1.3 Advantages of Futures

Small commission charges - compared to other instruments, the commission charges for futures trading are relatively small and paid only after a traders position has ended. Paper investment - When one purchases stocks or bonds, they actually own that particular investment, but with futures its different. Trading futures does not require the trader to have or own actual physical goods on hand in order to trade them. High leverage - The fact that futures are highly leveraged instruments, it implies that an investor can go into the market with a relatively small investment and potentially come out reaping large prots.

3.1.4 Disadvantages of Futures

Danger of leverage - If a trader chooses a wrong direction for a futures contract, he can lose a large portion of his investment in a very short space of time.

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They are complicated products - Futures can be complicated for new traders to understand, hence enough research has to be done prior to entering the futures market. Price limits - many commodities have a daily limit on how much the price can change. If a commodity value is changing rapidly, it will quickly reach the limit price and traders will not be able to continue trading. A trader who is caught on the wrong side of a trade making limit moves every day may be stuck in the contract with few options to stop the losses. Large margin deposit for new traders - Futures contracts are for large amounts of the underlying asset. Even though the margin requirement is a small percentage of the contract value, the dollar amount can be large for new investors.e.g. the margin deposit on a S&P 500 contract is $28,125 which can be large for a novice investor.

3.1.5 Options
There are basically two types of options, the call option and the put option. A call option contract gives the holder the right but not the obligation to buy the underlying asset at a pre-determined price and date. Assume that the current price of a stock is $100 i.e. at time, t0 and you agree to buy the same stock at maturity time t1 for $115, the price of the underlying at time t1 , $115 is called the strike or exercise price. If the stock falls below the strike price, the option will be worthless, to realise a prot, the price of the stock at time t1 must be greater than the strike price. A put option is the inverse of a call option such that the option is worthless if the stock price at time t1 is greater than the strike price. There are different types of options,these include: European option - an option that may only be exercised on expiration.

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American option - an option that may be exercised on any trading day on or before expiration. Bermudan option - an option that may be exercised only on specied dates on or before expiration. Barrier option - any option with the general characteristic that the underlying securitys price must pass a certain level or barrier before it can be exercised Exotic option - any of a broad category of options that may include complex nancial structures. Vanilla option - by denition, any option that is not exotic. South African options are of the American style hence they offer the advantage of being exible. It must be noted though that due to their exibility, American options are not easy to price as compared to other options.

3.2 Features of an options contract

Whether the option holder has the right to buy (a call option) or the right to sell (a put option) the underlying asset. The quantity and class of the underlying asset(s) (e.g. 100 shares of XYZ Co. B stock). The strike price, also known as the exercise price, which is the price at which the underlying transaction will occur upon exercise. The expiration date, which is the last date the option can be exercised. The settlement terms, for instance whether the writer must deliver the actual asset on exercise, or may simply tender the equivalent cash amount. The terms by which the option is quoted in the market to convert the quoted price into the actual premium i.e. the total amount paid by the holder to the writer of the option.

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3.2.1 Advantages of Options

Cost efciency - Options have greater leveraging power. An investor can take an option position that will mimic a stock position almost identically but at a huge cost saving e.g. In order to purchase 300 shares of a $25 stock, an investor must pay $7500, however, if the investor were to buy three $5 calls with each contract representing 100 shares, the total outlay will be $1500, the trick is in nding the right call to purchase. Less risky, depending on how you use them - Options are one of the most dependable forms of hedging, they are considered much more safer than stocks when it comes to hedging. It should also be noted that there are situations when buying options is riskier than owning equities. Higher potential returns. More strategic alternatives - Options are very exible and there are many ways investors can use options to recreate other positions, this is called position synthesis.

3.2.2 Disadvantages of options

A premium must be paid. Due to the premium associated with options, they may yield a lesser return than other marketing alternatives in certain market situations. If an option is exercised, a futures position, with all its nancial and contract obligations, is assumed. With the above information, it is the investors choice on which instrument to invest in on the derivatives market, we proceed to look more into the derivatives market on the JSE, we look at how it is composed and the participants.

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3.3 Derivatives market in South Africa

The Equity Derivative Division of the JSE has been in operation since 1990, coordinating trading activities in warrants, single stock futures (SSF), and equity indices and interest rate futures and options. Warrants are long-dated put or call options issued by a third party on individual or baskets of securities of listed companies. Single stock futures are futures contracts where the underlying security is an equity exchange listed on the JSE. A single stock futures contract is a legally binding commitment made through a futures exchange to buy or sell a single equity in the future. SSF are standardised with regard to size, expiration, and tick movement.

The price of a single stock futures contract is negotiated through the South African Futures Exchange (SAFEX) order matching platform called the automated trading system (ATS). The exchange also lists options on single stock futures which are American style options exercisable into single stock futures. There are four key agencies involved in South Africas derivatives market: The Financial Services Board of South Africa (FSB), established under Section 2 of the Financial Services Board Act 1990, supervises the activities of non-bank nancial institutions and other nancial services. The Capital Markets Department of the FSB is responsible for the supervision of licensed exchanges, central securities depositories and clearing houses. The JSE and the Bond Exchange of South Africa (BESA), which are licensed exchanges trading in derivative instruments and supervised by the FSB. When the JSE took over the business operations of the SAFEX in 2001, two divisions were created within the JSE, namely the Equity Derivatives Division and the Agricultural Products Division. The SAFEX Clearing Company, which is under the direction of the JSE and is licensed to clear transactions in derivatives traded on the JSE.

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Trading in derivatives takes place on both the over-the-counter (OTC) market and on the established stock exchanges. Trading on warrants, equity futures and options, and the agricultural commodity futures and options takes place on the JSE. Trading on xed-income derivatives such as bond futures, FRA, vanilla swaps and standard bond options takes place on the BESA. Trading on interest rate futures and options takes place on both exchanges. Trading on the currency futures and xed income derivatives (such as interest rate futures) are mainly concentrated in the OTC market. Exchange-based trading on interest rate futures and options commenced in 2003 on the BESA through Intersec, a xed income derivative platform. Exchange-based trading on currency futures commenced on the JSE currency futures exchange platform (Yield-X) in 2007. OTC markets are important alternatives to physically located exchanges, these are telephone or computer based network of dealers who do not physically meet to make a trade. Trades are usually between nancial institutions or between a nancial institution and a corporate client, trades done over the counter are much larger than those done on the physical exchange. The greatest advantage of this type of market is that there are no stringent rules as those on the exchange, both dealers can negotiate for the price in a more relaxed environment. It was noted that on the JSE, instruments such as Single Stock Futures are traded, hence it is important to understand what they are and the diversity they offer for an investor.