College of Accounting Education 3F, Business & Engineering Building Matina, Davao City The University of Mindanao Phone No.: (082)300-5456 Local 137 Big Picture in Focu! ULO I. Discuss the basics of derivative markets, and describe the different types of derivative market transactions Metalanguage The last type of capital markets that we are going to talk about in this course is derivative markets. As we go along, we want to know about the essential concepts under this topic. These are terms that we need to know: + Derivate securities — these are securities whose values depend upon another asset's value or its settlement is linked to another security/securities + Marked to market — this is the process of valuing assets at the end of each trading day, adjusted daily to reflect market conditions * Floor brokers — members of the exchange who place trades from the public * Long position — purchase of a futures contract + Short position — sale of futures contract * Clearinghouse — a separate corporation and intermediary between buyers and sellers of futures, responsible for settling the accounts, clearing trade, regulations and also reporting the data for a period * Black-Scholes option pricing model — used to determine the fair market price or the theoretical value and the intrinsic value for a call or put option based on several variables + Notional Principal — principal amount involved in a swap agreement Essential Knowledge Derivative securities have been very helpful in reducing financial risks. These are financial contracts whose value is derived from a value of an underlying asset. Mortgage securities market is where derivates are traded and itis claimed that this market is growing because investors or financial people are concemed about minimizing losses. There are four (4) main types of derivatives and these are futures, forwards, options, and swaps. September 1, 2020 =2,350 per gram (GOLD) Septerer 2021 (ater 1 year) 21500 per gram (GOLD) Increase of 160 par ram 92 ‘ae gitan ang 500?College of Accounting Education 3F, Business & Engineering Building Matina, Davao City The University of Mindanao Phone No.: (082)300-5456 Local 137 Nag contact patang sa, Yyoar rom now, mag buy sya ng oot gala, 2420 raghapan ivan inayat ang fate nals 2800 since 2,420 ran ang ‘ipl a conc. however. fina balgys nya, now aiona ang gamiton whichis 2500-so magia ‘gan ghapon sya ebuyniva Derivatives involves exchange of assets between two contracting parties at a specified future date. This contract is again, intended to avoid risk of loss but sometimes, because no price is permanent, and prices are fluctuating, large losses are unavoidable. Mortgage-backed security is an example of derivative security which involves large amounts of money, This security is based on the value of the mortgage. FORWARDS AND FUTURES CONTRACTS, Forwards and futures contracts involve exchange of asset for cash at a specified future date, Compared to spot contract, this is an agreement between a buyer and seller to pay cash and deliver the asset immediately and simultaneously. If the price is at 100.00 for an item, pay P100 to get the item right ahead. The goal is to avoid increase of prices for the buyer and decrease of prices for the seller. Plus the seller's income is guaranteed, and the buyer's asset is guaranteed Forward Markets Forward contract is a contractual agreement at time 0 between two parties to exchange a nonstandardized asset for cash at some time in the future. At point the price is already specified, and is fixed over the life of the contract. This type “of contract already has an illustration above. The major participants in this type of contract are the commercial banks, the investment banks, and the broker-dealers. Their income sprouts out from the spread between the price of the contract and the price of the underlying assets. Futures Markets While futures contract, this is a contractual agreement at time 0 between two parties to exchange a standardized asset for cash at some time in the future. Futures and forwards are almost the same, but futures are bilateral contracts ‘subject to default risk. Hence there are intermediaries, located in specific venues, that fix legal agreements on this type of contract such as standardizing interest rates and the size of the contracts. And unlike forwards, there are mark-to-market activities in the futures market. Futures markets that are popular in the US is the Chicago Board of Trade (CBT) and New York Mercantile Exchange (NYMEX). In 93College of Accounting Education 3F, Business & Engineering Building Matina, Davao City y of Mindanao Phone No.:(082)300-5456 Local 137 The Univers the trading platform, Spen-outery_auction method is used where traders face each other and “cry out” thelr offers to buy or sell securities. Futures market exchange only cater members as nonmembers are not allowed to transact in the exchange, and nonmembers may only transact through floor brokers. Just ike the stock marke, futures have long posifon and ehork josition trading. The trade will be completed through a clearinghouse who oversees the exchange. Traders in Futures Market Professional traders — they are like specialists on the stock ‘exchanges who trade using their own account Position traders — they base their expectations about the future directions of prices of underlying assets Day traders — they buy and sell within the day and liquidate before the day ends Scalpers — active traders that hold seourities for short petiod of time, say minutes, to earn more profit OPTIONS Options contract is an agreement between two parties, a buyer and seller, that gives the buyer of the option the right to purchase to buy or sell a particular asset at a future date at a predetermined price. We classify options as either call ‘options or put options. * Call option — a contract that gives the buyer the right to purchase an underlying security at a price called exercise or strike price. The buyer of the call option should pay the seller a fee called call premium in addition to the purchase price. + Put option — a contract that gives the buyer the right to sell an underlying security at a specified price. The buyer shall also pay put premium. Valuing options Black-Scholes pricing model is the most commonly used method by financial people in pricing options using the following factors: 1. Spot price of the underlying asset 2. Exercise price on the option 3. Option’s exercise date 4. Price volatility of the underlying asset 5. Risk-free rate of interest This model estimates the prices mathematically using the variation in prices over time, and solves the prices using differential equation. This will not be tackled in this section anymore. 94College of Accounting Education 3F, Business & Engineering Building Matina, Davao City Phone No.: (082)300-5456 Local 137 Options Market The Chicago Board of Options Exchange (CBOE), the European Options Exchange and the London International Financial Futures Exchange are the prominent options market. These exchanges, just like futures, only let members transact on the option floor. Trades from the public or nonmembers are also placed in with the floor broker, market maker or professional trader. Stock options is one type of options whose underlying asset is the stock of a publicly traded corporation. Stock options gives rights to an investor, but not an obligation to purchase additional shares at an agreed date and price CAPS, FLOORS and COLLARS Caps, floors, and collars are means to hedge interest rate risks. When someone decides to buy a cap, it means buying a call option on interest rate. While buying a floor means buying a put option on interest rate. And a collar occurs when an intermediate takes a simultaneous position in a cap or a floor. SWAPS. The last type of derivative is swap, an agreement between two contracting parties, called counterparties, to exchange cash flows in the future based on some underlying asset. An example of this type of derivate is when two contracting banks agrees that bank one pays the bank two the fixed interest on a certain principal. While bank two pays bank one the interest on the same principal mentioned above but at a variable rate called floating rate. The reason why firms enter into this agreement is for comparative advantage. In this chapter, we shall talk about interest rate swaps and currency swaps. Swap features may vary depending on the type, but its general principles are basically the same Interest Rate Swaps Interest rate swap, sold over-the-counter, is the largest sector in the swap market wherein two counterparties agree to exchange one stream of future interest payment for another based on a specific principal amount over a specified period. In this market, a swap buyer agrees to make a number of fixed interest rate based ‘on notional principal on a periodic manner to the swap seller, While the swap seller pays variable rate. Currency swaps Currency swap is used to protect or hedge against exchange rate risk when firms mismatch currencies of their assets and liabilities. This involves exchange of interest and/or principal in once currency to another. Counterparties agree beforehand whether or not they will exchange the principal amounts of the two currencies at the beginning of the transaction. There are three approaches on the 95College of Accounting Education 3F, Business & Engineering Building Matina, Davao City The University of Mindanao Phone No.: (082)300-5436 Local 137 exchange of interest rates: fixed rate to fixed rate; floating rate to floating rate; or fixed rate to floating rate. Credit swaps Credit swap is a kind of insurance against credit risk wherein a third party agrees to pay a lender if default happens, in return for receiving payments from the lender. Two types of credit swaps are total return swaps and pure credit swaps. If we say total return swap, this involves swapping an obligation to pay interest at a fixed or floating rate for payments representing the total return on a loan, that is interest and principal value. And if we say pure credit swap, lender will send each ‘swap period a fixed fee or payment to the counter party. ‘Self-Help: You canalso refer to the sources below to help you further understand the lesson: Brigham, Eugene & Houston, Joel F. (2015). Fundamentals of Financial Management (13th Edition). Pasig City: Cengage Leaming Asia Pte Ltd (Philippine Branch), (2014) [2015]. ‘Saunders, Anthony, and Marcia Millon. Cornett. Financial Markets and Institutions. McGraw-Hill/Irwin, 2018. 96College of Accounting Education 3F, Business & Engineering Building Matina, Davao City yy of Mindanao Phone No.:(082}300-5456 Local 137 The Univers Let's Check Acti ity 1. Let us answer the following questions to assess what we remember in the topic above 1. The example of derivative securities include a, swap contract b. option contract c. futures contract d. all of the above 2. The example of derivative securities is a. return backed security b. mortgage backed security c. cash flow backed security d. interest backed 4, The type of financial security whose payoff is linked to any other security is called a. strong security b. semi-strong security c. derivate security d._non-derivate security 4. Derivatives are a. complex financial securities that derive their value from another financial security. b. simple financial securities that derive their value from another financial security. ¢. complex financial securities that do not derive their value from another financial security. d._ simple financial securities that do not derive their value from another financial security. 5. Derivatives are contracts that: a. allow the holder to buy/sell a given commodity b. are sold only in established financial markets c. usually expose the holder to increased risk d. completely remove risk in financial and economic transactions 6. The difference between futures and forwards is: a. that forwards are standardized and futures customized contracts b. that most forwards are exercised and most futures closed out before expiry c. that futures predetermine the price of an underlying commodity, but a forward price is flexible d. that forwards are on currencies, and futures on interest rates 7. Futures are a. absolutely the same as forwards. 7College of Accounting Education 3F, Business & Engineering Building Matina, Davao City yy of Mindanao Phone No.;(082}300-5456 Local 137 The Univers b. over-the-counter derivatives, c. exchange-traded derivatives. d. customizable like forwards. 8. The purchaser or holder of a call option has: a. the obligation to sell the underlying security b. the obligation to buy the underlying security , the right but not the obligation to sell the underlying security d. the right but not the obligation to buy the underlying security 9. The type of unit which guarantees that all the buying and selling will be made by traders of exchange is called a. Trading house b. Guarantee house ¢. Clearinghouse d. Professional house 10. The type of option that gives the buyer the right to sell the underlying option at specific exercise price considered as a. Call option b. Putoy ©, Class option d. Take option 11. Derivative instrument have the following advantage: a. They help control risk b, They have lower transaction costs than most other financial assets ©. They aid in keeping spot prices close to their true values d. All of the above are advantages of derivative instruments 12, Which of the following is most similar to a stock broker? a. Futures commission merchant, b. Pit trader. c. Floor broker. d. Local. 13. Derivatives are contracts that: allow the holder to buy/sell a given commodity are sold only in established financial markets usually expose the holder to increased risk completely remove risk in financial and economic transactions apse 14. The difference between futures and forwards is: a. that forwards are standardized and futures customized contracts b. that most forwards are exercised and most futures closed out before expiry ¢, that futures predetermine the price of an underlying commodity, but a forward price is flexible 98College of Accounting Education 3F, Business & Engineering Building Matina, Davao City The University of Mindanao Phone No.:(082)300-5456 Local 137 d. that forwards are on currencies, and futures on interest rates 15. The purchaser or holder of a call option has: a. the obligation to sell the underlying security b. the obligation to buy the underlying security c. the right but not the obligation to sell the underlying security the right but not the obligation to buy the underlying security Activity 2. Differentiate the following in two to four sentences 1, Derivative vs Mortgage organ a loan thats buyers purchase rooms sly as wxans ae Bsn eho prope yo xan ha aw te Uuved as your clatera,Dervalves onthe aber hand are frnancal netumertstalcaneif'erbe an asset ora lably. Inderal, Ser san ‘exchange of asse! or IB belveen wo paves (cuyetand sell) Devaves ae used av rsk of bes —however, fis newiabl Snoe the fees conta excaroe of ronsandarizad snes, Boh conta te esipoeed robe achangedt esto cash a ata spected date in PITS Wn atures 3, Caps vs Floors vs Collars 4. Fixed rate to fixed rate vs Floating rate to floating rate vs Fixed rate to floating rate Ina Nutshell In this portion, let us check and somehow summarize what we have learned in this chapter. 1) 2) 99College of Accounting Education 3F, Business & Engineering Building Matina, Davao City yy of Mindanao Phone No.;(082}300-5456 Local 137 3) 4) 5) 6) 1) 8) 9) 10). 100