Chapter 2

2.6. Derivatives market

 Derivatives
• A derivative security is an agreement between two
parties to exchange a standard quantity of an asset
at a predetermined price at a specific date in the
future
• Derivative securities markets are the markets in
which derivative securities can be traded.
• Derivatives involve the buying and selling (i.e., the
transfer of) risk, which results in a positive impact on
the economic system
• Derivatives are used for hedging and for speculation.
 Derivatives . . .
• Speculative or taking an advantage over
specific profit opportunity,
• Hedging a portfolio against a specific risk.
 The development of Derivatives
• The first wave of modern derivatives were
foreign currency futures introduced by the
International Monetary Market (IMM) in 1971
and 1973
• The second wave of modern derivatives were
interest rate futures introduced by the Chicago
Board of Trade (CBT)
• The third wave of modern derivatives occurred in
the 1990s with the advent of credit derivatives.
 Types of Derivative contracts
• Futures contracts
• Forwards- contracts
• Swap contracts -
• Options-
• Various forms of bonds.
 Futures and Forward contracts
• A spot contract is an agreement to transact involving
the immediate exchange of assets and funds
• A futures contract is a legally binding commitment to
buy or sell a standard quantity of a something at a
price determined in the present (the futures price) on
a specified future date.
• Futures contracts are usually traded on organized
exchanges.
• The principal regulator of futures markets is the
Commodity Futures Trading Commission (CFTC)
Futures and Forward contracts. . .
Terms in Future contracts:
• A long position is the purchase of a futures contract
• A short position is the sale of a futures contract
• A clearinghouse is the unit that oversees trading on
the exchange and guarantees all trades made by the
exchange.
• Open interest is the total number of the futures,
put options, or call options outstanding at specific
date.
Futures and Forward contracts . . .
• Forward contract - a customized or non-
standardized contract to buy (sell) and asset at
a specified date and a specified price (forward
price.
• No payment takes place until maturity.
• The forward contract is a private agreement
between the two parties and nothing happens
between the contracting date and the date of
delivery.
Futures and Forward contracts. . .
Forwards and futures contracts markets include
diverse instruments on:
• Currencies;
• Commodities;
• Interest rate futures
• Short-term deposits
• Bonds
• Stock futures
• Single stock futures (contract for difference).
Futures and Forward contracts. . .
In Future contracts:
• There is no money exchanged when the
contract is signed.
• To ensure that each party shall fulfills its
commitments, a margin deposit is required.
• The exchanges set a minimum margin for
each contract and revise it periodically.
• Margin is determined depending upon the
risk of the individual contract
 Forward and futures valuation
• Valuation of all derivative models are based on
arbitrage arguments.
• The pricing of futures and forward contracts is
similar.
• If the underlying asset for both contracts is the
same, the difference in pricing is due to
differences in features of the contract that
must be dealt with by the pricing model.
Forward and futures valuation . . .
• If a futures price equals the spot (cash market)
price at delivery, nothing happened during the
life of the contract.
• The difference between the two prices is called
the basis:
Basis = Futures price – Spot price = F – S
• The basis is often expressed as a percentage of
the spot price. (discount or premium)
= Percentage basis = ( F – S ) / S
Forward and futures valuation . . .
• Futures valuation models determine the
theoretical value of the basis.
• This value is constraint by the existence of
profitable riskless arbitrage between the
futures and spot markets for the asset.
Forward and futures valuation . . .
In general, the formula for determining the
theoretical price of the contract: (cash-and-carry
trade)
• Theoretical futures price = Spot price + (Spot price) x
(Financing cost - Cash yield)
 Where:
 Financing cost - is the interest rate to borrow funds,
 Cash yield - is the payment received from investing
in the asset (e.g. dividend) as a percentage of the
cash price.
Forward and futures valuation . . .
Example
• Assume that the underlying asset price is 100 Euro,
financing cost is 1% and cash yield is 2%. Then the
theoretical futures price is:
100 Euro + [100 Euro × (1% − 2%)] = 99 Euro
• The future price can be above or below the spot
(cash) price depending on the difference between
the financing cost and cash yield.
• The difference between these rates is called the cost
of carry and determines the net financing cost.
Forward and futures valuation . . .
• Positive carry means that the cash yield
exceeds the financing cost, while the
difference between the financing cost and the
cash yield is a negative value.
• Negative carry means that the financing cost
exceeds the cash yield.
• Zero futures happen when the futures price is
equal to the spot (cash) price.
 Options
• An option is a contract that gives the holder the right, but
not the obligation, to buy or sell the underlying asset at a
specified price within a specified period of time
• A call option is an option that gives the purchaser the
right, but not the obligation, to buy the underlying
security from the writer of the option at a specified
exercise price on (or up to) a specified date
• A put option is an option that gives the seller the right,
but not the obligation, to sell the underlying security to
the writer of the option at a specified exercise price on (or
up to) a specified date
 Options
• The trading process for options is similar to
that for futures contracts
• The specified price is called the strike price or
exercise price
• The specified date is called the expiration date.
• The option seller grants this right in exchange for a
certain amount of money called the option premium
or option price.
• The option seller is also known as the option writer,
while the option buyer is the option holder.
 Options
An option can also be categorized according to when
it may be exercised by the buyer or the exercise
style:
• European option can only be exercised at the
expiration date of the contract.
• American option can be exercised any time on or
before the expiration date.
• Bermuda option or Atlantic option – is an option
which can be exercised before the expiration date
but only on specified dates is called.
 Components of the Option Price

The theoretical price of an option is made up of

two components:
• intrinsic value;
• premium over intrinsic value
 Intrinsic value of an option
• Intrinsic value- of an option is the profit available
from immediately exercising of an option.
• Where the value of the right granted by the option
is equal to the market value of the underlying
instrument (the intrinsic value is zero), the option
is said to be at-the-money.
• If the intrinsic value is positive, the option is said to
be in-the-money.
• If exercising an option would produce a loss, it is
called out-of-the-money
 Premium over intrinsic value of
options
• Time premium of an option, or time value of
the option, is the amount by which the
option’s market price exceeds its intrinsic
value.
• Because of the expectation of the underlying
asset will increase in contract period the
option buyer is willing to pay a premium
above the intrinsic value.
 Determinants of the Option Price
The factors that affect the price of an option include:
• Market price of the underlying asset.
• Strike (exercise) price of the option.
• Time to expiration of the option.
• Expected volatility of the underlying asset over the
life of the option.
• Short-term, risk-free interest rate over the life of the
option.
• Anticipated cash payments on the underlying over
the life of the option.
 Swaps
• A swap is an agreement between two parties to exchange
assets or a series of cash flows for a specific period of time at
a specified interval.
• The cash amount of the payments exchanged is based on
some predetermined principal amount, which is called the
notional principal amount or simply notional amount.
• The cash amount each counterparty pays to the other is
the agreed-upon periodic rate times the notional
amount.
• A swap is an over-the-counter (OTC) contract. Hence, the
counterparties to a swap are exposed to counterparty
risk.
 Swaps
• An interest rate swap is an exchange of fixed-interest
payments for floating-interest payments by two
counterparties
– the swap buyer makes the fixed-rate payments
– the swap seller makes the floating-rate payments
– the principal amount involved in a swap is called the
notional principal
• A currency swap is a swap used to hedge against exchange
rate risk from mismatched currencies on assets and liabilities
• Credit swaps allow financial institutions to hedge credit risk
• Commodity swaps-based on the value of a particular physical
commodity.
 Swaps
• Swaps are not standardized contracts
• Swap dealers (usually financial institutions)
keep markets liquid by matching counterparties
or by taking positions themselves
• The International Swaps and Derivatives
Association (ISDA) has more than 815 member
association among 56 countries that sets codes
of standards for swap documentation and
others.
Thank You!

The End !