FINANCIAL MARKETS

Phan Quynh Trang

 FINANCIAL MARKETS

CHAPTER 6. DERIVATIVES MARKETS

 GOALS

1. Types of derivative instruments

2. Understand caps, floors, and collars.
3. Identify the biggest derivative securities markets globally.
 OVERVIEW

 The payoff is linked to another security (underlying assets)

 Involve an agreement: predetermined price and at a
specified date in the future
 Involve the buying and selling of risk
 Basic instruments: forward, futures, swaps, options
 Underlying assets: interest rate, equity, foreign exchange,
energy, grain…..
 FORWARDS AND FUTURES

1. Spot contract
2. Forward contract
3. Futures contract
 FORWARDS

1. For example, in a three-month forward contract to deliver

$100 face value of 10-year bonds, the buyer and seller agree
on a price and amount today, but the delivery of the 10-year
bond for cash does not occur until three months into the
futures
2. If the forward price agree to at time zero was $98 per $100
of face value, in three months’ time the seller delivers $100
of 10-year bonds and receives $98 from the buyer
 FORWARD MARKETS

1. Participants: Commercial banks, investment banks and

broker-dealers
2. Underlying asset are non-standardized: foreign currencies,
interest rates…
3. Credit forward is a forward agreement that hedges against
an increase in default risk on a loan after loan rate is
determined and the loan is issue by a banks
 FUTURES

1. A futures contract, like a forward contract, is an agreement

between a buyer and a seller at time 0 to exchange a
standardized, prespecified asset at some later date at a price
set at time 0.
2. Futures trading occurs on organized exchanges
 FUTURES

1. Floor broker
2. Professional trader
3. Position traders
4. Day traders
5. Scalpers
 FUTURES

1. Long position
2. Short position
3. Clearing house
 FUTURES

1. Speculators (nhà đầu cơ)

2. Hedgers (nhà phòng ngừa rủi ro)
3. Arbitrageurs (nhà kinh doanh chênh lệch giá)
 FUTURES

1. Open interest: the total number of contracts outstanding

equal to number of long positions or number of short
positions
2. Settlement price: the price just before the final bell each
day used for the daily settlement process
3. Volume of trading: the number of trades in one day
 FUTURES

Margin account
1. Margin is cash or marketable securities deposited by an
investor with his or her broker
2. The balance in the margin account is adjusted to reflect
daily settlement
3. Margin minimizes the possibility of a loss through a
default on a contract
4. Retail traders provide initial margin and, when the balance
in the margin account falls below a maintenance margin
level, they must provide variation margin (margin call)
bringing balance back up to initial margin level.
 FUTURES

Margin cash flow

1. A trader has to bring the balance in the margin account up
to the initial margin when it falls below the maintenance
margin level
2. A member of the exchange clearing house only has an
initial margin and is required to bring the balance in its
account up to that level every day.
3. These daily margin cash flows are referred to as variation
margin
4. A member is also required to contribute to a default fund
 FUTURES

• When Futures Price Decreases • When Futures Price Increases

Clearing House Clearing House

Clearing House Clearing House Clearing House Clearing House

Member Member Member Member

Broker Broker Broker Broker

Long Trader Short Trader Long Trader Short Trader

 FORWARDS AND FUTURES
FORWARDS
Private contract between 2 parties
Non-standard contract
Usually 1 specified delivery date
Settled at end of contract
Delivery or final cash
settlement usually occurs
Some credit risk
FUTURES
Exchange traded
Standard contract
Range of delivery dates
Settled daily
prior to maturity
Virtually no credit
risk
 OPTIONS

Types of options
 A Call option
 A Put option
Option style
 American option
 European option
 OPTIONS

Types of position
 Long position
 Short position
Option positions
 Long call
 Long put
 Short call
 Short put
 OPTIONS

• intrinsic value: The difference between the underlying

asset’s spot price and an option’s exercise price
• time value: The difference between an option’s price (or
premium) and its intrinsic value
 STOCK OPTIONS

1. The underlying asset on a stock option contract is the stock

of a publicly
2. One option generally involves 100 shares of the underlying
stock
 STOCK INDEX OPTIONS

1. The underlying asset on a stock index option is the value of

a major stock market index
2. The difference between a stock option and stock index
option is that at expiration, the stock index option holder
cannot settle the option contract with the actual purchase or
sales of the underlying stock index
3. Stock index options are settle in cash
 OPTION ON FUTURES CONTRACTS

1. The underlying asset on a futures option is a futures

contract
2. The buyer of a call (put) option on a futures contract has the
right to buy (sell) the underlying futures contract at or
before expiration while the seller of a call (put) option on a
futures contract creates the obligation to sell (buy) the
underlying futures contract on exercise by the option buyer.
 CREDIT OPTIONS

 Hedge credit risk

 Credit spread call option: a call option whose payoff
increases as the (default) risk premium or yield spread on a
specified benchmark bond of the borrower increase above
some exercise spread.
 Digital default option: an option that pays a stated amount
in the event of a loan default (the extreme case of increased
credit risk).
 REGULATIONS OF FUTURES AND
OPTIONS MARKETS

1. Regulators of derivatives specify “permissible activities”

that the institutions may engage in
2. Once permissible activities have been specified, institutions
engaging in those activities are subjected to supervisory
oversight
3. Regulators attempt to judge the overall integrity of each
institution engaging in derivatives activities by assessing
the capital adequacy of the institutions and by enforcing
regulations to ensure compliance with those capital
requirement
 SWAPS

1. A swap is an OTC derivatives agreement between two

companies to exchange cash flows at specified future times
according to certain specified rules

2. Example: Currency swap between firm A and firm B. Firm

A had a loan in US dollars while firm B had a loan in Euro.
Firm A agreed to pay the interest on firm’s B borrowings
while firm B agreed to pay the interest on firm A’s
borrowing also.
 INTEREST RATE SWAPS

1. An interest rate swap is a succession of forward contracts

on interest rates arranged by two parties
2. The swap buyer agrees to make a number of fixed interest
rate payments based on a principal contractual amount
(notional principal) on periodic settlement dates to the swap
seller. The swap seller, in turn, agrees to make floating-rate
payments, tied to some interest rate, to the swap buyer on
the same periodic settlement date.
INTEREST RATE SWAPS – HEDGING
INTEREST RATE RISK
INTEREST RATE SWAPS – HEDGING
INTEREST RATE RISK
CURRENCY SWAPS
 CREDIT SWAPS

1. Hedge credit risk

2. A total return swap involves swapping an obligation to pay
interest at a specified fixed or floating rate for payments
representing the total return on a loan (interest and principal
value changes) of a specified amount
3. In a pure credit swap, the financial institution lender will
send (each swap period) a fixed fee or payment (like an
insurance premium) to the counterparty
 SWAP MARKETS

1. Swap transactions are heterogenous in terms of maturities,

indexes used to determine payments, and timing of
payments
2. Swap markets were governed by very little regulation
 CAPS, FLOORS, AND COLLARS

1. Help to hedge interest rate risk.

2. Buying a cap means buying a call option or a succession of
call options on interest rates
3. Buying a floor is similar to buying a put option on interest
rates
4. A collars occurs when a firm takes a simultaneous position
in a cap and a floor