Use of derivatives in today's financial market

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USE OF DERIVATIVES IN TODAY'S FINANCIAL MARKET

INTRODUCTION

The FINANCIAL MARKETS are simply a mechanisms and conventions that exist for the transfer of funds and their counterparts (i.e. the financial instruments) between the various participants.

All the ultimate lenders and borrowers (household, government, corporate and foreign sectors) and all the financial intermediaries are the participants in the financial markets. And so are the other financial entities that facilitate the transfer of funds and securities: the broker-dealers, the regulators, the financial exchanges (which essentially do more that facilitate the transfer of securities) and fund managers.

In terms of its main economic functions the financial markets provide channels for transferring the excess funds of surplus units to deficit units. Financial markets thus constitute the mechanism that links surplus and deficit units, providing the means for surplus units to finance deficit units either directly or indirectly through financial intermediaries.

In finance, financial markets facilitate:

– And are used to match those who want capital to those who have it.

Types of financial markets:

  1. Capital market(consisting of bond market and stock market)
  2. Commodity market
  3. Consumer market
  4. Derivative market
  5. Futures market
  6. Insurance market
  7. Foreign exchange market.

DERIVATIVES

Derivatives are contracts between two parties to buy, sell or exchange (optional or obligatory) a standard or non-standard quality and quantity of an asset or cash flow at a pre-determined price on or before a specified date in the future. The value of the underlying security or index (the spot market instrument that underlies the derivative) changes continuously, and this means that the value of the derivatives also changes.

The derivative markets may be broadly classified as:

1. Commodity derivative markets

2. Financial derivative markets

FUTURES

A futures contract is a standardized, exchange tradable contract between two parties to trade a specified asset on a set date in a future at a specified price.

Financial futures are based on an underlying financial instrument, rather than a physical commodity. Financial futures were invented in 1972 and within a few years, trading in financial futures exceeded trading in commodity futures.

Financial futures are based on an underlying financial instrument, rather than a physical commodity. They exist in four main categories:

1. Bond futures

2. Short interest rate futures

3. Stock index futures

4. Currency futures

The clearing house

When two traders agree to deal, the contract is created and the clearing house is informed. A clearing house is a self-contained institution whose only function is to clear futures trades and settle margin payments (described below). The clearing house checks that the buy and sell orders match each other. It then acts as “a party to every trade”. In other words it simultaneously acts as if it had sold to the buyer, and bought from the seller. Following registration, each party has a contractual obligation to the clearing house. In turn the clearing house guarantees each side of the original bargain.

Margin

Each party to a futures contract must deposit a sum of money known as “margin” with the clearing house. Margin payments act as a cushion against potential losses which the parties may suffer from future adverse price movements.

The potential losses referred to here are those that would arise if one party to the trade defaults on the agreement. The risk that you default on the agreement to trade may increase if the market moves against you.

When the contract is first struck, “initial margin” is deposited with the clearing house. Additional payments of “variation margin” are made daily to ensure that the clearing house’s exposure to credit risk is controlled. This exposure can increase after the contract is struck through subsequent adverse price movements.

Shortly before the contract is due to expire, the buyer and the seller normally close out the futures position, i.e. neutralize existing contracts by entering into equal but opposite contracts, and the clearing house returns the initial margin.

TYPES OF FUTURES

BOND FUTURES

For delivery, the contract requires physical delivery of a bond. If the contract were specified in terms of a particular bond then it would be possible simply to deliver the required amount of that stock. If the contract is specified in terms of a notional stock then there needs to be a linkage between it and the cash market.

The bonds which are eligible for delivery are listed by the exchange. The party delivering the bond will choose the stock from the list which is cheapest to deliver. The price paid by the receiving party is adjusted to allow for the fact that the coupon may not be equal to that of the notional bond which underlies the contract settlement price.

SHORT INTERSET RATE FUTURES

Short interest rate futures are based on a benchmark interest rate and settled for cash.

The price of these futures is quoted in a slightly unusual way.

The way that the quotation is structured means that as interest rates fall the price rises, and vice versa. The price is stated as 100 minus the 3-month interest rate. For example, with an interest rate of 6.25% the future is priced as 93.75.

The contract is based on the interest paid on a notional deposit for a specified period from the expiry of the future. However no principal or interest changes hands. The contract is cash settled. On expiry the purchaser will have made a profit (or loss) related to the difference between the final settlement price and the original dealing price. The party delivering the contract will have made a corresponding loss (or profit).

STOCK INDEX FUTURES

With stock index futures, the asset is a notional portfolio of shares as represented by the particular index. The seller of a futures contract based on a stock market index is theoretically supposed to deliver a portfolio of shares made up in the same proportions as the index. This is totally impractical, so stock index futures are always settled for cash. The cash amount on settlement is determined by the difference between the future price, that the investor agreed, and the index value on the day of settlement. The contract provides for a notional transfer of assets underlying a stock index at a specified price on a specified date.

CURRENCY FUTURES

The contract requires the delivery of a set amount of a given currency on the specified date.

USES OF FINANCIAL FUTURES

A company can use financial futures to “lock in” the value of assets or liabilities, or to guarantee the value of receipts and payments.

BOND FUTURES

When issuing bonds

If a company intends to issue bonds in the future but wishes to lock in the current level of yields, it could sell some bond futures contracts at the current price, thereby locking in current yields. This futures position would be unwound when the actual bond is issued.

When it has a fixed-rate loan

A company could agree to buy bond futures contracts to hedge the risk of interest rates falling if it has a fixed-interest rate loan. If interest rates fell, bond prices would rise and therefore, it would offset the “loss” from being unable to benefit from the fall in interest rates on its loan with a “gain” on its bond futures. Similarly, if interest rates rose, bond prices would fall and therefore the company would gain from its fixed interest rate loan but lose on its bond futures.

SHORT INTEREST RATE FUTURES

When it has a floating-rate loan

A company could use interest rate futures to protect it from the risk of rising interest rates. For example, if a company has raised capital by borrowing at floating interest rates, but wishes to fix its future interest payments, it can use interest rate futures to fund any increase in the interest rate payable (but will have to pay over any interest saved if market rates fall).

STOCK INDEX FUTURES

During a takeover

During a takeover, a rise in the target company’s share price can cause an increase in the amount the predator company has to pay. The predator company can buy stock market index futures to hedge this risk.

CURRENCY FUTURES

In the same way, currency futures could be used to fix the value of foreign receipts or payments. In practice, forward currency markets would be used.

FORWARDS

Like futures contracts, forwards are contracts to buy or sell an asset on an agreed basis in the future. The difference is that futures contracts are standardized contracts that can be traded in a recognized exchange.

So:

  • A forward contract is a non-standardized and privately negotiated contract between two parties to trade a specified asset on a set date in the future at a specified price.
  • A futures contract is a standardized, exchange-tradable contract between two parties to trade a specified asset on a set date in the future at a specified price.

OPTIONS

An option gives an investor the right, but not the obligation, to buy or sell a specified asset on a specified future date.

The buyer of an option has the right but not the obligation to take up the option at the specified exercise price. The seller (writer) of an option has the obligation to honor the option given to the buyer.

There are two basic types of options:

  • A call option gives the right, but not the obligation, to buy a specified asset on a set date in the future for a specified price.
  • A put option gives the right, but not the obligation, to sell a specified asset on a set date in the future for a specified price.

From these two types of option, there are four positions that an investor could hold:

1. Buying a call option

2. Buying a put option

3. “Writing” (i.e. selling) a call option

4. “Writing” (i.e. selling) a put option

Timing

Some options can be exercised only on the specified “expiry” or “contract” date, others can be exercised on any working day prior to expiry. They are respectively known as “European” style and “American” style options.

An American style option is an option that can be exercised on any date before its expiry.

A European style option is an option that can be exercised only at expiry.

Margin

Because a call writer’s liability can be unlimited, and a put option writer’s liability can be very large relative to the premium, margin is required from writers of options.

However, the buyer’s maximum loss is the premium that is paid at the outset of the contract. Therefore, margin is not required from holders of options.

The writer of the option pays a margin to the London Clearing House. The buyer pays a premium to the writer.

USES OF OPTIONS

Options allow a company to protect itself against adverse movements in the financial environment while retaining the ability to profit from favorable movements.

For example, a company that has borrowed at variable interest rates could purchase options to protect itself against increases in market interest rates. If rates fall the company will only suffer the loss of the premium paid to purchase the options.

Since an option is a right to buy (or sell) an asset rather than an obligation to do so, the company that holds the option can choose to exercise it or not, depending on whether events move in its favor or move against it. Therefore the option never becomes a liability to the company.

SWAPS

A swap is a contract between two parties under which they agree to exchange a series of payments according to a prearranged formula.

The swapped payments are normally either:

â- Interest rate swap

â- Currency swap

Pricing

The swap will be priced so that the present value of the cash flows is slightly negative for the investor and positive for the issuing organization. The difference represents the price that the investor is prepared to pay for the advantages brought by the swap on the one hand, and the issuer’s expected profit margin on the other.

Risks

Each counterparty to a swap faces two kinds of risk:

Market risk

The risk that market conditions will change so that the present value of the net outgo under the agreement increases.

The market maker will often attempt to hedge market risk by entering into an offsetting agreement. In other words the market maker would enter into a second agreement, which worked in the opposite direction, so that the potential loss is cancelled out.

Credit risk

The risk that the other counterparty will default on its payments.

This will only occur if the swap has a negative value to the defaulting party so the risk is not the same as the risk that the counterparty would default on a loan of comparable maturity.

TYPES OF SWAPS

Interest rate swaps

In the most common form of interest rate swap, one party agrees to pay to the other a regular series of fixed amounts for a certain term. In exchange, the second party agrees to pay a series of variable amounts based on the level of a short-term interest rate. Both sets of payments are in the same currency. These are known as coupon swaps.

The fixed payments can be thought of as interest payments on a deposit at a fixed rate, while the variable payments are the interest on the same deposit at a floating rate. The deposit is purely a notional one and no exchange of principal takes place.

Currency Swaps

A currency swap is an agreement to exchange a fixed series of interest payments and a capital sum in one currency for a fixed series of interest payments and a capital sum in another.

The exchange of principal under the swap at the end of the contract will be in the same direction as the interest flows. The initial exchange of principal under a currency swap is in the opposite direction to the interest payments and terminal exchange of principal.

Characteristics

Swaps are not conventional investments. They are financial tools, which allow institutions to change the nature of their assets and liabilities. Usually one party to a swap agreement will be a market making bank (often referred to as the market maker) and the other will be a company. The parties involved in a swap are often called the counterparties.

The swap will be priced so that the present value of the cash flows is slightly negative for the investor and positive for the issuing organization. The difference represents the price that the investor is prepared to pay for the advantages brought by the swap on the one hand, and the issuer’s expected profit margin on the other.

USES OF SWAPS

Risk management

A company can use swaps to reduce risk by matching its assets and liabilities. For example a company which has a short-term liability linked to floating interest rates but long-term fixed rate assets can use interest rates swaps to achieve a more matched position. Currency swaps would be used by a company with liabilities in one currency and assets in another.

Reducing the cost of debt

If one company has a comparative advantage in borrowing at a floating rate while another company has a comparative advantage in borrowing at a fixed rate, they can use an interest rate swap to reduce the total cost of financing and both benefit from a lower cost of debt.

Swaps enable companies to borrow in the form that offers the lowest yield margin (or financial cost) to them. If the cheapest form of borrowing is not what the company wants, it can swap the payments into the desired form (ie floating or fixed) using an interest rate swap. Similarly, if the cheapest form of borrowing is not in the currency the company wants, it can use a currency swap to swap the payments into the desired currency.

HEDGING

A hedge is an investment position intended to offset potential losses/gains that may be incurred by a companion investment. In simple language, a hedge is used to reduce any substantial losses/gains suffered by an individual or an organization. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of over-the-counter and derivative products, and futures contracts.

Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another.

Hedging also occurs when an individual or institution buys an asset (such as a commodity, a bond that has coupon payments, a stock that pays dividends, and so on) and sells it using a futures contract. The individual or institution has access to the asset for a specified amount of time, and can then sell it in the future at a specified price according to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset, while reducing the risk that the future selling price will deviate unexpectedly from the market's current assessment of the future value of the asset.

Derivatives trading of this kind may serve the financial interests of certain particular businesses.

SPECULATION AND ARBITRAGE

Derivatives can be used to acquire risk, rather than to hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset. Speculators look to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is less.

Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset.

ECONOMIC FUNCTION OF THE DERIVATIVE MARKET

Some of the salient economic functions of the derivative market include:

  1. Prices in a structured derivative market not only replicate the discernment of the market participants about the future but also lead the prices of underlying to the professed future level. On the expiration of the derivative contract, the prices of derivatives congregate with the prices of the underlying. Therefore, derivatives are essential tools to determine both current and future prices.
  2. The derivatives market reallocates risk from the people who prefer risk aversion to the people who have an appetite for risk.
  3. The intrinsic nature of derivatives market associates them to the underlying Spot market. Due to derivatives there is a considerable increase in trade volumes of the underlying Spot market. The dominant factor behind such an escalation is increased participation by additional players who would not have otherwise participated due to absence of any procedure to transfer risk.
  4. As supervision, reconnaissance of the activities of various participants becomes tremendously difficult in assorted markets; the establishment of an organized form of market becomes all the more imperative. Therefore, in the presence of an organized derivatives market, speculation can be controlled, resulting in a more meticulous environment.
  5. Third parties can use publicly available derivative prices as educated predictions of uncertain future outcomes, for example, the likelihood that a corporation will default on its debts.

In a nutshell, there is a substantial increase in savings and investment in the long run due to augmented activities by derivative Market participant.

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