Derivatives

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A derivative is an agreement between two parties in which each agrees to transfer an asset or amount of money on or before a specified future date at a specified price. A derivative s value is derived from one or more underlying variables. Originally, derivatives trading involved commodities as a way for farmers to hedge away the financial risk of their business, but today derivatives are tied to everything from currencies and interest rates to the weather.

A forward contract is a transaction in which the buyer and seller agree upon the delivery of a specified quality and quantity of asset at a specified future date. A price is normally specified in advance or at the time of delivery.

A futures contract is a legally binding obligation for the holder of the contract to buy or sell a particular commodity at a specific price and location at a specific date in the future. The appeal of an exchange-traded future is that the contracts can be standardized, so that everyone in the market is trading the same contract.

An option gives the buyer the right but not the obligation to buy (call) or sell (put) the underlying asset at a specified price (called the strike price ) up to or on a specific future date (expiration date). The buyer of the option pays the seller of the option a premium for this right.

A swap is the simultaneous buying and selling of a similar asset or obligation of equivalent capital amount. This exchange of financial arrangements provides both parties with more favorable conditions than they would otherwise expect. For example, a payer of fixed-rate debt may desire paying floating-rate debt, and a payer of floating-rate debt may want to pay fixed-rate debt. If the two sides can agree on a notional amount upon which to compute coupon payments, then they can swap fixed for floating and floating for fixed. The notional amount never changes hands, and interest payments are netted.

A look at swaps

How is a swap possible? How can both sides be made better off in an interest rate swap transaction? What we ve learned from financial derivatives is that its a tough world out there, and if you re making money, that s because you re breaking someone else s back (i.e., its a zero sum game). If you ve taken an international economics class, you may remember discussing gains from international trade. A similar concept is at work in the financial markets. Let s take a look at an example:

MMMM ( Four M) is a multinational corporation with a triple A credit rating. MMMM needs to borrow $100 million for 5 years. MMMM can borrow at a low fixed rate, but would prefer to take advantage of a floating rate basis loan.

Chewbacca is a triple B rated energy trading company named after the Star Wars character. Chewy needs to raise $100 million for 5 years. Because of Chewy s lower credit rating, it is easier for the firm to borrow on a floatingrate basis, or to issue debt with a high coupon. But alas, Chewy would prefer a fixed-rate loan in order to better predict future interest payments.

Each firm s situation is summarized below:

RATES

MMMM CAN BORROW FIXED

CHEWY CAN BORROW FLOATING

FIXED

6%

10%

FLOATING

LIBOR

LIBOR + 1%

Assuming that both corporations do not believe there to be substantial default risk, then an interest rate swap can be negotiated as follows:

1. MMMM borrows fixed rate at 6%

2. Chewy borrows floating at LIBOR + 1%

3. MMMM and Chewy enter into a $100 million notional interest rate swap agreement for five years such that:

MMMM makes floating rate payments of LIBOR + 1% to Chewy

Chewy makes fixed rate payments 9% to MMMM. Chewy agrees to make this higher fixed rate to MMMM because of its lower credit rating.

Financial Products

Now both sides of the swap look like this:

Now both sides of the swap look like this:

LIBOR

LIBOR 2%

LIBOR

LIBOR

Notice that the swap has allowed both MMMM and Chewy to achieve a lower cost of borrowing than either would have been able to access without each other. Notice also that these savings were possible even though MMMM had a lower fixed and floating rate available to it at the outset. These savings will be reduced by the dealer s fee for arranging the swap. In this happy world, customers and dealer both profit. Originally, dealers acted as matchmakers between counterparties. Today, the swaps market has become so standardized that dealers stand ready to take the other side of the proposed interest rate swap trade.

Risk management

The main reason for using derivatives is to manage risk. The derivatives market offers hedgers like the CFO of a large industrial company a way to hedge away his firm s financial risk, and it provides speculators (who are hopelessly addicted to leverage) an opportunity to profit from a particular market view. Arbitrageurs keep the market efficient by exploiting any price discrepancies between different markets or between the derivative and the underlying asset. Derivatives can trade in three ways, explained in the following sections.

Fixed income derivatives

Fixed income derivatives are any derivatives instruments which derive value from a fixed income security. Typically these instruments are structured by Wall Street firms as a way to reallocate risks from corporations (who are seeking to mitigate business or financial risk) to speculators (who are seeking risk exposure in the expectation of profiting from a particular market view). Dealers will create a derivative instrument, and to support the development of

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this market will subsequently engage in creating and maintaining an active secondary market. As the market becomes more developed, spreads that the dealers pocket decrease dramatically. When interest rate swaps were popularized by Bankers Trust, BT was able to extort exorbitant fees from relatively unsophisticated corporate treasurers. Today, the interest rate swaps market is a screen-based market with razor-thin margins, and credit derivatives are all the rage. One word of caution for the neophyte fixed income derivative enthusiast: Warren Buffet has characterized derivatives as financial weapons of mass destruction. While Wall Street has peddled derivatives as an efficient manner of reallocating risk, as the Long Term Capital Management debacle demonstrated, there are tremendous amounts of counter-party risk, since risk ends up being concentrated in relatively few hands, and one default in the derivatives market can trigger multiple defaults throughout the system, threatening the integrity of the entire worldwide financial market.

Equity derivatives

Equity derivatives trade listed and OTC equity options. OTC options are contracts structured by the firm to meet the needs of specific institutional customers. Listed options are exchange-listed products that are completely standardized and more liquid. Call holders have the right (but not the obligation) to purchase shares of the underlying company at a pre-specified price. Put holders have the right to sell shares of the underlying company at a pre-specified price. Dealers are typically sellers of options, and the vast majority of options expire worthless (out-of-the-money). Being short options is equivalent to being short volatility (some options desks now call themselves Volatility Trading Desks ). Options give the right to buy or sell an underlying stock: the higher the volatility, the greater the price of the option; the lower the volatility, the lower the price of the option. When a desk is net short options, it is short volatility, and will profit if volatility does not exceed the implied volatility at which the options were sold at. Think of options desks as insurers who are constantly collecting small premiums, but must every once in a while make a large payout related to a natural or man-made disaster.

Financial Products

Over-the-counter (OTC) derivatives

Dealers structure and trade just about anything that can generate a fee, but typically these structured products compete with standardized exchange-traded products. These products include currency and commodity derivatives, as well as interest rate swaps. Structured products like interest rate swaps will typically trade over-the-counter, whereas more standardized products are traded on exchanges such as the Chicago Board of Trade (CBOT) and the London International Financial Futures and Options Exchange (LIFFE).

By now you should understand that the OTC equity market, the OTC bond market and the OTC derivatives market are all inter-dealer markets connected by telephone and computer network. There is no centralized exchange floor.

Trading Systems for Derivatives

On the exchange floor (open outcry)

Note that structured products are normally built with standardized derivative securities, and that in most circumstances, the dealer must then go out and hedge the exposure that he s taken on from the client (at least until he can find another customer to take an equal and offsetting position) by going to the exchange. This requires the dealer to structure a hedge using standardized future and option contracts that trade on the exchange floors.

Regional exchanges are continuously rolling out new products to trade, and successful products tend to develop pockets of liquidity on one or two major exchanges. For example, the Philadelphia Stock Exchange has a booming business in currency options. The Chicago Mercantile Exchange trades, among other things, currency and equity options.

Some futures exchanges use specialists in the same way that the NYSE employs specialists as a buyer or seller of last resort. On other exchanges, like the NYME, a trade cannot be completed unless there is someone else willing to take the other side of the trade. The commodity futures prices are determined in an open and continuous auction on the floor by brokers acting as agent (preserving anonymity of the customer) or principal. This auction process involves a lot of yelling and hollering, and is appropriately called open outcry. Highest bids are matched with lowest offers and supply and demand push the contract price in the appropriate direction.

Financial Products

Electronic trading (GLOBEX)

Electronic trading was introduced as a way to extend the trading hours of the major exchanges, and today has grown into a big business. Electronic trading systems apply the same rules that are enforced on the trading floor. Customers enter bids and offers into the system. This information is disseminated electronically to all market participants, and the orders are matched off subject to the individual rules of the market.

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