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Derivatives DemystifiedA Step-by-Step Guide to Forwards, Futures, Swaps and Options
By Andrew M. Chisholm
John Wiley & SonsISBN: 0-470-09382-X
Chapter OneThe Market Background
DERIVATIVES BUILDING BLOCKS
A derivative is an asset whose value is derived from the value of some other asset, known as the underlying. Imagine that you have signed a legal contract that, with the payment of a premium, gives you the option to buy a fixed quantity of gold at a fixed price of $100 at any time in the next three months. The gold is currently worth $90 in the world market. The option is a derivative and the underlying is gold. If the value of gold increases, then so does the value of the option, because it gives you the right (but not the obligation) to buy the metal at a predetermined price.
For example, suppose that the market price of gold rose sharply in the weeks after signing the deal and the quantity specified in the contract was now worth $150. Then you could if you wished exercise (take up) the option, buy the gold for $100, and immediately sell it on to a dealer for $150. The option contract has become a rather valuable item. Suppose, instead, that the price of gold had collapsed, and the quantity specified in the contract was only worth $50. The option would then be virtually worthless, and it is unlikely that it would ever be exercised.
Derivatives are based on a very wide range of underlying assets. This includes metals such asgold and silver; commodities such as wheat and orange juice; energy resources such as oil and gas; and financial assets such as shares, bonds and foreign currencies. In all cases, the link between the derivative and the underlying commodity or financial asset is one of value. An option to buy a share at a fixed price is a derivative of the underlying share because if the share price increases then so too does the value of the option.
In the modern world there is a huge variety of different derivative products. These are traded on organized exchanges or agreed directly in the so-called over-the-counter (OTC) market, where deals are contracted over the telephone or through electronic media. The good news is that the more complex structures are constructed from some simple building blocks - forwards and futures; swaps; and options - which are defined below.
Forwards. A forward contract is a contractual agreement made directly between two parties. One party agrees to buy a commodity or a financial asset on a date in the future at a fixed price. The other side agrees to deliver that commodity or asset at the predetermined price. There is no element of optionality about the deal. Both sides are obliged to go through with the contract, which is a legal and binding commitment, irrespective of the value of the commodity or asset at the point of delivery. Since forwards are negotiated directly between two parties, the terms and conditions of a contract can be customized. However, there is a risk that one side might default on its obligations.
Futures. A futures contract is essentially the same as a forward, except that the deal is made through an organized and regulated exchange rather than being negotiated directly between two parties. One side agrees to deliver a commodity or asset on a future date (or within a range of dates) at a fixed price, and the other party agrees to take delivery. The contract is a legal and binding commitment. There are three key differences between forwards and futures. Firstly, a futures contract is guaranteed against default. Secondly, futures are standardized, in order to promote active trading. Thirdly, they are settled on a daily basis. The settlement process is explained in detail in later chapters.
Swaps. A swap is an agreement made between two parties to exchange payments on regular future dates, where the payment legs are calculated on a different basis. As swaps are OTC deals, there is a risk that one side or the other might default on its obligations. Swaps are used to manage or hedge the risks associated with volatile interest rates, currency exchange rates, commodity prices and share prices. A typical example occurs when a company has borrowed money from a bank at a variable rate and is exposed to an increase in interest rates; by entering into a swap the company can fix its cost of funding. (Although it is often considered as one of the most basic types of derivative product, a swap is actually composed of a series of forward contracts.)
Options. A call option gives the holder the right to buy an underlying asset by a certain date at a fixed price. A put option conveys the right to sell an underlying asset by a certain date at a fixed price. The purchaser of an option has to pay an initial sum of money called the premium to the seller or writer of the contract. This is because the option provides flexibility; it need never be exercised (taken up). Options are either negotiated between two parties in the OTC market, one of which is normally a specialist dealer, or freely traded on organized exchanges. Traded options are generally standardized products, though some exchanges have introduced contracts with some features that can be customized.
Derivatives have a very wide range of applications in business as well as in finance. There are four main participants in the derivatives market: dealers, hedgers, speculators and arbitrageurs. The same individuals and organizations may play different roles in different market circumstances. There are also large numbers of individuals and organizations supporting the market in various ways.
Dealers. Derivative contracts are bought and sold by dealers who work for major banks and securities houses. Some contracts are traded on exchanges, others are OTC transactions. In a large investment bank the derivatives operation is now a highly specialized affair. Marketing and sales staff speak to clients about their requirements. Experts help to assemble solutions to those problems using combinations of forwards, swaps and options. Any risks that the bank assumes as a result of providing tailored products for clients is managed by the traders who run the bank's derivatives books. Meantime, risk managers keep an eye on the overall level of risk the bank is running, and mathematicians - known as 'quants' - devise the tools required to price new products.
Hedgers. Corporations, investing institutions, banks and governments all use derivative products to hedge or reduce their exposures to market variables such as interest rates, share values, bond prices, currency exchange rates and commodity prices. The classic example is the farmer who sells futures contracts to lock into a price for delivering a crop on a future date. The buyer might be a food-processing company which wishes to fix a price for taking delivery of the crop in the future, or a speculator. Another typical case is that of a company due to receive a payment in a foreign currency on a future date. It enters into a forward transaction with a bank agreeing to sell the foreign currency and receive a predetermined quantity of domestic currency. Or it buys an option which gives it the right but not the obligation to sell the foreign currency at a set exchange rate.
Speculators. Derivatives are very well suited to speculating on the prices of commodities and financial assets and on key market variables such as interest rates, stock market indices and currency exchange rates. Generally speaking, it is much less expensive to create a speculative position using derivatives than by actually trading the underlying commodity or asset. As a result, the potential returns are that much greater. A classic application is the trader who believes that increasing demand or reduced production is likely to boost the market price of a commodity. As it would be too expensive to buy and store the physical commodity, the trader buys an exchange-traded futures contract, agreeing to take delivery on a future date at a fixed price. If the commodity price increases, the value of the contract will also rise and can then be sold back into the market at a profit.
Arbitrageurs. An arbitrage is a deal that produces risk-free profits by exploiting a mispricing in the market. A simple example occurs when a trader can purchase an asset cheaply in one location and simultaneously arrange to sell it in another at a higher price. Such opportunities are unlikely to persist for very long, since arbitrageurs would rush in to buy the asset in the 'cheap' location, thus closing the pricing gap. In the derivatives business arbitrage opportunities typically arise because a product can be assembled in different ways out of different building blocks. If it is possible to sell a product for more than it costs to buy the constituent parts, then a risk-free profit can be generated. In practice the presence of transaction costs often means that only the larger market players can benefit from such opportunities.
There are, in addition, many individuals and organizations who support the derivatives market and help to ensure orderly and efficient dealings. For example, those who are not members of a futures and options exchange have to employ a broker to transact or 'fill' their orders on the market. A broker acts as an agent and takes an agreed fee or commission. Trading in derivatives generally is overseen and monitored by government-appointed regulatory organizations. For example, the Commodity Futures Trading Commission (CFTC) was created by Congress in 1974 as an independent agency to regulate commodity futures and options markets in the USA.
Market participants have also set up their own support and self-regulatory organizations such as the International Swaps and Derivatives Association (ISDA) and the US-based National Futures Association (NFA). Trade prices on exchanges are reported and distributed around the world by electronic news services such as Reuters and Bloomberg. Information technology companies provide essential infrastructure for the market, including systems designed to value derivative products, to distribute dealer quotations and to record and settle trades.
ORIGINS AND DEVELOPMENT OF DERIVATIVES
The history of derivatives goes back a very long way. In Book One of Politics, Aristotle recounts a story about the Greek philosopher Thales who concluded (by means of astronomical observations) that there would be a bumper crop of olives in the coming year. Thales took out what amounted to option contracts by placing deposits on a large number of olive presses, and when the harvest was ready he was able to rent the presses out at a substantial profit. Some argued that this proves that philosophers can easily make money if they choose to, but they are actually interested in higher things. Aristotle was less than impressed. He thought the scheme was based on cornering or monopolizing the market for olive presses rather than any particularly brilliant insight into the prospects for the olive harvest.
Forwards and futures are equally ancient. In medieval times sellers of goods at European fairs signed contracts promising delivery on future dates. Commodity futures can be traced back to rice trading in Osaka in the 1600s. Feudal lords collected their taxes in the form of rice, which they sold in Osaka for cash. Successful bidders were issued with vouchers that were freely transferable. Eventually it became possible to trade standardized contracts on rice, similar to modern futures, by putting down a deposit that was a relatively small fraction of the value of the underlying rice. The market attracted speculators and also hedgers seeking to manage the risks associated with fluctuations in the market value of the rice crop.
The tulip mania in sixteenth-century Holland, which saw bulbs being bought and sold in Amsterdam at hugely inflated prices, also brought about trading in tulip forwards and options, but the bubble finally burst spectacularly in 1637. Derivatives on shares were being dealt on the Amsterdam Stock Exchange by the seventeenth century. At first all deals on the exchange were made for immediate delivery, but soon traders could deal in call and put options which provided the right to buy or to sell shares on future dates at predetermined prices.
London superseded Amsterdam as Europe's main financial centre, and derivative contracts started to trade in the London market. The development was at times controversial. In the 1820s problems arose on the London Stock Exchange over trading in call and put options. Some members condemned the practice outright. Others argued that dealings in options greatly increased the volume of transactions on the exchange, and strongly resisted any attempts at interference. The committee of the exchange tried to ban options, but was eventually forced to back down when it became clear that some members felt so strongly about the matter that they were prepared to subscribe funds to found a rival exchange. Meantime in the USA, stock options were being traded as early as the 1790s, very soon after the foundation of the New York Stock Exchange.
The Chicago Board of Trade (CBOT) was founded in 1848 by 82 Chicago merchants. The earliest forward contract (on corn) was traded in 1851 and the practice rapidly gained in popularity. In 1865, following a number of defaults on forward deals, the CBOT formalized grain trading by developing standardized agreements called 'futures contracts'. The exchange required buyers and sellers operating in its grain markets to deposit collateral called 'margin' against their contractual obligations. Futures trading later attracted speculators as well as food producers and food-processing companies. Trading volumes expanded in the late nineteenth and early twentieth centuries as new exchanges were formed, including the New York Cotton Exchange in 1870 and Chicago Mercantile Exchange (CME) in 1919. It became possible to trade futures contracts based on a wide range of underlying commodities and (later) metals.
Futures on financial assets are more recent in origin. CME launched futures contracts on seven foreign currencies in 1972, which were the world's first contracts not to be based on a physical commodity. In 1975 the CBOT launched futures on US Treasury bonds, and in 1982 it created exchange-traded options on bond futures. In 1981 CME introduced a Eurodollar futures contract based on short-term US dollar interest rates, a key hedging tool for banks and traders. It is settled in cash rather than through the physical delivery of a financial asset.
In 1973 the Chicago Board Options Exchange (CBOE) started up, founded by members of the CBOT. It revolutionized stock option trading by creating standardized contracts listed on a regulated exchange. Before that, stock options in the USA were traded in informal over-the-counter markets.
Excerpted from Derivatives Demystified by Andrew M. Chisholm Excerpted by permission.
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