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This book makes the reader aware of the background to the derivatives markets, how they have developed and their importance today. It does this by providing not only text but also a CD-ROM, Derivatives and Commodities, which contains material on derivatives to refresh the readers memory on the basics of derivatives.
Clearing and Settlement of Derivatives addresses how and why derivative products are used and how the industry is structured, looking at both the exchange and over-the-counter markets. The role of the various parties is explained and the interaction between securities, commodities and derivatives explored.
The key regulation that affects the use of derivatives by banks, corporate companies, institutional investors and private clients is covered and by way of example, the book reviews the various Directives affecting investment funds' use of derivatives, capital adequacy requirements on banks and guidelines for private client use. The regulations looked at will be international, making this book suitable for most UK, European, and North American markets. Informs and educates the reader about derivative products and everything that happens when trades take place without using confusing technical detail and unexplained jargon
What are derivatives?
'Derivatives' is a generic term used to describe a wide range of products that derive their price or have their value linked in some way to some other product.
As a result the derivative product can be used as a synthetic version of that other product, often referred to as the underlying, and this enables many different strategies to be developed, including hedging and speculative ones. For instance if we think the price of say BP shares is likely to move sharply upwards but it would equally be possible that something might happen to make the shares fall in price, we may be reluctant to commit funds to buying the shares. On the other hand if there is a product that allows us to have an exposure to the BP share price but without, at this stage, committing to paying the full value we would be more inclined to back our judgement. This is because we would know that if we were wrong we would not have committed all the required funds needed to buy the shares themselves but if we were right the product, a derivative of BP, would tend to move in the same way as the price of BP shares and we would profit from it.
Two derivative products that were established early on were the futures contract and the options contract. It is not easy to determine exactly when these products or similar types of product first saw the light of day but one thing for sure is that today, futures and options markets are global and trade contracts on a wide range of products encompassing currencies, commodities, interest rates, shares, indices, insurance; in fact you can find derivatives on just about anything.
We do know that this vast array of products traded today would seem unbelievable to the farmers and merchants of the Midwest of the United States of America who first started trading futures contracts, in a form similar to today, in the mid-1800s.
What is a futures contract?
A futures contract is a legally binding agreement to buy or sell a predetermined amount of a defined product at or by a set date for an agreed price.
Did derivatives exist before the 1800s?
The development of futures markets can be traced back at least as far as the Middle Ages and revolved around the supply and demand of people like farmers and merchants. The early contracts were, therefore, for delivery of 'underlying' products like grains, e.g. oats, corn and wheat. These trades took place for either immediate settlement ('spot' trades) or settlement at some time ahead ('forward' trades). They were not without problems. To establish the current price for say wheat, farmers would take their harvested crops to the major towns and visit each merchant in turn to find out who would pay the best price. Picture the scene as hundreds of farmers going back and forth across the town. Often many ended up dumping all or some of their crops as they could not manage to find a buyer, especially when there were bumper harvests. Even when the farmer had reached agreement with a merchant before harvest time, as there was no regulations in place there was no guarantee that the agreement would be honoured and both parties were potentially the 'guilty' ones to the default if prices moved in their favour.
The first futures market
The Chicago Board of Trade (most exchanges use mnemonics/ abbreviations and in this case the one used is CBOT or in speech sometimes 'the Board') was established in 1848 to standardise the size, quality and delivery date of these commodity agreements that were forwards contracts into a contract that could be traded on an exchange.
Once established, the standardisation of the terms of the contract enabled contracts to be readily traded as what we call today 'futures contracts'. Thus the forerunner of today's markets was born and farmers or merchants who wanted to hedge against price fluctuations, caused by poor or bumper harvests, bought and sold futures contracts with traders or market makers who were willing to make a different price for buying and selling. Speculators, who wanted to gamble on the price going up or down without actually buying or selling the physical grains themselves, were also attracted to the market. Therefore liquidity in the contracts was created, as many buyers and sellers came together to trade. The trader was able, if they wanted, to lay off the risk they had assumed from buying and selling with the hedgers, by doing the opposite, that is buying and selling with the speculators. The trader's profit was the difference between buying and selling the contracts.
Another important result of the creation of the CBOT was the ability to discover the price of a commodity. As buyers and sellers joined together on the floor of the exchange to trade and quoted prices to each other, the 'real' price for, say, soybeans was established. Price discovery helps to create a stability in price because anyone, buyer or seller, can immediately see by looking at the futures price what price the supply and demand for the underlying is generating.
In essence, today's markets do the same job as the original concept back in 1848 but in hundreds of different products. The CBOT, for instance, trades a wide range of contracts on commodities, like soybeans and silver as well as financials like Treasury Bonds and Notes.
In 1874, following in CBOT's footsteps, the Chicago Produce Exchange provided the market for perishable agricultural products like butter and eggs. After some upheaval in 1898, certain traders broke away and formed what is now known as the Chicago Mercantile Exchange (CME). In 1919 the CME was recognised to allow futures trading. Futures on a variety of commodities have since come to the exchange, including pork bellies, hogs and cattle as well as financials like currencies and index products.
The emergence of financial futures and options markets
In 1972 the CME established a division known as the International Monetary Market (IMM). Its purpose was to enable trading in futures contracts based on foreign currencies. In 1982 the CME started trading futures contracts on the S&P 500 Stock Index and now trades many different index products.
In the United States, prior to 1975, nearly all contracts traded were agricultural. Volume in these contracts was less than 10 million per year. However, by 1994 the figure had risen to almost 700 million contracts and by the end of 2003 to a staggering 8.1 billion contracts.
From the end of Second World War until the early 1970s there was a very stable economic environment in the United States helped by the Bretton Woods Agreement, which kept interest rates in a narrow range. However, when the US dollar was devalued, partly as a consequence of the funding of the Vietnam War and a heavy domestic spending programme, uncertainty and fluctuation in interest rates replaced the economic stability. Europe and Japan had also recovered in economic terms from the re-building effects of Second World War and, with their economies growing, the Dollar came under severe pressure. The need to be able to hedge (or to protect) against the risk associated with volatile currencies and interest rates became critical for many businesses and industries. The result was the birth of the first financial contracts, which became the cornerstone of the futures and options industry, as we know it today.
It was in 1975 that the CBOT launched the first futures contract on a financial instrument, the Ginnie Mae Mortgage Bond future, followed by the CME, which listed a Eurodollar contract. Shortly, the CBOT listed what was to become one of the world's most heavily traded futures contract, the Treasury Bond future.
Since then, the growth in volume of futures and options contracts in the United States and the rest of the world has been quite phenomenal, as more and more exchanges have opened and a plethora of financial products were developed and listed to meet the demand for risk-hedging mechanisms.
This process continues today as new markets open in the developing countries. However, the emergence of futures and options markets outside the United States has seen a change in the make-up of the overall volume of business traded. Today Eurex, formed from the amalgamation of the German Deutsche Terminborse and the Swiss Options and Financial Futures Exchange, is one of the largest exchanges in the world by volume of contracts traded. The Euro Bund future traded on Eurex is one of the heaviest traded futures contracts in the world and, to illustrate the global nature of today's market, the Kospi option traded on the Korea Stock Exchange was in 2003 the heaviest traded derivatives contract in the world (Table 1.1).
Mergers and alliances between derivative markets and stock exchanges has been common in recent times and today we have Euronext, the combined stock and derivative markets of France, Belgium, Portugal and the Netherlands together with the main derivative market in the United Kingdom, the London International Financial Futures & Options Exchange (LIFFE, pronounced 'life'). Other merged markets include, The Singapore Exchange (SGX), formed from the merger of the Singapore International Monetary Exchange (SIMEX) and the Stock Exchange of Singapore and the joining of the Hong Kong Stock Exchange and the Hong Kong Futures Exchange to create HKEx.
Other significant developments have included the approval by the US Regulators and the launch by Eurex, the German-based exchange, of a new exchange in the United States, Eurex US, to directly compete with the established Chicago markets.
Also in the United States was the combining of the clearing for the two largest futures markets, the CBOT and the CME, with resulting efficiencies and cost savings for members.
The first options markets
Like futures, the use of options can be traced back to the eighteenth century, and in certain forms as far back as the Middle Ages. In the eighteenth century, options were traded in both Europe and the United States, but unfortunately due to widespread corrupt practices the market had a bad name. These early forms of options contracts were traded between the buyer and the seller and had only two possible outcomes. The option was delivered (i.e. the underlying product changed hands at the agreed price) or it expired without the buyer taking up his 'option' to exercise the contract for delivery. In other words there was no 'trading' of the option positions and, still worse, in the early days just as we saw with forward trades there was no guarantee that the seller would honour his obligation to deliver the product if the buyer exercised his option.
However, there was little doubt that options were considered highly flexible and desirable products and therefore in April 1973 the CBOT proposed a new exchange, the Chicago Board Options Exchange (CBOE), to trade stock options in a standardised form and on a recognised market where performance of the options contract on exercise was guaranteed. This was the birth of what we call today 'traded options'.
Since 1973, option markets have grown in the United States and of course globally. Like futures markets they cover a wide range of products, including options on futures, a derivative with another derivative as the underlying. Although options have been trading on exchange for a shorter time than futures, they are nevertheless extremely popular with both hedgers and speculators alike.
The Australian Options Market (now owned by the Australian Stock Exchange) opened in 1976. In 1978, the first traded options markets started trading in Europe. The European Options Exchange opened in Amsterdam followed soon after by the London Traded Option Market (now owned by the LIFFE).
Other futures and options markets followed. The London International Financial Futures & Options Exchange opened for business in 1982, the Singapore International Monetary Exchange in 1984 and the Hong Kong Futures Exchange in 1985. Many new markets in the Americas, Europe and the Far East followed these during the late 1980s and the early 1990s.
Excerpted from Clearing and Settlement of Derivatives by David Loader Copyright © 2005 by Elsevier Ltd. . Excerpted by permission of BUTTERWORTH-HEINEMANN. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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