ch11

Forwards

A forward contract is an agreement between two parties in which one party agrees to buy from the seller an underlying at a later date for a price established at the start of the contract. The future date can be in one month, in one year, in five years, or at any other specified date. Investors primarily use forward contracts to lock in the price of an underlying and to gain certainty about future financial outcomes. No payment on the contract is required by either party prior to delivery. At expiration, forward contracts usually settle with physical delivery. At settlement, one party will lose and the other party will gain relative to the spot price at the expiration date—this price variance also serves to increase counterparty risk.

hedge

A hedge is an action that reduces uncertainty or risk. enter into a contract to buy the wheat in the future at an agreed on price. This counterparty may anticipate being able to sell the wheat at a higher price in the market than the price agreed on with the farmer. This counterparty may be called a speculator. This counterparty is not hedging risk but is instead taking on risk in anticipation of earning a return. no guarantees of return

performance bond.

A performance bond is a guarantee, usually provided by a third party, such as an insurance company, to ensure payment in case a party fails to fulfil its contractual obligations (defaults). As an alternative to a performance bond, collateral may be requested. Collateral refers to pledged assets.

Swaps in which two parties exchange cash flows include interest rate and currency swaps.

An interest rate swap, the most common type, allows companies to swap their interest rate obligations (usually a fixed rate for a floating rate) to manage interest rate risk, to better match their streams of cash inflows and outflows, or to lower their borrowing costs. A currency swap enables borrowers to exchange debt service obligations denominated in one currency for equivalent debt service obligations denominated in another currency. By swapping future cash flow obligations, the two parties can manage currency risk. The use of swaps has grown because they allow investors to manage many kinds of risks, including interest rate risk, currency risk, and credit default risk. In addition, investors can use swaps to reduce borrowing and transaction costs, overcome currency exchange barriers, and manage exposure to underlying assets. 6

Options may trade in the over-the-counter market, but they trade predominantly on exchanges.

An option contract specifies the underlying, the size, the price to trade the underlying in the future (called the exercise price or strike price), and the expiration date. A buyer chooses whether to exercise an option based on the underlying's price compared with the exercise price. A buyer will exercise the option only when doing so is advantageous compared with trading in the market, which puts the seller at a disadvantage. Because of the unilateral future obligation (only the seller has an obli- gation), options have positive value for the buyer at the inception of the contract. The option buyer pays this value, or option premium, to the option seller at the time of the initial contract. The premium paid by the option buyer compensates the option seller for the risk taken; the option seller is the only party with a future obligation. The maximum benefit to the option seller is the premium. The option seller hopes the option will not be exercised

Credit default swaps (CDS)

Credit default swaps (CDS) are not truly swaps. Like options, credit default swaps are contingent claims and unilateral contracts. One party buys a CDS to protect itself against a loss of value in a debt security or index of debt securities; the loss of value is primarily the result of a change in credit risk. The seller is providing protection to the buyer against declines in value of the underlying. The seller does this in exchange for a premium payment from the buyer; the premium compensates the seller for the risk of the contract. The contract will specify under what conditions the seller has to make payment to the buyer of the CDS. Similar to sellers of options, sellers of CDS may misjudge the risk associated with the contracts and incur losses far in excess of payments received to enter into the contracts.

derivatives

Derivatives are contracts that derive their value from the performance of an underlying asset, event, or outcome- hence their name. Since the development of derivatives contracts to help reduce risk for farmers, the uses of derivatives are no longer just about reducing risk, but form part of the investment strategies of many fund managers. Given their sheer volume, derivatives are very important to financial markets and the work of investment professionals.

underlying

Derivatives can be created on any asset, event, or outcome, which is called the underlying. The underlying can be a real asset, such as wheat or gold, or a financial asset, such as the share of a company. The underlying can also be a broad market index, such as the S&P 500 Index or the FTSE 100 Index. The underlying can be an outcome, such as a day with temperatures under or over a specified temperature (also known as heating and cooling days), or an event, such as bankruptcy. Derivatives can be used to manage risks associated with the underlying, but they may also result in increased risk exposure for the other party to the contract Derivatives allow companies and investors to manage future risks related to raw material prices, product prices, interest rates, exchange rates, and even uncontrollable factors, such as weather. They also allow investors to gain exposure to underlying assets while committing much less capital and incurring lower transaction costs than if they had invested directly in the assets.

an option's premium depends on the current spot price of the underlying, exercise price, time to expiration, and volatility of the underlying.

Factors that Affect Option Premiums Option premiums are expected to compensate option sellers for their risk. The option premium represents the maximum profit that the option seller can make. If an option seller underestimates the risk associated with the option, the premiums may be far less than the losses incurred if the option is exercised. The lower the exercise price for a call option relative to the current spot price, the higher the premium because the likelihood that it will be exercised is greater. The higher the exercise price for a put option relative to the current spot price, the higher the premium because the likelihood that it will be exercised is greater. The longer the time to expiration of an option, the higher the option premium because the likelihood is greater that the underlying will change in favour of the option buyer and that it will be exercised. Similarly, the greater the volatility of the underlying, the higher the option premium because the likelihood is greater that the underlying will change in favour of the option buyer and that it will be exercised.

Distinctions between Forwards and Futures

Forwards and futures differ in how they trade, the flexibility of key terms in the contract, liquidity, counterparty risk, transaction costs, timing of cash flows, and settlement

FORWARDS AND FUTURES

Forwards and futures involve obligations in the future on the part of both parties to the contract. Forward and futures contracts are sometimes termed forward commitments or bilateral contracts because both parties have a commitment in the future. Bilateral contracts expose each party to the risk that the other party will not fulfil the contractual agreement.

Another way of reducing the counterparty risk for futures contracts is by marking to market daily.

Marking to market means that profits or losses on futures contracts are settled at the end of every business day, which has the effect of resetting the contract price and cash flows to buyers and sellers At the end of each day, the exchange estab- lishes a settlement price based on the closing trades and determines the difference between the current settlement price and the previous day's settlement price. Daily marking to market reduces counterparty risk and administrative overhead for the exchange. The result is enhanced trading, increased liquidity, and reduced transaction costs on futures contracts.

What if the farmer does not want to lock in the price because the farmer thinks the price of wheat is going to increase?

Option markets may provide the solution for both parties. Options give one party (the buyer) to the contract the right to extract an action from the other party (the seller) in the future. In an option contract, the buyer of the option has the right, but not the obligation, to buy or sell the underlying. Options are termed unilateral contracts because only one party to the contract (the seller) has a future commitment that, if broken, represents a breach of contract. Unilateral contracts expose only the buyer to the risk that the seller will not fulfil the contractual agreement. The buyer of the contract will exercise the right or option if conditions are favourable or if specified conditions are met. For this reason, options are also known as contingent claims—that is, claims are dependant on future conditions. If the buyer decides to use (exercise) the option, the seller is obligated to satisfy the option buyer's claim. If the buyer decides not to exercise the option, it expires without any action by the seller. Options may trade in the over-the-counter market, but they trade predominantly on exchanges.

put options

Put options protect the buyer by establishing a minimum price the option buyer will receive when selling the underlying; the minimum price is the exercise price. ■■ A put option is said to be "in the money" if the market price is less than the exercise price. In this case, the option would be exercised. 4 The number of shares associated with an option varies with the exchange. 276 Chapter 11 ■ Derivatives A put option is "out of the money" if the market price is greater than the exer- cise price. In this case, the option would not be exercised. A put option is "at the money" if the market price and exercise price are the same. In this case, the option may be exercised. ■■ ■■ An option's in- or out-of-the-money designation, also known as "moneyness", reflects whether it would be profitable for the buyer to exercise the option at the current time.

Settlement

Settlement describes how a contract is satisfied at expiration. Some contracts require settlement by physical delivery of the underlying and other contracts allow for or even require cash settlement. If physical delivery to settle is possible, the contract will specify delivery location(s). Contracts with underlying outcomes, such as heating or cooling days, cannot be settled through physical delivery and must be settled in cash. In practice, most derivatives contracts are settled in cash.

Swaps

Swaps are typically derivatives in which two parties exchange (swap) cash flows or other financial instruments over multiple periods (months or years) for mutual benefit, usually to manage risk. Swaps of this type involve obligations in the future on the part of both parties to the contract. These swaps, like forwards and futures, are forward commitments or bilateral contracts because both parties have a commitment in the future. Similar to forwards and futures, a contract's net initial value to each party should be zero and as one side of the swap contract gains the other side loses by the same amount. Swaps in which two parties exchange cash flows include interest rate and currency swaps.

The amount deposited on the day that the transaction occurs is called the initial margin.

The initial margin should be sufficient to protect the exchange against movements in the underlying's price. The exchange sets the margin amount depending on the underlying's price volatility—the greater the underlying's price volatility, the higher the margin.

Size and Price

The price specified in the contract may be called the exercise price or the strike price. Note that the price specified in the contract is not the current or spot price for the underlying but a price that is good for future delivery.

counterparty risk

The risk that the other party to the contract will not fulfil its contractual obligations is called counterparty risk. To reduce counterparty risk, the parties to a forward contract evaluate the default risk of the other party before entering into a contract. If the risk of default is significant, the parties may not agree to a forward contract. Or one or both parties may require a performance bond.

There are four main types of derivatives contracts: --------------------------------------------------------- All derivatives contracts specify four key terms:

There are four main types of derivatives contracts: forward contracts (forwards), futures contracts (futures), option contracts (options), and swap contracts (swaps). ------------------------------------------------------------------------------------ All derivatives contracts specify four key terms: the (1) underlying, (2) size and price, (3) expiration date, and (4) settlement.

A number of different standardised contracts may trade for an underlying on an exchange, but standardisation of futures contracts reduces the number of contract types available for the same underlying

Typically, each of the contracts is the same with respect not only to the underlying but also to size and settlement. Exercise price and expiration date may vary among contracts.

Underlying

Underlying Derivatives are constructed based on an underlying, which is specified in the contract. Originally, all derivatives were based only on tangible assets, but now some contracts are based on outcomes. Examples of underlyings include the following: ■■ Agricultural products (such as wheat, rice, soybeans, cotton, butter, and milk) ■■ Livestock (such as hogs and cattle) ■■ Currencies ■■ Interest rates ■■ Individual shares and equity indices ■■ Bond indices ■■ Economic factors (such as the inflation rate) ■■ Natural resources (such as crude oil, natural gas, gold, silver, and timber) ■■ Weather-related outcomes (such as heating or cooling days) ■■ Other products (such as electricity or fertilisers) A derivative's underlying must be clearly defined because quality can vary.

Futures

What if the farmer could not identify a party that wanted to be on the other side of the contract? Futures markets may provide the solution. A futures contract is similar to a forward contract in that it is an agreement that obligates the seller, at a specified future date, to deliver to the buyer a specified underlying in exchange for the specified futures price. The buyer of the contract is obligated to take delivery of the underlying, and the seller of the contract is obligated to deliver the underlying The main difference is that futures contracts are standardised contracts that trade on exchanges. The buyers and sellers do not necessarily know who is on the other side of the contract. Because the contracts are traded on exchanges, they are liquid and it is possible for a buyer or seller to close out a position by taking the opposite side. In other words, the buyer of a contract can sell the same contract and the seller of a contract can buy the same contract. The presence of an exchange as an intermediary between buyers and sellers helps reduce counterparty risk. Counterparty risk cannot be eliminated completely, however, because there is always a remote chance that the exchange fails to fulfil its own contractual obligations. To protect itself against one of the parties defaulting, the exchange typically requires that parties to the contract deposit funds as collateral. The depositing of funds as collateral is called posting margin.

ignoring the premium paid, an option buyer's payoff is never negative. Option buyers pay premiums to option sellers to compensate option sellers for their risk. But if an option seller underestimates the risk associated with the option, the premiums paid may be far less than the losses they incur on exercise. Call options protect the buyer by establishing a maximum price the option buyer will have to pay to buy the underlying; the maximum price is the exercise price.

■■ A call option is said to be "in the money" if the market price is greater than the exercise price. In this case, the option would be exercised. ■■ A call option is "out of the money" if the market price is less than the exercise price. In this case, the option would not be exercised. ■■ A call option is "at the money" if the market price and exercise price are the same. In this case, the option may be exercised.

There are two basic types of options: options to buy the underlying, known as call options, and options to sell the underlying, known as put options.

■■ An investor who buys a call option has the right (but not the obligation) to buy or call the underlying from the option seller at the exercise price until the option expires. ■■ An investor who buys a put option has the right (but not the obligation) to sell or put the underlying to the option seller at the exercise price until expiration. The cereal producer may buy a call option to secure the right, but not the obligation, to buy wheat at the exercise price. The farmer may buy a put option to secure the right, but not the obligation, to sell wheat at the exercise price. Note that the cereal producer and farmer enter into totally different option contracts to manage their risks.