Reading 66

A derivative is a security that derives its value from the value of another security or a variable (such as an interest rate or stock index value) at some specific future date. The security or variable that determines the value of a derivative security is referred to as the underlying for the derivative. The value of a derivative at a point in time is derived from the value of the underlying (asset or variable) on which the derivative contract is based.

A Simple Forward Contract Example

A relatively simple example of a derivative is a forward contract that specifies the price at which one party agrees to buy or sell an underlying security at a specified future date. Consider a forward contract to buy 100 shares of Acme at \(\$30\) per share three months from now:

• Acme shares are the underlying asset for the forward contract.
• \(\$30\) is the forward price in the contract.
• The date of the future transaction, when the shares will be exchanged for cash, is referred to as the settlement date (maturity date) of the forward contract.
• 100 shares is the contract size of the forward contract.
• The forward price is set so that the forward contract has zero value to both parties at contract initiation; neither party pays at the initiation of the contract.

We can examine three outcomes for the price of Acme shares at settlement:

1. The spot price equals the forward price (\(\$30 = \$30\)). Neither party has profits or losses on the forward contract. Ignoring transactions costs, the seller could buy the shares back at \(\$30\) and the buyer could sell them at \(\$30\).
2. The spot price (\(\$40\)) is greater than the forward price (\(\$30\)). The buyer of 100 Acme shares for \(\$3{,}000\) at settlement can sell those shares at the spot price for \(\$4{,}000\), realizing a profit of \(\$1{,}000\). The seller delivers shares with a market value of \(\$4{,}000\) and receives \(\$3{,}000\), realizing a \(\$1{,}000\) loss.
3. The spot price (\(\$25\)) is less than the forward price (\(\$30\)). The buyer pays \(\$3{,}000\) for shares worth only \(\$2{,}500\), realizing a \(\$500\) loss. The seller delivers shares with a market value of \(\$2{,}500\) and receives \(\$3{,}000\), realizing a \(\$500\) gain.

To summarize: the buyer of the shares in a forward contract gains when the market price at settlement is greater than the forward price and loses when it is less. The seller of the shares gains when the market price at settlement is less than the forward price and loses when it is greater. The gains of one party equal the losses of the other party at settlement.

We refer to the party that agrees to buy the underlying asset as the buyer of the forward. The buyer of the forward gains when the price of the underlying increases (and loses when it falls), similar to a long position in the underlying. We say the forward buyer has long exposure to the underlying, while the seller has short exposure, gaining when the price of the underlying decreases and losing when it increases.

In practice, a forward contract may be a deliverable contract, meaning the payment and the shares must be exchanged at settlement. A cash-settled contract specifies that only the gains and losses are exchanged at settlement. In our example with a share price of \(\$25\), cash settlement would require the buyer to pay \(\$500\) to the seller. Ignoring transaction costs, the gains and losses are economically equivalent under both settlement methods.

We can view a derivatives contract as a way to transfer risk from one party to another. Consider a situation where the share seller in the forward contract owns 100 shares of Acme. She has existing risk because the future price of Acme shares is uncertain. If she enters the forward contract, she will receive \(\$3{,}000\) for her shares at settlement, regardless of their market price. This effectively transfers her existing Acme price risk to the buyer.

When a party to a derivative contract has an existing risk that is transferred to another party, we say that party has hedged (offset, reduced) their existing risk. If the risk of the forward contract exactly matches an existing risk, then the forward contract can be used to fully hedge the existing risk. If a derivative is used to reduce, but not entirely offset, an existing risk, we say the existing risk is partially hedged.

If the Acme share buyer in our example has no existing Acme price risk, she clearly increases her risk by entering the forward contract. In this situation, the buyer is said to be speculating on the future price of Acme shares.

Our share seller could have achieved her goal of eliminating Acme price risk by simply selling her shares (a cash market transaction). Derivatives have potential advantages over cash market transactions:

• Investors can gain exposure to a risk at low cost, effectively creating a highly leveraged investment in the underlying.
• Transaction costs for a derivatives position may be significantly lower than for the equivalent cash market trade.
• Initiating a derivatives position may have less market-price impact on the underlying, relative to the equivalent cash market transaction.

Underlying Assets and Variables

The underlying for a derivative is most often a stock or bond price, the level of a stock or bond index, or an interest rate. Examples of underlying assets and variables include:

• A bond, for example a forward contract on a 30-year U.S. Treasury bond. The risk involved is the uncertainty about future bond prices.
• An index, for example the S&P 500 Index or the Citi Goldman Sachs Investment Grade Corporate Bond Index. A portfolio manager can reduce the risk of a U.S. equity portfolio by selling a forward on the S&P 500. An investor can gain long exposure to high-grade corporate bonds, quickly and at low cost, by buying a forward on the index.
• A currency, for example British pounds (\(\text{£}\)). A U.S. manufacturer expecting a large \(\text{£}\) payment in six months can offset USD-value uncertainty by selling a forward contract on the expected \(\text{£}\) amount. A UK manufacturer needing to make a large USD payment in one year can offset \(\text{£}\) cost uncertainty by buying a forward on the USD priced in \(\text{£}\).
• An interest rate, for example the 1-year Treasury bill rate. Higher interest rates mean gains for the buyer of an interest rate forward, whereas higher interest rates mean lower bond prices and losses for the buyer of a bond forward.
• Commodities, which are physical assets including hard commodities (typically mined or extracted, such as gold and oil) and soft commodities (typically grown, such as cotton, coffee, pork, and cattle). A farmer expecting a cotton crop in four months can reduce her cotton price risk by selling cotton forward. A utility requiring oil over the coming year can reduce its oil price risk by buying oil forwards.

• Credit derivatives include credit default swaps (CDS), in which one party makes fixed periodic payments to another, who will make a payment only if the underlying credit instrument suffers a loss in value due to a default by the issuer.
• Derivative contracts are also created with the weather (for farmers, energy producers, travel and tourism companies), cryptocurrencies, or longevity (for life insurers or annuity providers) as the underlying.

Along with forwards and futures, the derivative types covered in subsequent readings are:

• Options: Put options give the buyer the right (but not the obligation) to sell the underlying for a specific price in the future. Call options give the buyer the right (but not the obligation) to buy the underlying for a specific price in the future.
• Swaps: In a simple interest rate swap, one party agrees to make periodic payments at a fixed interest rate, and the other agrees to make periodic interest payments at a rate based on a future market reference rate (MRR). The resulting cash flows are equivalent to one party (the fixed-rate payer) borrowing at a fixed rate and using the proceeds to buy a floating-rate bond.

Exchange-Traded Derivatives

Centralized physical exchanges provide markets for futures contracts, some options contracts, and some other derivative contracts. The largest by volume of trades are the National Securities Exchange (India), the B3 market (Brazil), and the CME Group (the United States).

Exchange-traded derivatives are standardized and backed by a central clearinghouse. The exchange specifies the terms of each derivative contract and the rules for trading on the exchange.

A central clearinghouse (CCH) essentially takes the opposite position to each side of a trade (called novation), guaranteeing the payments promised under the contract. The CCH requires deposits from both participants when a trade is initiated, and additional deposits for accounts that decline in value, to support its guarantee and minimize counterparty credit risk.

Exchange members (dealers or market makers) buy and sell derivatives at slightly different prices and primarily earn trading profits from the bid/ask spreads, rather than from holding (speculating on) specific derivatives positions, although they may hold such positions to meet customer needs.

The standardization of contracts allows exchange-traded derivatives to be more liquid and more transparent. A market participant can easily exit a position by entering into an opposite contract. Standardization reduces trading costs compared to customized derivative contracts.

Standardization also facilitates the clearing and settlement of trades. Clearing refers to executing the trade, recording the participants, and handling the exchange of any required payments. Settlement refers to the exchange of underlying assets or payments of the final amounts due at contract settlement (maturity).

Dealer (OTC) Markets for Derivatives

Forwards, most swaps, and some options are custom instruments created and traded by dealers in a market with no central location. Some dealer markets are quite structured (e.g., the Nasdaq market), while others are not. A dealer market with no central location is referred to as an over-the-counter (OTC) market. OTC markets are largely unregulated and less transparent than exchange markets. In OTC markets with no central clearinghouse, each side of a trade faces counterparty credit risk. Dealers (market makers) make derivatives trades with end users and may also trade with each other to reduce their exposures to changes in prices of underlying assets.

OTC derivatives contracts can be customized to fit the needs of an end user regarding contract size, definition of the underlying, settlement date, whether the contract is deliverable or cash settled, and other relevant details. Users gain or hedge a specific risk via OTC derivatives when a standardized contract will not meet their needs (including a desire for privacy).

After the financial crisis of 2008, regulators worldwide instituted a central clearing mandate requiring that, for many swap trades, a central counterparty (CCP) takes on the counterparty credit risk of both sides of a trade, similar to the role of a central clearinghouse. As an example, multiple dealers record their swap trades on a swap execution facility (SEF). When a dealer makes a swap trade, that information is sent to the SEF and the CCP replaces the trade with two trades, with the CCP as the counterparty to both, reducing counterparty risk. The downside is that counterparty risks are concentrated rather than distributed among financial intermediaries.

Derivatives in dealer markets that are subject to the central clearing mandate have reduced counterparty risk, are subject to more disclosure of trades, and are easier to clear and settle, but are still customizable and are contracts with dealers or financial intermediaries.