Derivatives Exchanges: Clearing Houses & Trading

• A derivatives exchange is a marketplace where standardized contracts, defined by the exchange, are traded.
• The Chicago Board of Trade (CBOT) was established in 1848 to standardize grain trading, later developing the first futures-type contract known as a to-arrive contract.
• The Chicago Mercantile Exchange (CME) was established in 1919 as a rival futures exchange.
• The CME Group was formed through the merger of CME and CBOT, including the New York Mercantile Exchange, COMEX, and KCBT.
• The Chicago Board Options Exchange (CBOE) began trading call option contracts on 16 stocks in 1973, creating an orderly market for options.
• The CBOE now trades options on over 2,500 stocks and various stock indices, with underlying assets including foreign currencies and futures contracts.
• When traders agree on a trade, the exchange clearing house manages risks by acting as an intermediary.
• The clearing house requires traders to deposit margin to ensure obligations are met, mitigating credit risk.
• Derivatives exchanges have largely replaced the open outcry system with electronic trading, where computers match buyers and sellers.
• Electronic trading has facilitated the growth of high-frequency and algorithmic trading in derivatives markets.

Over-the-Counter (OTC) Markets

• Banks, financial institutions, fund managers, and corporations primarily participate in OTC derivatives markets.
• After an OTC trade, parties can clear it through a central counterparty (CCP) or bilaterally.
• A CCP, similar to an exchange clearing house, interposes itself between parties to eliminate default risk.
• Bilateral clearing involves agreements covering termination conditions, settlement calculations, and collateral requirements.
• Banks often act as market makers, providing bid and offer prices for commonly traded OTC instruments.
• Post-2007 credit crisis, regulations aim to improve transparency, efficiency, and reduce systemic risk in OTC markets.
• Standardized OTC derivatives in the U.S. must be traded on swap execution facilities (SEFs).
• CCPs are required for most standardized derivatives transactions globally.
• All trades must be reported to a central registry.

Market Size

• Both OTC and exchange-traded derivatives markets are substantial.
• OTC markets have fewer transactions but larger average transaction sizes.
• The OTC market is significantly larger than the exchange-traded market.
• By December 2012, the OTC market reached $632.6 trillion, while the exchange-traded market was at $52.6 trillion.
• The gross market value of outstanding OTC transactions was estimated at $24.7 trillion in December 2012.

Forward Contracts

• A forward contract is an agreement to buy or sell an asset at a future date for a set price and is traded OTC.
• A spot contract involves an almost immediate exchange of an asset.
• The party agreeing to buy takes a long position, and the party agreeing to sell takes a short position.
• Forward contracts are used to hedge foreign currency risk.
• Large banks employ both spot and forward foreign-exchange traders.

Forward Prices

• There's a relationship between forward prices, spot prices, and interest rates in the relevant currencies.
• A bank might offer to buy GBP at $1.5541 and sell at $1.5545 in the spot market.
• The same bank can offer different rates for forward contracts, such as buying GBP in 1 month at $1.5538 and selling at $1.5543.
• A treasurer can hedge against exchange rate moves by using forward contracts.
• Buying £1 million 6 months forward at an exchange rate of 1.5532 locks in that rate for a future payment.

Payoffs from Forward Contracts

• A forward contract obligates a corporation to buy £1 million for $1,553,200.
• If the spot exchange rate rises, the forward contract is valuable because it allows purchase at a lower rate.
• If the spot exchange rate falls, the forward contract has a negative value because it requires paying more than the market price.
• Payoff from a long position is ST - K, where K is the delivery price and ST is the spot price at maturity.
• Payoff from a short position is K - ST.
• Because there's no initial cost to enter a forward contract, the payoff is also the total gain or loss.

Forward and Spot Price Relationship

• The 1-year forward price of a $60 stock with a 5% interest rate should be $63.
• If the forward price is higher, one could borrow to buy the stock and sell it forward for a profit.
• If the forward price is lower, an investor could sell the stock and enter a forward contract to buy it back for a profit.

Futures Contracts

• Like forward contracts, futures contracts agree to a future transaction at a set price.
• Futures contracts are typically traded on an exchange with standardized features.
• The exchange guarantees the contract will be honored since the parties may not know each other.
• The CME Group (formed by CBOT and CME) is the largest exchange for futures contracts.
• Exchanges offer futures contracts on commodities like pork bellies, gold, and financial assets like stock indices.
• If more traders want to go long the price goes up; if the reverse is true, then the price goes down.
• The December futures price of gold quoted on September 1 is the price at which traders can agree to trade gold for December delivery.

Types of Traders

• Derivatives markets attract hedgers, speculators, and arbitrageurs, ensuring liquidity.
• Hedgers reduce risk from market variable movements.
• Speculators bet on the future direction of a market variable.
• Arbitrageurs lock in profit with offsetting positions in multiple instruments.
• Hedge funds are significant users of derivatives for hedging, speculation, and arbitrage.

Hedging Using Forward Contracts

• Companies can reduce risks with forward contracts and options.
• ImportCo can hedge by buying GBP in the forward market to fix the price paid to a British supplier.
• ExportCo can hedge by selling GBP in the forward market to lock in the USD value of future GBP earnings.
• Hedging reduces risk, but the outcome may not always be better than not hedging.
• The purpose of hedging is to reduce risk, without guarantee of a better outcome.

Speculators

• While hedgers avoid risk, speculators take positions to bet on price movements.

Speculation Using Futures

• A speculator can purchase currency in the spot market or take a position in futures, hoping for profit.
• Buying futures requires a smaller upfront investment due to leverage, using a margin account.
• Spot market outcomes are affected by interest earned or paid unlike futures.

Arbitrageurs

• Arbitrageurs lock in riskless profits by simultaneously trading in multiple markets.
• Arbitrage occurs when futures prices are out of line with spot prices, or in options markets.
• Simultaneously buying a stock in one market and selling it in another to profit from price differences is an arbitrage.
• Arbitrage opportunities are short-lived because arbitrageurs' actions correct price disparities.
• The existence of arbitrageurs ensures that only very small arbitrage opportunities are observed
• Arguments concerning futures and forward prices often assume no arbitrage opportunities exist.

Dangers

• Derivatives’ versatility can cause problems when traders speculate instead of hedging or following arbitrage strategies.
• Risk controls and daily monitoring are essential to ensure derivatives are used as intended.
• Even with risk limits, mistakes can occur, as seen during the 2007 credit crisis.
• The key lesson from the credit crisis is that financial institutions should always ask what can go wrong, and how much they stand to lose