1 - Introduction.docx

QCM examen à points négatifs Password : Open files : M1_109_2018 Print : M1I_109_2018 Office hours : every Wednesday 4-5pm at porte dauphine P610 Exercises handout TO DO: Futures Forwards and swaps Options Credit risk CHAPTER 1 : INTRODUCTION Section 1 : The principles of derivative instruments...

QCM examen à points négatifs Password : Open files : M1_109_2018 Print : M1I_109_2018 Office hours : every Wednesday 4-5pm at porte dauphine P610 Exercises handout TO DO: Futures Forwards and swaps Options Credit risk CHAPTER 1 : INTRODUCTION Section 1 : The principles of derivative instruments Market maker: you are always prepared to quote a bid and an offer price. Call option: gives the right to buy at a certain price before a certain date Put option: gives the right to sell at a certain price before a certain date US options can be exercised whenever VS EU options can only be exercises at maturity. Three broad categories of traders can be identified: hedgers, speculators, and arbitrageurs. Hedgers use derivatives to reduce the risk that they face from potential future movements in a market variable. Speculators use them to bet on the future direction of a market variable. Arbitrageurs (risk free) take offsetting positions in two or more instruments to lock in a profit. Forward contracts are designed to neutralize risk by fixing the price that the hedger will pay or receive for the underlying asset. Option contracts, by contrast, provide insurance. They offer a way for investors to protect themselves against adverse price movements in the future while still allowing them to benefit from favorable price movements. 3 concepts: Hedging: protecting the price and ensuring I can pursue my business Speculation Arbitrage A derivative instrument = financial asset whose value depends on the price of one or more underlying products. The underlying asset can literally be everything. Most underlying assets : currency, stocks, indices, bonds, interest rates, commodities, credit risk (2008 crisis), climate risk, exchange traded funds, other derivatives… The main categories of derivative instruments: Forward contract Futures contract Swap These are fixed instruments. As a buyer you have an obligation de make an exchange at a particular time at a particular price. Same obligation for the buyer and the seller to honor the deal. Option floor, cap, collar These are Optional instruments: the buyer has an option. You pay a front to acquire the option and then you may exercise the option or not according to the market situation. Section 2: the organization of trading in the derivative markets Organised markets Physical place where deals take place. It has evolved to something less clear now. Having some stock exchange has benefits: Quality of the product No fear that the exchange is going to default: no counterpart risk No scarcity Liquidity because volumes are high. Everything is available. Nobody can squeeze the price of a particular asset. Price discovery volatility discovery Agents have a clear view of the assets: the price is rather stable. Trading of futures, options and swaps. Quotation method : Electronic trading. In the past, open outcry (people shouting prices on the trading floor). Today, transactions are electronic and happen right away. You can easily access the prices of the stock. All the markets participants have access to information. Centralized exchanges: Clearing (happens through the clearing house) or CCP (central counter part) When you want to buy a stock, you call a broker. The broker sets a price. In the end, the central party is the coordinator of each and every transactions. The market guarantees that the deal is going to take place and is going to be honored. Being the center of billions of transactions involves a lot of risk. This provides trade facilitation and security to the system Market liquidity : nobody can influence the market The evolution of transaction volumes: Including all contracts Futures / options By type of underlying asset By region #1: CME #2: NSE of India: big emergence of India in the derivative market. China and India derivate a lot on agricultural market. The big importance of North America. Massive center in India. Brazil. Europe, Moscow exchange. China (commodities and agricultural products). Equity index and individual equity account up to half of the total volumes. Emergence of commodities along with the emergence of Asia. Interest rate slowly is slowly and steadily increasing. 2011: equity markets became uncertain, no steady returns. Source of decline: market related / lateral and multilateral netting. Only futures on this graph. A very big part of it is Asia, and it is growing. Europe is still pretty important. Only options here. Biggest is north America. Evolution by category: futures and options Total number of futures and options contracts, 2017: 25.2 billions -0.1% since 2016 New record in 2016 since 2011 Total number of futures contracts: 14.8 billions +100% since 2006 Total number of options contracts: 10.4 billions +15% since 2006 Equity index and individual equity dominate. The blue boxes are financial contracts. A lot of interest rates and equity indexes. Currency has been growing. Big variety in terms of underlying products. The options are more used as financial contracts, domination of individual equity and equity index, currency then interest rates. Main reason : people tend to go to fixed instruments for commodities: if there is a catastrophe, you need the commodities market to protect you, you want to avoid risk. It is one of the few markets where people go for hedging. Essentially, optional instruments are more focused on financial underlying assets. 1980: agriculture +++ in order to hedge and protect crops. People were trading in the real economy. Foreign currency for trade across borders. Small amount of interest rates. 2016: equity index and interest rates +++. Mainly financial assets. Smaller portion of agriculture, energy has become a rather big part. Breakdown by region 2017: Both Asia, North America and Europe dominate the global futures and options. Those figures are in volume. But America dominates open interest. Open interest: The amount of contracts outstanding. When 2 counterparts meet and agree on a deal, the open interest goes up by 1. If we both exit this deal, then the open interest goes down by 1. Open interests differ from volume. As long as the instrument exists and is exchanged, the open interest remains still. Over the counter markets (OTC) Main change of OTC: introduction of CCP It is not a centralized market, not a physical place. Informal network of agents that contact each other. People usually use a broker as an intermediate. The broker might enter the deal. Also an intra dealer market where they can easily talk to each other. Bilateral relations Transactions between: Financial institutions Fund managers and corporate treasurers Negotiating contracts, forwards (= OTC counterpart of a future), options (1st and 2nd and 3rd generation), swaps, caps, floors, collars, and other structured products. Some of these instruments are also in the organized markets. Evolution of all contracts, highlights Outstanding OTC market in December 2017: $ 532 trillions (80 000 millions in 1998) Decline in activity since 2014, largely thanks to trade compression with the new regulations after 2008 Graphique: Since 1998, big rise in trading. Trade compression: bilateral netting (compensation) B owes 500 000 to A. B only receives from A 400 000. So B must spend 100 000 more to A. This brings down the number of transactions. Multilateral netting (central counterparts CCP) → OTC transactions 1 to 1, huge risk regarding your counterpart. Risk of liquidity for specific deals and specific debts. Opacity, not a lot of information about your counterpart along with the credit risk. Since 2008, the landscape has changed +++ because of new regulations. Certain instruments are very regulated now and some aren’t at all. Non-centralized bilateral netting: Gross notional amount: 100+50+120+80+100 (money changing hands) Exposure of A: 180 Exposure of B: 150 Exposure of C:200 Exposure of D: 170 The exposure of CCP is 0. How to solve the ccp: Net exposure of A: 20 (100-80) (Débit) Net exposure of B: 50 (Crédit) Net exposure of C: 40 (C) Net exposure of D: 70 (D) Clearing House: 0 Gross exposure of the market: 180 the notionals and values have been decreasing because of new regulations, it doesn’t evolve less volume. Notional amount: notional value of all derivative contracts not yet settled. Determines contractual payments. Gross market value: sum of the absolute values of all outstanding contracts (= contrats en vigueur), with either positive or negative replacement values, at current market prices. The cost of replacing all existing contracts at current market prices. Gross credit exposures: measure of exposure to counterparty credit risk. Gross market values after legally enforceable bilateral netting but before collateral. OTC Derivative markets: the shift to central clearing • June 2016, % of outstanding OTC derivatives against central counterparts (CCP) : they were not being settled, going through the clearing process 64% overall are being cleared through a CCP: more security to the system. It mitigates counterparty risk of default. Ads security and stability to the system . 75% for interest rates 37% for credit derivatives less than 2% for currency and equity Options are not regulated at the moment. Lot of regulation being imposed to interest rate swaps after the crisis: lot of protection for the agents transacting these. Across time, emergence of different financial classes. Credit derivatives are being squeezed. The $ and the € are the 2 most exchanged currencies. By maturity: short term is the biggest but the 3 are quite equivalent By sector: mostly other financial institutions. The financials play a major role in the transactions of the OTC market. Big decline for $ and € since the crisis The $ is accounting for the majority of transactions, followed by €, Yen and £. Yen is quite surprising, reason why is : Yen is thought as a safe currency + particular speculative trade for years (buying Yen and hiding them in Swiss etc to make a profit). The Yen is a very important player in the currency market. By maturity: more short terms by far. Longer terms are thus less liquid. By sector: half and half or reporting dealers and other financial institutions. Dominated by forwards and swaps. Other commodities is important because of hedging. Gold is also a significant part because it is a safe reserve asset. European countries are less important now compared to the US. Shorter terms securities are mort important. Dealers and other financial institutions. Credit default swap is used to take a bet or protect yourself against default (the main one is bankruptcy, but it also refers to the inability of the counterparty to meet his payment obligation). When taking a bet on default, it creates an insurance. Conclusion: Organized markets: Between 1972 and 2017, transactions in futures contracts rose from 18.3 millions to 25 billions. Importance of the Asian markets (35% of the total volume) OTC markets: over 50% of traded instruments are swaps. Contraction of transactions with the effect of regulation. Shift to central clearing. Exchange market is more stable although smaller. OTC is much bigger but unstable. Domination of global OTC contracts. From 2013 good part of US Swaps. Swap is a fixed instrument. Exchange of payals from 1 countepart to another. CDS used to be very important but not so much anymore. This big decline is mainly because of regulation. Recently, both have been more cleared and regulated. Section 3: The economic functions of the derivatives markets Risk Management Goal is to cover yourself against market fluctuations. Primary function: hedging, risk management Risk transfer (neither pooling nor diversification). Pooling = bringing the risks together and transfer. Risk transfer involves transferring the risk from an entity to another. Derivatives markets = zero-sum games: in the whole market, amount of gains of ones = losses of others. No global wealth creation. Risk is divided into several parts and reallocated between operators. Speculation and arbitrage Speculation = taking a bet, uncertainty with potential profit and potential loss. Derivatives are used in speculation, with very small capital you can take a big exposure with a big ability to speculate, for better or worse. Objective is to generate return/profit. Risk-taking based on anticipation. Critical function: it allows hedging and coverage. Three categories of speculators (based on the holding period of the position) : Scalpers: the shortest horizon, generate a large number of transactions. Liquidity supply. Day traders: position during the day but no overnight position Position traders: the farthest horizon. Hold a short position (position to sell) , a long position (buy) or a spread (take position in the value of difference between sell and buy). Speculation on commodities: an example • In January, a speculator buys 5 contracts of coffee, $2.45 / lb, for the end of August • Transaction costs are USD 200 • In June, the speculator resells the 5 coffee contracts at $2.65 / lb for the end of August • The benefit is equal to: 5 * 37, 500 * (−2.45+2.65) − 200 = 37, 300$ •If prices had fallen to $2.10/lb, the loss would have been: 5 * 37, 500 * (−2.45+2.10) − 200 =  − 65, 825$ The 37,500 is the contract size. Arbitrage = spot a market inefficiency that shouldn’t be there, then do an arbitrage (go into the market and take advantage of this small opportunity). It has to be extremely quick (smaller than 1 sec). Objective: generate return/profit by exploiting a market anomaly. No or very little risk taking. Critical function: it ensures the convergence between physical and paper markets. Price Discovery Price discovery = Ability to determine a fair price of an instrument Price discovery is the process through which the futures markets reveal information relating to future spot prices. Spot price is the price at which an asset can be bought or sold for immediate delivery of that asset • It is possible because futures prices are: Public free comparable with each other according to the contract maturity reliable • Information: Anticipation of the value of future spot price : F (t, T) = Et [S (T)]  F (t, T): t futures price for delivery in T E: expectation operator [.] S (T): T spot price • Resource allocation: Temporal / Spatial Volatility Discovery Market Volatility = changes in price. The higher the volatility the higher the potential returns and loss. Standard deviation (écart type) is linked to market volatility and then linked to the risk taken. Volatility discovery is possible in the presence of active options markets • Implied volatility: Equalizes the market price of the option and its theoretical price Provides information on expected future volatility Efficiency of Transactions Derivatives allow us to transact efficiently with low cost and high speed. Direct and free access to a competitive market Creating a reference point (benchmark) Questions and exercises : 1.2 : Difference between hedging; speculation; arbitrage: - hedging aims at reducing risks - speculation is a bet on price fluctuations - arbitrage involves taking advantages of market efficiencies 1.5 : An investor enters into a short forward contract to sell 100,000 British pounds for US dollars at an exchange rate of 1.4000 US dollars per pound. How much does the investor gain or lose if the exchange rate at the end of the contract is (a) 1.3900 : gain of 100 000*(1.4-1.39) = 1000 (b) 1.4200: loss of 100 000 * (1.42-1.4) = 2000 1.6 : A trader enters into a short cotton futures contract when the futures price is 50 cents per pound. The contract is for the delivery of 50,000 pounds. How much does the trader gain or lose if the cotton price at the end of the contract is (a) 48.20 cents per pound: gain of 50 000*(0,5-0,4820) = 900 (b) 51.30 cents per pound: loss of 50 000*(51.30-50) = 650 1.8 (first sentence) : What is the difference between the over-the-counter market and the exchange-traded market? Exchange-traded market : physical place to meet on (even though electronic nowadays), less default risk OTC market: no physical place, transactions from 1-to-1, more default risk and opacity 1.19: A trader enters into a short forward contract on 100 million yen. The forward exchange rate is $0.0080 per yen. How much does the trader gain or lose if the exchange rate at the end of the contract is (a) $0.0074 per yen : gain of 100m*(0.008-0.0074)= 60 000 (b) $0.0091 per yen: loss of 100m*(0.0091-0.008)=110 000 2.19: "Speculation in futures markets is pure gambling. It is not in the public interest to allow speculators to trade on a futures exchange." Discuss this viewpoint. Speculators add liquidity to the market. Contracts must be useful both for hedging and speculation.