Derivatives Part 1 PDF

Chapter One Introduction to Derivatives 1. General Introduction 3 2. Futures 5 3. Forwards...

Chapter One Introduction to Derivatives 1. General Introduction 3 2. Futures 5 3. Forwards 9 4. Contracts for Differences (CFDs) 11 5. Options 13 6. Gearing 23 7. Liquidity 26 8. Exchange-Traded versus OTC-Traded Products 27 9. Swaps 31 10. Markets and Participants 41 This syllabus area will provide approximately 6 of the 100 examination questions 1 2  Introduction to Derivatives 1. General Introduction 1 Mention derivatives and people tend to think of high-risk instruments that are impenetrably complex. Derivatives can be high risk; after all, it was mainly trading in derivatives that brought about the collapse of Lehman Brothers in 2008 and, in 2002, may have contributed to the bankruptcy of crypto exchange, Futures Exchange (FTX). However, it is not necessarily true that these instruments are inherently dangerous – they are chiefly designed to be used to reduce the risk faced by organisations and individuals (technically referred to as hedging). In fact, many of these derivatives are not particularly complex either. To illustrate the underlying simplicity, imagine that you want to purchase a new sofa from a furniture showroom. You make your choice of sofa and see that it will cost £1,000. On enquiry, you discover from the sales assistant that the sofa is currently out of stock in the warehouse. However, you can sign a contract to accept delivery of the sofa in two months’ time (when the stock will be replenished) and at that stage the store will charge the £1,000 to your credit card. If you sign, you have agreed to defer delivery for two months – and you have entered into a derivative (it is derived from something else – here, a sofa). This is very similar to a futures contract. You have contracted to buy an underlying asset (the sofa) and pay a pre-agreed sum of money (£1,000) in two months’ time (the future date). This is an example of a futures-type contract that we could refer to as a sofa future. In the jargon of the derivatives markets: You are long a sofa future because you have agreed to buy at a future date. The furniture store is short a sofa future because it has agreed to sell at a future date. That said, since the sofa future was not traded on an exchange, technically it should be described as a sofa forward, which is another type of derivative. 3 Forwards are similar to futures, except that futures are traded on an exchange with standardised contracts; in contrast, forwards are traded over-the-counter (OTC) with customisable terms. Exchanges and OTC trading are covered in more detail in chapter 3, section 1. Futures and forwards are not the only types of derivative – one other type is options. To illustrate how options differ from futures, we can use the same example of a sofa in a furniture store. This time, the sales assistant tells you the sofa you want is not in stock at present, but there is a small batch of ten sofas due for delivery in two months’ time. Of these ten sofas, nine have been pre-sold. You cannot make up your mind whether to go ahead and commit to buy the tenth sofa or to try a few other stores to see if anything else catches your eye. Noticing this, the sales assistant makes you an offer: if you pay £30 now, he will give you the right to reserve the tenth sofa. Note that this is not a deposit, where it would be ordinarily deducted from the final price, but rather a charge in addition to the price of the sofa, which is paid regardless of whether you choose to purchase it later or not. It will become yours on the payment of a further £1,000 in two months’ time and, in the intervening period, the sales assistant cannot sell it to anyone else. Again, this is a derivative transaction (derived from something else – the sofa). If you agree to it, you will be paying a non-returnable sum of money (£30) that gives you the right to buy the sofa for £1,000 in two months’ time. This is a sofa option and, using derivatives jargon: You are long the option because you have the right to buy the sofa for £1,000). You are not obliged to buy the sofa, but, if you decide not to buy, you will lose the £30 you paid at the outset. The furniture store is short the option because they have given you the right to buy the sofa for £1,000) in return for the receipt of an agreed sum (here £30). Note that in both rather simplified cases, you have guaranteed the ability to buy a sofa at £1,000 in the future. Even if the store raises prices in the interim, you have locked in the price for your sofa, therefore you have hedged your position. 1.1 Uses of Derivatives There are three ways that futures can be used. 1.1.1 Speculation Speculators take a view on the market’s direction and seek to make a profit from price movements by buying or selling futures contracts. Speculative investments may involve a high degree of risk and usually have short holding periods. For example, if an investor feels the price of the underlying is going to go up, they can speculate by buying the underlying itself, or alternatively, by buying futures contracts on that underlying. Derivatives are often seen to be more attractive than the underlying because they can be highly geared. Put simply, this means that a small expenditure/initial investment gives the holder a big exposure to a market (ie, the potential for large profits or losses). However, a speculator has to allow for margin requirements (see chapter 6, section 3) and must have sufficient capital to sustain the open position. 4  Introduction to Derivatives 1.1.2 Hedging 1 Participants who want to guard themselves against adverse price movements hedge using derivatives. A hedger seeks to protect a position, or anticipated position, in the underlying market by taking an opposite position in the futures market. A perfect hedge is a risk-free position. For example, a fund manager can remove or reduce their exposure to a stock market fall that will affect the portfolio of shares they manage, by taking a temporary short position in futures in the relevant equity index. This will deliver profits to offset the impact a fall in the stock market would have had (the extent to which the risk is offset will depend on how closely their portfolio is correlated to the index – also known as ‘basis’). Fund managers often use hedging strategies as temporary ‘shields’ against market movements. 1.1.3 Arbitrage Arbitrageurs exploit price anomalies between two markets. They observe that the same underlying asset or financial instrument is selling at two different prices in two different markets. They undertake a transaction whereby they buy the asset/instrument at the lower price in one market and, at the same time, sell it at the higher price in the other market. Arbitrage gives them a risk-free profit that will be realised when the prices in the two markets come back into line and the arbitrageur closes out both positions. The classic definition of arbitrage includes the word ‘mispricing’ across contracts, which implies that prices must come back in line. The three most common forms of arbitrage are: intertemporal – when the prices between the one-month and six-month LME zinc contracts are ‘out-of-line’ geographic – as between two identical contracts across multiple exchanges; when the prices of the Singapore Exchange’s June eurodollar future is different from the CME’s June contract, and value-chain – as between the prices of crude oil and refined products. 2. Futures Learning Objective 1.1.1 Understand the basic concepts and fundamental characteristics of: forward and futures contracts; contracts for differences 1.1.4 Understand the risks and rewards associated with derivatives: rewards; counterparty risk; market risk; liquidity risk; operational risk 2.1 What is a Future? A future is a legal agreement between two parties to make or take delivery of a specific quantity and quality of a specified asset on a fixed future date at a price agreed today. They originated in the agricultural market where they were based on commodities, with some of the earliest recorded examples including rice futures traded in Japan in 1730 and cotton contracts in Egypt in 1861. 5 Unlike our example of a sofa future above, futures are often described as futures contracts because they are traded on organised exchanges, such as ICE Futures (Europe), the CME Group in the US, and the Shanghai Futures Exchange (SHFE) in China. The terms of each contract are standardised in a legal document called the contract specification. This is because it would not be financially viable for an exchange to precisely satisfy every single trader’s requirements regarding particular underlying assets (or ‘underlying’ for short). The aim of the contract specifications is to allow participants to take positions on general price movements in any given market. Contract specification also promotes transparency across all users of the exchange, as it goes to great lengths to detail precisely what is acceptable in terms of the quality and type of asset to be traded. When using derivatives, it is very important to be familiar with the contract specifications as these will help determine the profit and loss from the contract as well as other key terms such as, where applicable which underlying assets must be delivered upon maturity. The price is agreed between the buyer and the seller. In fact, it is the sole element of the futures contract that is open to negotiation. However, the exchange does specify the minimum permitted movement in price and the method of quotation. For a wheat future contract, for example, the quote is on a ‘per bushel’ basis and the minimum movement is 0.25 of a cent ($0.0025) per bushel (known as the full tick size). Since each contract represents 5,000 bushels, the value of the minimum price movement per contract (the full tick value) is $12.50 per contract. The fixed future date is also laid down by the exchange. Although it is a set day within the month, the fixed future date is often referred to as the contract month. In respect of wheat futures traded on the CBOT, the delivery months are March, May, July, September and December. Alongside wheat and other commodity futures, there are also financial futures (which are based on interest rates, bonds, currency exchange rates and stock market indices), among a broad range of other underlying assets. For all futures contracts, the contract specification standardises the futures product and, provided the contracts have a common underlying asset and a common delivery date, the contract is said to be fungible (ie, identical to, and substitutable with, others traded on the same exchange). For example, all March long gilt futures on ICE Futures Europe are fungible. A March long gilt future on ICE Futures, Europe is not fungible with a June long gilt future on the same exchange, because the delivery dates are different. The consequences of standardisation and fungibility are: contracts are easy to trade as they have set terms, and the concentration of activity provides liquidity, as measured by volume. Note that while standardisation is attractive to many market participants, the demand for flexibility is a key factor in the demands met by the over-the-counter (OTC, or off-exchange) market. With OTC derivatives, the features of the contract are negotiated between the two parties to that contract, rather than standardised in the contract specification. 6  Introduction to Derivatives The fungible nature of contracts also means that a trader can remove any delivery obligations by taking 1 an equal and opposite position. For example, a trader who has bought a future and is required to buy a specified quantity of the underlying asset can simply sell a fungible future. The result is that they have agreed to both buy and sell the same item at the same future date. The trader is described as having exited the trade or closed out their position. 2.1.1 How Do Futures Work? Futures positions are opened by going long (buying) or short (selling). By opening either a long or short futures position, the trader becomes exposed to changes in the futures price, and the position will incur profits or losses as a result of the movement in price. Holding the contract to expiry will oblige the trader to meet the delivery obligations. If the price of the asset rises, the futures buyer (long position) will make a profit – this is because the trader will take delivery at the lower price and be able to sell the asset in the cash market at the higher price. At the same time, the futures seller (short position) will make a loss. Conversely, if the price is lower than the agreed price, the futures buyer will make a loss since they will take delivery at the higher price, while the futures seller will make a profit. It is worth noting that the profit and loss of each counterparty is not exactly opposite, as the charges incurred by each will differ based on their specific brokerage arrangements. The main advantages of futures are: Fungibility – the standardisation of contract specifications on exchange draws liquidity to the contract, as participants know that all counterparties will be trading the same product. Counterparty risk – with exchange-traded futures, counterparty risk is reduced considerably by novation through the central clearing house – novation is the legal process whereby the clearing house becomes the counterparty to all trades, and is covered in section 1.1 of chapter 6. Cost – given the low counterparty risk, high fungibility and high volume associated with exchange- traded futures, the brokerage fees associated with trading tend to be low. 2.2 Futures Profit and Loss Profiles 2.2.1 Long Futures The outcome for a buyer or seller of a future when it reaches its expiry date is driven by the price of the underlying asset at that time. Because the market price can vary, this is known as the market risk. A futures buyer commits to buy at a pre-agreed price (eg, £115) and will make a profit as long as the underlying asset is trading above this price at expiry. 7 This can be represented graphically as follows: Profit Price of underlying £115 at expiry £115 Loss As shown, the risk to the buyer of a futures contract is maximised when the value of the underlying at expiry falls to zero. In that case, the buyer will pay the pre-agreed sum (£115) for an asset worth nothing, losing the £115. The reward to the buyer is, theoretically, unlimited – the higher the price of the underlying at expiry, the higher the profit made by the futures buyer. 2.2.2 Short Futures Because the seller of a future is the other side of the transaction from the buyer of the future, the outcome is a mirror image of the outcome for the buyer. It is driven by the price of the underlying asset at expiry and a profit is made if the underlying asset’s price falls below the pre-agreed level. A loss will be made if the underlying asset at expiry is priced above the pre-agreed futures price. This can be represented graphically as follows: Profit £115 Price of £115 underlying at expiry Loss 8  Introduction to Derivatives The risk to the seller of a futures contract is, theoretically, unlimited. As the price of the underlying 1 asset rises above the pre-agreed level at expiry, the futures seller suffers a loss since they must pay the higher market price and sell at the lower pre-agreed price to the futures buyer. The futures seller’s reward increases as the price of the underlying asset falls below the pre-agreed level and is limited to the futures price, whereas the seller can deliver the underlying asset that has cost nothing in exchange for the pre-agreed futures price. Exercise 1 An investor has the view that economic growth will slow down in the next 12 months. This slower growth will cause metal prices to fall, due to a drop in demand. Based on this view, the investor sells 20 contracts of the LME’s June (one-year maturity) LMEX futures at 3400. The LMEX is a cash-settled index-based futures contract that is based on the weighted average of the price of the LME’s six primary metals (aluminium, copper, lead, nickel, tin and zinc). One month before its maturity, the June LMEX future is trading at 3190. The contract’s specification is $10 per index point. What is the investor’s profit or loss? The answer can be found in the appendix at the end of this chapter. 3. Forwards Forwards are very similar to futures contracts, as they are similarly legally binding agreements to make or take delivery of a specified quantity of a specific asset at a certain time in the future for a price that is agreed today. Forwards are, therefore, settled only on the delivery date. Thus, forwards can also be used for the same purposes as futures. Forward contracts are traded on a wide variety of assets such as currencies, commodities and equities. The key difference between futures and forwards is that futures are always, by definition, exchange- traded, while forwards are usually traded OTC (usually with banks or investment firms) although similar contracts are also traded on-exchange. Although some market participants value the fungibility that standardisation of contract terms brings to futures, forwards have a degree of customisability that make them attractive to participants requiring a more tailored product. Additionally, they may not be marked- to-market (revalued) daily or, if they are, the resulting profits are not paid out until maturity. This can reduce the working capital intensity of hedges. for example, as hedgers do not face the possibility of ‘topping-up’ their brokerage account every day to sustain a losing position. 9  Example A French company has a series of future yen payments over the next 12 months and is concerned that the euro will weaken against the yen, thus making its materials more expensive. In order to lock in its cost now, the company can enter into a series of EUR/JPY forward contracts that will allow it to set the exchange rate today for its future payments. This is done through FX forwards contracts where the company buys yen against the euro, for specific future dates at rates that are agreed today. Since this is an OTC transaction, the company can arrange the amounts and dates to match exactly the payments it must make to its Japanese supplier. The forward contracts’ rates will be based on the current FX spot rate and the interest rate differential between euros and yen. Since euro interest rates are slightly lower than yen rates over the period, the euro will be at a slight premium to the yen, thereby making it less expensive at that forward date. The main advantages of forwards compared with futures are: flexibility (eg, size, date, specific grade, quality, or delivery point) better margining and collateral terms a wide range of underlying assets, and they are available from most commercial banks. The main disadvantages are potential counterparty risk, particularly where forwards are not cleared, as this increases the potential for default (termed credit or default risk). In some cases liquidity on forwards can be low, given more specialised contract specifications will reduce the fungibility of the contracts and therefore the amount of participants willing to trade. The combination of these factors usually leads to higher fees across OTC products, as compared to those traded on exchange. Outright forwards are a common product traded in the foreign exchange (FX) market. Corporations, institutional investors and banks use forwards to manage their FX transaction risks. If an organisation is importing or exporting goods (or investing) in another currency, they can use forwards to protect against adverse currency movements. Forward contracts are also used to lock in the price of physical commodities, such as energy, metals and foodstuffs. For example, in the physical markets (where physical delivery is common), an airline might use forward prices on jet fuel to lock in one of their major costs. The future price agreed for a forward is based on the spot price of the underlying asset (usually known as just ‘the underlying’). In the case of a currency, it will be adjusted for the interest rates in the relevant currencies. 10  Introduction to Derivatives 4. Contracts for Differences (CFDs) 1 Learning Objective 1.1.1 Understand the basic concepts and fundamental characteristics of: forward and futures contracts; contracts for differences 5.1.9 Understand how spread betting differs from other contracts for difference (CFDs) 5.1.11 Understand the basic concepts and fundamental characteristics of CFDs Contracts for difference (CFDs) allow investors to benefit from the capital gains from a particular underlying index, stock, currency or commodity without having to actually physically own or pay for it. The investor enters into an agreement with a CFD provider (usually a stockbroker or a firm offering an online dealing service) to settle the difference between the opening price of a particular asset when the agreement is made and its price when the agreement is ended. The profit or loss is determined by the difference between the prices at which the investor buys and sells the contract and the contract amount. Example An investor buys a FTSE 100 CFD at an agreed ‘price’ of 7200 points and chooses to close their position when the index stands at 7350 points. The investor has made a profit, not by buying or selling a tangible asset such as shares, grain or a bond, but by receiving a set amount of cash for each point gained. The amount of money for each point is specified in the CFD contract. Most brokers will usually provide a CFD contract to investors that closely mimics the most fungible exchange-traded product. In this case, assuming the broker mimics the ICE Futures Europe FTSE 100 futures contract, the value of each point is £10, so the broker simply pays the buyer 150 points multiplied by £10, ie, £1,500. It is important to note that, although CFDs can be a ‘mirror’ of exchange-traded products, actual prices on the broker’s platform can deviate from those shown on exchange, partly due to trading fees that are often included in the quoted price (known as ‘spreads’). Investors using CFDs have one key decision to make: do they think the underlying asset is going to go up or down in value? If they get it right, they will win; if they get it wrong, they will lose. The key feature of CFDs is that they do not have a set maturity and, since they are OTC contracts, the contract’s specification ranges from the asset to the amount negotiated between the buyer and seller. CFDs are cost efficient, in that an investor buying a CFD on a share does not have to pay stamp duty, nor the broker’s fee that is normally associated with share transactions. CFDs also allow investors who are bearish on a share an easier way to profit from the fall in a share’s price, rather than physically going short a share. 11 CFDs are based on margin trading, so an investor can leverage their position. Most brokers require a margin deposit of 10–30% of the contract’s value. This allows investors to increase their risk, based on the size of their initial investment. However, many contracts include an automatic stop-loss order as part of the contract, which minimises the risk of a large loss. Most CFD trades are intra-day trades, since each time this type of position is held open overnight, it incurs an interest charge. CFDs do not have an expiry or maturity date like options or futures. As opposed to an expiry date, a CFD is effectively renewed/rolled over at the close of each trading day if desired. An investor can keep their position open indefinitely, provided there is enough margin in their account to support the position. Example An investor is bearish on company ABC plc shares, which are currently trading at 145p. The investor decides to sell a CFD on 5,000 shares at that price. The investor’s broker requires a 15% margin: Cost of CFD = 5,000 x £1.45 = £7,250 Broker’s margin = 15% x £7,250 = £1,087.50 Just before closing, ABC’s shares have fallen to 137p. The investor decides to end the CFD: Sale proceeds = 5,000 x £1.37 = £6,850 Investor’s profit = £7,250 – £6,850 = £400 Investor’s return = £400 / £1,087.50 = 36.8%. 4.1 Spread Betting An alternative way of entering into a CFD is to place a bet with a spread-betting firm. The two key differences between spread betting and CFDs are that: CFDs do not have a fixed maturity/expiration date, and spread betting in the UK is considered gambling and, therefore, is treated differently as far as tax is concerned, since CFDs are subject to capital gains tax. Another common difference between CFDs and spread betting is that CFDs may charge a commission while brokers are compensated by spread bets only through the price spread they quote. Note that, given the overwhelming majority of users of both CFDs and spread betting are retail investors, the leveraged nature of these services puts ordinary investors at risk of significant financial loss, and have therefore been prohibited in the US, China and India. EU countries also have much tougher restrictions on online brokers of these products than the UK, with many making spread betting illegal. One of the most popular of these types of spread betting trades involves a short-term interest rate (STIR) contract, such as the three-month short sterling future. 12  Introduction to Derivatives 1 Example If an investor thinks a particular market will continue to rise over the short term, they could place an up bet, which is similar to buying a CFD, where the investor benefits by a set amount for each point that the market price increases. Say they believe the FTSE 100 Index of the UK’s largest companies is going to rise after a recent sell-off. If the FTSE 100 is currently 7200 index points, a spread-betting firm may be quoting 7250/7275 for three months into the future. Let us say the investor places an up bet at £10 a point at the quote of 7275 (the choice of pounds per point is up to the investor), and a month later the index has risen to 7350. The quote from the spread-betting firm is now 7375/7400 and the investor decides to cash in their close-out (profitable position). This is achieved by placing a down bet of £10 per point at 7375. A down bet is similar to selling a CFD contract where the investor benefits by a set amount for each point that the market decreases. The difference between the buy and sell prices is 100 index points (ie, 7375 – 7275), which, multiplied by £10, gives a gain of £1,000. This gain is not subject to capital gains tax (CGT). If an investor thinks it likely that the FTSE 100 will fall, they could speculate by placing a down bet via a spread-betting firm. 5. Options Learning Objective 1.1.2 Understand the basic concepts and fundamental characteristics of options contracts, including: basic puts and calls; options on cash and derivative products; American, European, Asian; exotics 5.1 What is an Option? As illustrated by the sofa option in the introduction to this chapter, an option is a contract that gives the buyer the right, but not the obligation, to buy (call) or sell (put) a particular asset at a particular price, on or before a specified future date. Conversely, the seller of the option assumes an obligation in respect of the underlying asset upon which the option has been traded. Options are available on a variety of underlying assets – physical assets (such as crude oil and sugar) and financial assets (such as cash, shares, bonds, foreign currency and indices). The option may be based on the current cash price, an OTC forward agreement, or a futures contract, where the underlying asset is a future (known as options on futures). Options on futures give the holder the right, but not the obligation, to become the buyer (call) or seller (put) of a specified futures contract – in this way, they are a derivative of a derivative. All major derivatives exchanges offer options based on their futures contracts. 13  Example You sell two February calls on a Euronext Paris’ rapeseed oil futures contract. If the corresponding futures contract is above the call’s strike price at expiration, it will be automatically exercised and you will now be short two futures at the option’s strike price. As with futures, investors attempting to place directional bets in options are known as speculators, but options can also be used to hedge existing positions, and indeed execute arbitrage opportunities. Options are trading and risk management tools which offer an extremely wide set of choices for investors and fund managers with differing attitudes to market direction and volatility, and with differing appetites for risk. 5.2 Options Terminology Long – the buyer of an options contract, also called the holder or owner of the contract. Short – the seller of an options contract, also called the writer of the contract. Call option – an option giving the holder the right to buy an underlying asset for a specified price (the strike or exercise price) on or before a specified date. Put option – an option giving the holder the right to sell an underlying asset for a specified price on or before a specified date. Strike price – the price at which the option can be exercised. Also called the exercise price or, simply, strike. Settlement price – the price that determines the pay-off when the option expires. Premium – the cost of the option to the buyer. Premiums are non-returnable and are paid by the option holder to the option writer – the holder pays the premium via their broker, who then passes it on to the clearing house for the account of the counter-party’s broker. In-(out)-of-the-money – the extent to which an options contract is in profit (or loss), quoted as the difference between the strike price of the contract and the current price of the underlying asset. An ‘at-the-money’ option is considered breaking even. Intrinsic value (IV) – only options that are in the money have intrinsic value. Extrinsic value – where option premiums differ from the option’s intrinsic value, the option has value that is being derived from factors other than just the price of the underlying asset, for example time value, implied volatility and interest rates. Time value – the extrinsic value that the market assigns to an option, given the probability that there may be an increase in the intrinsic value of the option. Options with long expiration dates tend to have higher time value, as the likelihood of the option being in-the-money (ITM) is theoretically higher because there is more time remaining on the option. The exercise style of an option describes how it may be exercised: European-style option – an option that can be exercised on its expiry day only (remember ‘E’ for ‘European’ and ‘expiry day’). American-style option – an option that the holder can exercise on any day during its life (remember ‘A’ for ‘American’ and ‘any day’). 14  Introduction to Derivatives Asian-style option – an option where the pay-off is not determined by the underlying price at 1 maturity, but by the average underlying price over the entire length or a specified part of the contract. There are two common versions of Asian options: The strike price is set at the beginning and the settlement price is the average asset price over the life of the option. The strike price is the average traded price over the life of the option (also sometimes called an ‘average strike option’). This may seem complicated, but keep in mind: either the ending price or the strike is an average. Determining the pay-off is then straightforward, as with normal options. Bermudan-style option – an option where early exercise is restricted to certain dates during its life, usually a series of dates over the contract’s life that are spaced in regular intervals. It derives its name from the fact that its exercise characteristics are somewhere between those of the American and the European styles. Since Bermudan options are more flexible regarding exercise than European-style options, but less flexible than American-style options, their premiums are more expensive than the former but cheaper than the latter, if all other factors are the same. European- and American-style options are described as standard, so are often referred to as ‘plain vanilla’ options. Asian- and Bermudan-style options are described as exotic (ie, their pay-offs are based on how the underlying asset’s price moves over the whole or part of the option’s life, or they may be an option on another option rather than an underlying asset). There are a number of exotic options, and the most common types that are currently traded are as follows: A lookback option is path-dependent, meaning the strike price is dependent on the historical price of the underlying market. and is where the option owner has the right to buy (or sell) the underlying instrument at its lowest (or highest) price over some preceding period. A barrier option is another type of path-dependent option whose existence and pay-off depends on whether the underlying asset has reached a predetermined price. There are two types of barrier options: A knock-in option is one that is activated or starts to exist once the underlying asset has reached the predetermined price. A knock-out option is the opposite: when it is purchased, it exists, but it ceases to exist if the underlying asset reaches the predetermined price. A binary option (also known as a digital option) pays a fixed amount or nothing at all, depending on the price of the underlying instrument at maturity or at stated times prior to maturity. A chooser option is an option that allows its holder to decide whether the option is a call or a put, at a pre-determined time during the option’s life. A compound option is an option that gives the owner the right to purchase another option, with specific strike prices at pre-determined dates, during the option’s life. There are four types of compound options: calls on calls, calls on puts, puts on calls and puts on puts. There will, therefore, be two strike prices and two expiration dates. A rainbow option is an option on multiple underlying assets (eg, a group or basket of commodities, securities or currencies). They are also referred to as multi-asset options, correlation options and basket options. 15 5.3 Options – Risks, Rewards and Profit and Loss Profiles Learning Objective 1.1.9 Understand how to interpret basic options diagrams (long call, long put, short call, short put) The following examples are based on American-style options on the shares of two fictional companies – ABC plc and XYZ plc. 5.3.1 Buying a Call (Long Call) eg, March ABC plc 700 Call @ 30 The buyer of the option (holder) pays the premium (30p), which is the amount due per share, quoted in pence to the seller. The holder now has the right, but not the obligation, to buy one share in ABC for 700p, until the defined time on the expiry day in March. What Happens at Expiry? It will depend on the price of ABC shares on the expiry day: If the share price prevailing in the market is below 700p, the option expires worthless and the holder will abandon the option. Would you pay 700p for the share if you could buy it for less in the market? If the prevailing share price is above 700p, the holder has the right to buy the shares for 700p, which is a lower price than in the cash market. They will, therefore, exercise the option, paying 700p for the share, and then may sell it in the market for the higher price. Even if the market price is 701p, the option is worth exercising as the holder will make a profit of 1p per options contract, which can then be used to offset the upfront cost of the premium. The break-even price of the call is its strike plus its premium; in this case, the break-even is 730p (ie, 700p + 30p). 16  Introduction to Derivatives The potential for gain or loss can be represented diagrammatically, with profit or loss shown on the 1 Y-axis (vertical axis) and the price of the underlying at expiry on the X-axis (horizontal axis): Profit Buying a Call 700p 730p Price of underlying 30p at expiry Loss In Summary The maximum cost to the buyer is limited to the premium paid, which is paid regardless of the outcome at expiry. A net profit will be made by the buyer if the profit on exercise exceeds the premium paid. The break-even point is the strike price plus the premium. The maximum potential profit for the buyer is unlimited as the long call option will become increasingly valuable to them as the share price rises above the exercise price. 5.3.2 Selling a Call (Short Call) eg, March ABC plc 700 Call @ 30 The seller of the option immediately receives the premium (30p) from the buyer, which is the amount due per share. The seller is now under an obligation to deliver the share should the holder of the option decide to exercise. What Happens at Expiry? If the share price prevailing in the market is below 700p, as indicated in the first example, the buyer will abandon the option and the seller will no longer hold any obligation. The premium has already been received and provides the seller’s profit. If the prevailing share price is above 700p, the buyer will exercise the option against the seller. The seller is obliged to deliver the share for 700p. The seller may not already own the share so will have to acquire it in the market at a higher price and take the loss. Provided that the loss is lower than the premium received, the seller will still make an overall profit. 17  Profit Selling a Call 700p 730p 30p Price of underlying at expiry Loss In Summary The maximum loss for the seller is potentially unlimited. A net loss will be made by the seller if the loss on exercise exceeds the premium already received. The seller’s break-even point is the strike price plus the premium. The seller’s maximum potential profit is limited to the premium received. 5.3.3 Buying a Put (Long Put) eg, March XYZ plc 450 Put @ 17 Similarly to the earlier examples, the buyer of the option pays the premium (this time, say, 17p) to the seller. The buyer now has the right to sell one share in XYZ for 450p. What Happens at Expiry? It will depend on the price of XYZ shares on the expiry day: If the share price is above 450p, the holder will abandon the option as the option is worthless. Would you sell the share for 450p if you could sell it for more in the market? If the share price is below 450p, the holder can buy the share in the cash market at the lower price, then exercise the option at the 450p strike price, thus selling the share at the higher price (450p) to make a profit. Even if the market price is 449p, the option is worth exercising as the buyer will make a profit of 1p per options contract, which can be used to offset the cost of the original premium. 18  Introduction to Derivatives Profit Buying a Put 1 433p 450p 17p Price of underlying at expiry Loss In Summary The maximum loss to the buyer is limited to the premium paid. A net profit will be made by the buyer if the profit on exercise exceeds the premium paid. The break-even point is the strike price less the premium. The buyer’s maximum potential profit will arise if the share price falls to zero, and is the strike price less the premium. 5.3.4 Selling a Put (Short Put) eg, March XYZ plc 450 Put @ 17 The seller of the option receives the premium (17p) from the buyer. The seller is now under an obligation to buy XYZ shares for 450p each if the buyer decides to exercise. What Happens at Expiry? As you might expect by now, it will depend on the price of XYZ shares on expiry day: If the share price is above 450p, the buyer will abandon the option (as they can receive a higher price in the market for the share, as explained earlier). The seller keeps the premium received. If the share price is below 450p, the buyer will exercise the option (as they can achieve a higher price by exercising than is possible in the market). The seller will be obliged to buy the share for 450p and sell it on in the market at the lower price, thus taking the loss. Provided the loss is lower than the premium received, the seller will still make an overall profit. 19  Profit Selling a Put 433p 450p 17p Price of underlying at expiry Loss In Summary The seller’s maximum profit is limited to the premium received. A net loss will be made by the seller if the loss on exercise exceeds the premium received. The seller’s break-even point is the strike price less the premium. The seller’s maximum potential loss is the strike price less the premium, and will arise if the share price falls to zero. 5.4 Loss and Profit Summary Learning Objective 1.1.4 Understand the risks and rewards associated with derivatives: rewards; counterparty risk; market risk; liquidity risk; operational risk The following table summarises the potential maximum loss and profit in each of the four option positions: Position Maximum Loss Maximum Profit Long call Limited to premium Unlimited Short call Unlimited Limited to premium Long put Limited to premium Strike price less premium (underlying asset price would have to fall to zero) Short put Strike price less premium (underlying Limited to premium asset price would have to fall to zero) 20  Introduction to Derivatives The counterparty risk associated with options reflects the fact that, when an option is out-of-the- 1 money (OTM), there is no risk that it will be exercised. Therefore, for an option seller, under normal circumstances, they do not have any counterparty risk once they have received the premium, since after that the buyer has no obligation to the seller. In the case of an option buyer, they do have counterparty risk relative to the seller, but only when the option has intrinsic value (IV) – that is, when the option is at-the-money (ATM) or in-the-money (ITM). This is because the seller will have to either buy the underlying asset (in the case of a put) or sell the underlying asset (in the case of a call) at a loss, based on its current market price. 5.5 Profit and Loss Calculator The following table provides the formulae for calculating the profit or loss made on each of the four positions at expiry: Expiry price < strike Expiry price > strike Long call Loss = premium Gain = (expiry price – strike) – premium Short call Gain = premium Loss = (strike – expiry price) + premium Long put Gain = Loss = premium (strike – expiry price) – premium Short put Loss = Gain = premium (expiry price – strike price) + premium Exercise 2 If a call option with a premium of 10p gave the buyer the right to buy a share for 100p, what would be the gain (or loss) if at expiry the share was priced at: a. 120p b. 100p c. 95p The answers to this exercise can be found in the appendix at the end of this chapter. 21 5.6 FLEX Options Learning Objective 1.1.8 Understand the trading mechanisms by which OTC and exchange-traded markets meet: EFPs (exchange for physical) The FLexible EXchange (FLEX) option concept was pioneered by the Chicago Board Options Exchange (CBOE) in 1993. Since then, a number of other options and derivatives exchanges have launched similar products. FLEX options are hybrid exchange-traded products which introduce some OTC features. The concept is to provide an exchange-traded product, which will offer greater flexibility by mixing the strengths of classic exchange-traded (ie, fully standardised) options with OTC (freely negotiable terms) options. FLEX options differ from standardised exchange products in allowing users to specify certain parameters that are normally specified by the exchange within the terms of the contract. They give the ability to customise key contract terms like exercise price, exercise style and expiry date. For example, FLEX options are available on the S&P 500 on the Chicago Board Options Exchange (CBOE) and investors can specify the exercise price and expiry day of the contract. FLEX options have the added benefit of reducing the credit risk normally associated with OTC contracts. Credit risk denotes the possibility that a counterparty that has an out-of-the-money (OTM) position may not have sufficient capital to pay the counterparty that is in-the-money. It is generally considered a subset of counterparty risk. Given FLEX options are exchange-traded products, credit risk is substantially reduced due to the exchange’s use of a central clearing house. Notably, market, liquidity and operational risks, associated with all derivatives, remain key aspects of FLEX option risk management. Two aspects of wholesale trading facilities are: Exchange for physical (EFP) – an off-market transaction that involves the swapping (or exchanging) of an OTC position for a futures position. In order that an EFP transaction can take place, the OTC side and futures components must be substantially similar in terms of either value and/or quantity. Exchange for swap (EFS) – similar to EFP, in that it involves the swapping (or exchanging) of an OTC swap with a series of futures contracts. The OTC swap must have a price correlation so that the futures are a suitable instrument for hedging the cash market transaction. Price correlation is when the price movement in one instrument is similar to the movement in another; ideally identical. EFP transactions have a number of benefits for market participants including: Counterparty credit exposure can be reduced when an existing OTC position is reversed and replaced with a futures position. In doing so, an EFP allows counterparties to release credit, clearing their credit limits for further OTC trading. Reduced balance sheet and margin requirements. By netting OTC positions against offsetting futures positions, margin and credit limit requirements can be reduced. 24-hour trading – EFP transactions can normally be negotiated around the clock but must be registered during exchange business days between explicit time brackets. 22  Introduction to Derivatives The risks of EFP transactions include: 1 Operational risk can increase substantially when dealing in futures contracts, as opposed to their OTC equivalents (usually swaps and forwards). The mark-to-market accounting and daily-margin settling can be an onerous burden for some corporations that primarily use OTC products for hedging their main business activity, which may be food manufacturing for example. Auditors will usually be reticent to grant these non-financial corporates access to futures accounts, without clear internal audit obligations and accounting covenants. 5.7 Warrants A warrant is a type of security that is similar to an option, in that it gives its owner the right to buy an asset at a set price. Warrants are often attached to or are part of a bond. Warrants can be separated from the bond and traded on their own. Warrants are covered in detail in chapter 2, section 5.3. 6. Gearing Learning Objective 1.1.5 Understand the significance of gearing to derivatives: how trading on margin facilitates gearing; effect on derivative positions; reward versus outlay; reward versus risk Derivatives, such as futures and options, are all highly geared (or leveraged). In the derivatives market, gearing is the measure of the amount of cash or initial investment spent on establishing a futures or options position, compared to the actual value of the underlying asset. At its simplest, gearing is the ability for the value of a derivative to rise faster (say, by 100%) over a very short timescale, when the underlying asset has only risen by a far smaller amount (say, by 10%). A small change in the price of the underlying asset can result in a much bigger proportionate change in the value of the derivatives position – this is due to the fact that the initial investment (eg, the option premium) is relatively small compared to the face value of the underlying asset. This principle can be illustrated by looking at the gearing in the context of buying a house and taking out a mortgage. Example – Gearing Illustration A person buys a £100,000 flat by putting up £10,000 and taking out a mortgage for the remaining £90,000. If the flat increases in value by 10% to £110,000, and the individual still owes £90,000, the equity (ie, the value of their invested funds) has risen to £20,000 – a 100% increase on their investment on a 10% increase in the underlying property. Had they bought the flat outright for £100,000 without a mortgage, an increase in value of 10% would translate to a 10% increase on their investment. 23 6.1 Options Gearing As the option premium is usually only a small fraction of the value of the asset, changes in the price of the underlying asset can produce disproportionate changes in the price of the option. Example You buy an XYZ plc 850 call for a premium of 20 when the share price is 800. On expiry, the share price is 880. You would exercise the option and crystallise a net profit of 10, ie, (880 – 850) – 20. Your return on investment is 50% (ie, 10 ÷ 20). However, if you had bought the share for 800 and later sold it for 880, your return on investment would have been 10% (ie, 80 ÷ 800). Buying the call option might appear to be a more attractive reward than buying the share, but it is also riskier. If the share price only rises to, say, 808, then you will lose 100% of your investment (ie, the premium of 20), whereas holding the underlying share will have produced a profit of 1% (ie, 8 ÷ 800). The amount of gearing in an option is a direct function of the premium paid for it, relative to the price of the underlying asset; the smaller the premium, the higher the potential gearing. Options can also be volatile, offering high potential returns and losses (although the losses are limited to the initial investment) to investors. Time is also a factor, as options have limited lives and their value erodes as the expiry date approaches, due to the fact that the likelihood of them being exercised decreases over time. 24  Introduction to Derivatives 6.2 Futures Gearing 1 Gearing in a futures contract comes about through the margining system. When you buy a future, although you do not pay for the underlying asset, you must keep some collateral aside in case things go wrong. This collateral (initial margin) is a small fraction of the contract’s face value. However, when you make any profits or suffer any losses, it is based on the contract’s full face value. See chapter 6, section 3.2.1 for an in-depth explanation of the concept of initial margin. The fact that exchanges, and therefore brokers, require only a small percentage of a contract’s full value as an initial investment, in the form of initial margin, leads to the ability to gear futures trading positions. In other words, the gearing on a future exists because the buyers or sellers only pay a small proportion of the market price of the underlying asset as initial margin, yet have the potential to gain or lose the full amount of any subsequent change in the price of the underlying asset. It is important to note that gearing, sometimes also used interchangeably with the term ‘leverage’, is a key aspect for those participants using derivatives for speculation purposes. However, just as gearing magnifies potential profit, it can also magnify losses, relative to a similar sized position in the underlying asset. As mentioned in the sections above on CFDs and spread betting, regulators in most jurisdictions across the world take a strongly interventionist view towards retail investors participating in derivatives, as they are likely not fully qualified to assess the magnitude of the losses they are opening themselves to. Indeed, this is why many of these products are prohibited in the world’s largest economies. Example The Singapore Exchange (SGX) Japanese Government Bond (JGB) futures contract is based on a bond with a face value of JPY100 million. A broker normally requires only a percentage of the contract’s full face value as initial margin – say, 20%. This means that their client will incur profits or losses on each contract based on JPY100 million, with only an initial payment of, say, JPY20 million. This is how gearing works. Example You go long, or buy, a FTSE 100 Index future at 7200. As per the exchange’s margin requirements, you will need to put aside a proportion of the value of the contract, say, 300 points – as each point is worth £10, this equals £3,000 of collateral. Later, you close your position for 7260, giving a profit of 60 points. In monetary terms, this is a profit of £600 or, in percentage terms, of 20% on your collateral (ie, 600 ÷ 3,000). In contrast, the index has only moved 60 points, which is less than 1% (ie, 60 ÷ 7200). 25 7. Liquidity Learning Objective 1.1.6 Understand the principles and differences between the two major measures of exchange- traded liquidity (open interest and volume) In the market for shares, the term ‘liquidity’ represents the ease with which shares can be converted into cash. It is also used to describe how easy it is to trade in an asset without moving the market price significantly or incurring excessive costs. Liquid markets are described as deep, which refers to that market’s ability to absorb sudden shifts in supply and demand without dramatic price distortions. A security is said to be liquid if the spread between the bid and the ask price is narrow, and trades of a reasonable size can be done at those quotes. Market prices in derivatives markets will be established by the process of price discovery, with buyers and sellers stating their bid and offer prices. The difference between the bid and offer prices is the bid/ offer spread (or dealing spread); the tighter this spread (ie, the narrower the difference between the two prices), the more liquid the market. Furthermore, if there is a high volume of willing buyers and sellers either side of the bid/offer spread, any changes in demand will not move the price significantly – this is referred to as a low price elasticity of demand. A consequence is that it is cheaper to trade on liquid markets, as a dealer must give up less value when agreeing a trade with the other side of the market because dealing spreads are close. One of the main goals of derivatives exchanges is to have contracts that are liquid and easily traded. In short, liquidity encourages trading – this gives confidence that positions can be entered into and closed out (offset) without too much difficulty or expense. In turn, this creates a virtuous circle that encourages more investors, which further adds to liquidity. The main elements of a liquid market are: many buyers and sellers small bid/offer spreads low commissions, and large amounts can be traded without causing major price movements. Liquidity can be quantified by assessing the volume traded in a given period, or by looking at the number of cumulative open positions (the open interest). Volume typically quantifies the number of contracts traded on a particular day, with each contract being counted once. It is, therefore, either the total number of long or short positions entered into during that day. 26  Introduction to Derivatives Open interest looks at the total number of long or short positions that remain outstanding at the end of 1 a particular trading day. These are contracts which remain open and must, by definition, eventually be closed out (or settled by delivery if remaining open at the date of final maturity of the defined contract), hence open interest is a good indicator of the market’s willingness to take and hold a position, and of long-term commitment to the market. The higher the open interest and volume figures, the greater the liquidity. There are three other measures of liquidity: Immediacy refers to the time needed to successfully trade a certain amount of a contract or asset at a specific cost. Market depth is the size of the order book above (offers) and below (bids) the latest trade or current quoted price. If there are large unfilled orders immediately above and below the current price, then more sizable orders can be filled without unduly impacting the execution price, representing a more liquid market. A large market order placed when market depth is thin may ‘gap’ suddenly to the next order to buy or sell, meaning the average price to fill the order is far from where the market had previously been trading – this is an example of ‘slippage’, and can significantly increase the cost of trading. Resilience (the final dimension of liquidity) is the speed with which prices return to former levels after a large transaction. Unlike the other measures, resilience can only be determined over a period of time. 8. Exchange-Traded versus OTC-Traded Products Learning Objective 1.1.7 Understand the main features and differences of OTC-traded products in contrast to exchange- traded products: how an OTC-traded product is traded; standard versus bespoke OTC contracts; set maturity or expiry dates versus bespoke OTC contracts; margin requirements versus collateral; counterparty risk; liquidity; market transparency versus confidential transactions Derivatives can be entered into via one of two ways: standardised contracts provided on derivatives exchanges (such as ICE Futures Europe, the CME Group and the Japan Exchange Group’s Osaka Exchange), or they can be negotiated and entered into away from any exchange, directly between the two counterparties, which are referred to as OTC (or off-exchange) products. Exchange-traded derivative (ETD) products, such as futures, require market participants to put collateral aside in the form of margin to mitigate the risk of one of the participants not fulfilling their obligations under the contract. The margin is administered by a central counterparty (CCP) (the clearing house, such as ICE Clear). The use of margin has become more common and structured for OTC transactions. The Basel Committee on Banking Supervision (BCBS) and the Board of the International Organization 27 of Securities Commissions (IOSCO) have developed a standardised margin schedule for most OTC derivatives, which is being phased in by most market participants. While the margin requirements began entering force for very large OTC transactors in 2016, since September 2022, even smaller OTC participants, with month-end notional OTC value of €8bn are required to post initial and variation margin. The requirements for margin will be explored in more detail later in chapter 6, section 3. The following table shows the fundamental points of comparison between exchange-traded and OTC derivatives: Exchange-Traded OTC-Traded Standardised. Size, quality Customised, specifically negotiated, Contract terms and quantity defined in the totally confidential, flexible, large size product specification. possible. Standardised, under Delivery the exchange’s product Negotiable. specification. Fixed dates. Can be limited, varies dramatically Excellent on major contracts, depending on the underlying asset. Liquidity fast order execution. Largely Slower execution. Some markets may be an electronic environment. made by fewer competing firms, perhaps only one. Possibility of counterparty default exists, Existence of a CCP means that hence credit rating is important. A credit counterparty risk is removed. rating is an independent assessment of a Financial Daily mark to market (MTM), company’s credit risk, and is usually only integrity which entails calculation and accepted from one of the large credit- settling of variation margin at rating agencies (S&P, Fitch and Moody’s). the end of each trading day. Prime brokers can reduce and simplify counterparty risks. While formal margin payments are not usually required, some contracts do Margin is always required, require the payment or pledging of in the form of initial and collateral. It is agreed on a case-by-case variation margin. Initial basis to secure the trade; it does not margin is the required have a fixed payment, such as the margin amount of capital that a payments associated with ETD trades, Margin participant needs to keep a but is often reset to a minimum level position open, while variation (with the associated profits and losses margin is the daily profit or changing hands) on a fixed schedule, loss on the position that must such as quarterly. In periods of high be settled (see chapter 6, volatility, additional collateral could be section 3). demanded and the amount could change frequently. 28  Introduction to Derivatives Exchange-Traded OTC-Traded 1 Tends to be one-off and more complex, although certain standard documentation Documentation Standard and concise. is provided by trade associates, such as the International Swaps & Derivatives Association (ISDA). Since 2008, OTCs have become increasingly more regulated – eg, European Market Infrastructure Regulation (EMIR) in the EU, Dodd-Frank Subject to significant in the US. Under EMIR, many types of Regulation regulation. trades are required to be cleared through a CCP. Market participants are also required to report trades to a warehouse (trade repository). See also Regulation in the table that follows. Highly transparent, public Price quotes Limited. Need to shop around. dissemination. Transaction Individually priced, more expensive than Standardised, lower. costs exchange-traded like-for-like derivatives. The following table highlights the relative merits of exchange-traded contracts compared to entering into similar OTC contracts: Feature Exchange-Traded OTC-Traded The exchange standardises the Contracts are tailor-made between expiry dates and underlying Standardisation the participants, with the expiry date for each contract. As a result, and flexibility and underlying agreed between the the contracts are relatively participants. Highly flexible. inflexible. Individual contracts that have The contracts are customised and are Fungibility the same expiry are totally not as fungible. fungible. Contracts are easily traded on Contracts are not standardised and the exchange and therefore are not easily traded, so liquidity can liquid. Trading can be be restricted. The tailor-made nature Trading and conducted with any member of contracts means that closing the liquidity of the market, and the fungible contract will involve negotiating with nature means that contracts can the original counterparty. However, be opened with one member some products are regularly traded and closed with another. between dealers in banks. 29  Feature Exchange-Traded OTC-Traded The counterparty risk will be driven by The counterparty in exchange- the credit standing of the counterparty traded contracts is the CCP Counterparty to the deal. However, some OTC (the clearing house). The risk products can be cleared centrally counterparty risk is relatively through a clearing house, reducing small. counterparty risk. Regulation has historically been very light for OTC products. However, that has changed with the implementation There is reasonable regulation Regulation of legislation (such as the Dodd-Frank for exchange-traded products. Act in the US), and is expected to continue changing as new regulation is introduced. There is little or no real-time publication Trading activity and prices on of trading activity on the OTC markets the exchange are published on a – resulting in more confidentiality, real-time basis – trading details but a lack of information on the Public are revealed to the market, competitiveness of quoted prices. With information although the identification the introduction of the Commodity of the participants remains Futures Trading Commission (CFTC) confidential. and EMIR reporting, there is real-time reporting of OTC transactions. The standardised nature of contracts means that precisely The negotiation of the terms and hedging a particular position conditions between participants Hedging may not be possible due to the can result in precisely hedging the restricted contract sizes and underlying position. expiry dates available. The availability to speculate is almost The available speculative unlimited in terms of constant product Speculation exposures are restricted to innovation, but can be restricted in exchange-traded products. terms of counterparty availability. As mentioned in the table above, actively hedging a portfolio using either exchange-traded or OTC derivatives carries its own particular risks. While OTC derivatives contracts allow one to structure a hedge that exactly matches the underlying exposure (in amount, specific asset characteristics and maturity), these contracts do have counterparty risks and may have limited liquidity. In contrast, exchange-traded contracts do not have counterparty risk, but, given their standardised nature, risks may arise from any slight mismatch between the portfolio and the derivatives contract in terms of maturity, contract size or slightly different asset characteristics. This should be taken into account when analysing the hedge’s risk profile. 30  Introduction to Derivatives 9. Swaps 1 Learning Objective 1.1.3 Understand the basic concepts and fundamental characteristics of swaps A swap is an OTC derivative contract through which two counterparties exchange the cash flows or liabilities from two different financial instruments. Most swaps involve cash flows based on a notional principal amount, such as a loan or bond, although the instrument can be almost anything. Swaps are considered to be derivatives because, like other forms of derivatives, their valuation is based upon the value of other assets or determining factors, such as interest rates, currency rates, default rates, commodity prices and equity prices. Since swaps are traded on such a wide range of underlying assets, it is the largest (in nominal terms) of all of the derivatives markets, with the largest type of swap being interest rate swaps. 9.1 Interest Rate Swaps and Swaptions Learning Objective 5.1.2 Understand the basic concepts and fundamental characteristics of interest rate swaps: underlying (fixed/fixed, fixed/floating, floating/floating); interest calculation (compared to bond markets) An interest rate swap is an OTC derivative where two counterparties exchange one stream of future interest payments against another, based on a specified principal amount over a set period. These payment streams are called the legs of the swap. As they are OTC instruments, swaps come in a variety of forms: Fixed/floating swap – a ‘plain vanilla’ swap that is also known as a coupon swap. The two parties agree to swap, or exchange, interest cash flows for fixed and floating rate loans. Floating /floating swap – also known as a basis swap, each of the two payment streams is based on a floating rate. Fixed/fixed swaps – a type of foreign currency swap in which both parties pay each other a fixed interest rate on the principal amount. At each payment date, a net payment will be made between the two participants based on the difference between the two rates on the underlying principal sum for the quarter. Whichever rate exceeds the other, the difference will be paid to the party that is due to receive the higher rate and pay the fixed interest. For example, a straightforward interest rate swap (plain vanilla swap) involves one party exchanging a floating interest rate obligation (eg, SONIA) for another party’s fixed-rate obligation. The floating rate will be determined on the swap’s reset date – for a fixed versus six-month floating swap, the reset date 31 will be every six months. Once the floating rate is determined, the swap will start accruing interest as of its effective date. The swap will specify particular periods at the end of which the cash flow exchanges will take place; this is known as the swap’s payment date. With the agreement of both parties and after an evaluation or mark to market of the swap’s value, either party can initiate action to cancel or end the swap after an agreed payment. When this happens, all calculations of accrued interest are based on the swap’s termination date. This is the date that the swap officially ceases to exist. For example, a three-year plain vanilla interest rate swap might be arranged with quarterly payments based on a principal sum of £6 million, effective from 1 January 2022, exchanging a fixed interest rate for a floating interest rate based on SONIA. The first payment under the swap will be at the end of March 2022, the second at the end of June 2022, and so on. A swaption is an arrangement where a buyer pays an upfront sum for the right to enter into a swap agreement by a pre-agreed date in the future. In other words, the buyer of a swaption has the option to enter into a swap. The concept is the same as for options. Large corporations and other institutions use these interest rate swaps and swaptions to manage risk and, potentially, take advantage of cheaper and more appropriate funding. The arrangements are facilitated by financial institutions. It is a wholesale market, not open to smaller or retail investors. 9.2 Inflation-Linked Swaps Learning Objective 5.6.4 Know the purpose of inflation swaps An inflation swap involves an exchange of cash flows, with one or both of its legs calculated with reference to an inflation index. It provides investors with protection against rising prices on a notional principal or an asset’s future value. An investor who wants protection from rising prices agrees to pay a fixed amount based on the expected rate of inflation. The swap payments are based on benchmarks such as the retail prices index (RPI) in the UK, the eurozone’s Harmonised Index of Consumer Prices (HICP), or the US Consumer Price Index (CPI). Maturities normally range from five to 30 years for inflation swaps. 32  Introduction to Derivatives 9.2.1 Zero Coupon Inflation Products 1 Learning Objective 5.1.7 Understand the basic concepts and fundamental characteristics of zero-coupon inflation products A zero coupon inflation product is a standard derivative product based on an inflation rate. The underlying asset is a single price index (inflation measure). It is called a zero coupon product or swap because there is only one financial flow, at the end, without any intermediate coupon. At the maturity date, there is a swap of a fixed amount against a floating amount. This type of product allows market participants to: hedge against/speculate on future inflation fluctuations evaluate inflation-linked securities, including asset swapping Treasury inflation-protected securities (TIPS) and other securities, and hedge against central bank credit tightening policies (since central banks could tighten monetary policy to fight rising inflation). 9.3 Currency Swaps Learning Objective 5.1.3 Understand the basic concepts and fundamental characteristics of FX and currency forwards and swaps: FX forward (outrights quotes versus pips); currency swaps A currency swap is an FX transaction that involves trading the principal and interest in one currency for the same in another currency, for an agreed period of time. They are used by banks, multinational corporations and investors to obtain foreign currency loans at a better rate of interest than they could obtain by borrowing directly in a foreign market, or as a way of hedging transaction risk on foreign currency loans that they have already taken out. Currency swaps are one of the earliest types of swap. One of the first examples dates back to 1981, when IBM wanted to borrow US dollars and the World Bank wanted to borrow Swiss francs and German marks. However, because the World Bank was already a frequent issuer of European currency debt and IBM was not, the rarity value meant IBM could borrow Swiss francs and German marks more cheaply. Thus, IBM borrowed Swiss francs and German marks, the World Bank borrowed US dollars and they entered into a swap – the result being that they both saved money on their borrowings. 33 Currency swaps have since continued to develop. It is possible to enter into currency swaps that exchange: fixed interest in one currency for floating interest in another currency fixed interest in one currency for fixed interest in another currency, or floating interest in one currency for floating interest in another currency. An illustration of the potential benefit of a currency swap is provided below: Example A UK company expects to receive a stream of US dollars over the next five years from exports. It needs to convert US dollars into sterling. Rather than use a series of separate forward FX transactions to achieve this, it could instead use a currency swap. The series of US dollar flows are considered as a package and, in the swap, the company agrees to pay these flows to a counterparty over the five years, in return for a series of sterling cash flows. This would be a fixed-fixed currency swap without principal exchanges. The UK company has protected itself against its UK income being eroded by exchange rate movements depreciating against the US dollars. Conversely, if exchange rates improve, it will see no benefit. As seen here, the uses of currency swaps include potentially reducing the cost of borrowing and replacing future cash flows that are unpredictable (due to exchange rate movements) with predictable cash flows agreed in a swap. The downside here is, as with all hedges, that using a currency swap removes the possibility of upside from a strengthening in the US dollar/weakening in sterling. Additionally, currency swaps come at a cost, usually in the form of a slightly weaker-than-market exchange rate. 9.4 Equity Swaps Learning Objective 5.1.4 Understand the basic concepts and fundamental characteristics of equity forwards, swaps and swaptions: equity baskets/index; equity forwards; equity swaps 5.6.1 Know common equity swap instruments and their relationship to other markets and products: total return; volatility; variance; dividend swaps Equity swaps are swaps whose payments on one or both sides are linked to the performance of equities or an equity index. They are sometimes used to avoid withholding taxes, obtain leverage, or enjoy the returns from ownership without actually owning equity. They can be especially useful in accessing certain emerging markets which have foreign ownership restrictions on cash equities or for which there are no futures available. Thus, equity swaps enable the creation of a synthetic portfolio of shares without the need to buy all of the individual underlying shares and incur the transactions costs for doing so. 34  Introduction to Derivatives This type of swap allows an investor or fund manager to exchange the returns on an equity investment 1 (an individual share, a basket or index) for a return on another non-equity or equity-based investment. Its returns are strictly based on the relative volatility of an individual share or index. The simplest type of equity swap is a bullet swap in which all payments are made at maturity. Example Investor A swaps $10 million at ICE SOFR + 0.05% (ICE SOFR + 5 basis points) against the return of the Hang Seng (Hong Kong) index over six months. Investor A will receive from investor B any percentage increase in the Hang Seng applied to the $10 million notional. If the Hang Seng declined over the year, not only will investor A receive nothing from investor B, but investor A will have to pay investor B the value of the fall in the index, thereby creating a synthetic investment in the index. Let us assume that in six months’ time, ICE SOFR is 5.5% and also assume a swap tenure of precisely 180 days. If that is the case, then the floating leg payer/equity receiver (investor A) will owe (5.5% + 0.05%) x $10,000,000 x 180/360 = $277,500 to the equity payer/floating leg receiver (investor B). If, over the same period, the Hang Seng rose from 23,100 to 25,250 or 9.3%, investor B would have to pay investor A 9.3% of $10 million = $930,000. The net payment would be $652,500 from investor B to investor A (ie, $930,000 - $277,500). However, if the Hang Seng fell to 22,100 or by 4.3% over that same period, investor A will have to pay investor B a total of $707,500 ($430,000 due to the drop in the index and $277,500 for the ICE SOFR leg of the swap). Equity basket swaps are swaps where one or both of the underlying assets is/are a non-index basket of shares. The shares in this basket often have similar characteristics to exchange-traded equity index derivatives, but are always traded OTC, since the basket of shares used is not standardised as an equity index. The shares that are included in these baskets are normally used for correlation trading; that is, they are included in the basket to fulfil the objective that one of the counterparties requires. The fact that these baskets are specific for each swap is the main reason why these are traded on an OTC basis. An equity forward contract is an OTC contract between two parties to buy or to sell an individual share, basket of shares or equity index at a specified future time at a price agreed upon today. Forward contracts on an equity basket or index work in the same way as on an individual share. Instead of entering into separate contracts for each of the individual shares in the basket, the investor can give a list of securities in the portfolio to their broker who will quote the price for which the dealer will purchase or sell the securities in the basket at a future date. 9.4.1 Variance Swaps A variance swap takes the concept of an equity swap beyond the movement in equity prices. A variance swap allows an investor to hedge or speculate on the future price movements of an underlying asset, which can be a currency, interest rate, commodity or index. In a variance swap, one side’s payment will be linked to the realised variance (ie, the price movements of the specific asset) over the life of the swap. These prices are recorded on a daily basis and are most commonly based on the asset’s closing price. The other side of the swap will pay a fixed amount, which is agreed upfront. 35 The main attraction/advantage of a variance swap is that it provides pure exposure to the volatility of the underlying asset’s price as opposed to straight call or put options, which may require delta hedging. It is for this reason that variance swaps are more widely used in the equity markets than volatility swaps. The profit/loss of a variance swap depends solely on the difference between implied and actual volatility. 9.4.2 Dividend Swaps A dividend swap is a swap that allows one to swap fixed payments (eg, ones which might be based on current interest rates) with dividend payments from an individual share, group of shares or an equity index. Unlike other equity-related swaps, dividend swaps are based solely on the actual dividend payments without taking into account the underlying share price or index level. The holder of the fixed leg will pay their counterparty a predesignated fixed payment at each interval. The other party – the holder of the floating leg – will pay their counterparty the total dividends that were paid out by a selected underlying asset which can be a single share, a basket of shares or all the members of an index. The payments are multiplied by a notional number of shares which is agreed when the swap is first entered into. Like most swaps, the contract is usually arranged such that its value at signing is zero. This is accomplished by making the value of the fixed leg equal to the value of the floating leg – in other words, the fixed leg will be equal to the average expected dividends over the term of the swap. Therefore, the fixed leg of the swap can be used to estimate market forecasts of the dividends that will be paid out by the underlying. 36  Introduction to Derivatives It is important to remember that dividends do have an effect on forwards; however, when you compare 1 the effect from a risk management perspective for a basket or equity index, dividends have a minor impact when compared to the price movements in the shares that make up the index or basket. Most equity forwards do not pay dividends except for forwards that are total return forwards. Total return forwards take into consideration the payments and reinvestment of any dividends paid on any shares that are included in the index. This is in addition to the return on the index itself. 9.5 Asset and Total Return Swaps Learning Objective 5.1.6 Understand the basic concepts of total return and asset swaps 9.5.1 Asset Swaps An asset swap is a swap that can be used to change the interest rate exposure or currency exposure of an investment. The swap itself can be straightforward. The term ‘asset swap’ is used to denote the reason for doing the swap and is also used for the whole package of the asset and the swap together. An investor might, for example, buy a floating rate note (FRN) and also transact a swap to receive a fixed interest rate and pay SONIA. The result will be a synthetic fixed-rate investment. Alternatively, in reverse, they might create a synthetic FRN by buying an underlying fixed-rate investment while paying fixed and receiving floating in the swap. The advantage of such a structure is that the investor is able to choose the underlying asset according to such criteria as availability, credit quality, liquidity and competitive pricing. The choice of whether to invest in fixed or floating rates can be separated from the choice of asset. Typically, a bank offering asset swaps to clients will need to hedge their exposure to the underlying asset, unless they have a mandate to speculate (which is rare due to the risks involved). Therefore, a disadvantage of asset swaps is the ability of the counterpart to hedge their exposure to the underlying asset chosen by the investor. This usually manifests in the lack of available counterparts to transact with from the investor’s perspective, and the significant spreads that may be charged to the investor by a willing bank, to provide some insurance that they will be protected from a deterioration in the price correlation of the underlying asset and the instrument used to hedge the bank’s exposure. 37  Example An investor wishes to buy a ten-year FRN issued by the government (because they want the highest credit rating possible) but no such issue exists. They can instead buy a ten-year government fixed- rate bond and swap it. Even if such an FRN does already exist, it might be that the synthetic structure using the swap achieves a slightly better yield, if the two markets are not exactly in line. Pays fixed rate of ten years Buyer: ten-year ASSET SWAP INVESTOR Receives six-month government