Derivatives Markets Introduction PDF 2021-2022

DERIVATIVES MARKETS: INTRODUCTION 1 D. LAUTIER - UE 109 - 2021-22 1 Section 1. The main derivative instruments Section 2. The organisation of trading in the derivatives marke...

DERIVATIVES MARKETS: INTRODUCTION 1 D. LAUTIER - UE 109 - 2021-22 1 Section 1. The main derivative instruments Section 2. The organisation of trading in the derivatives markets Section 3. The main economic functions of the derivatives markets 2 D. LAUTIER - UE 109 - 2021-22 2 Section 1. The main derivative instruments A derivative instrument is a financial asset whose value depends on the price of one or more underlying products (underlying assets) D. LAUTIER - UE 109 - 2021-22 3 3  Underlying products: - currency - stocks / indices - bonds / interest rates - commodities - credit risk - climate risk - Exchange Traded Funds - Volatility indexes (VIX) - Bitcoins, water, CO2, …. - other derivatives 4 D. LAUTIER - UE 109 - 2021-22 4 The main categories of derivative instruments Forward contract Fixed instruments Futures contract Swap Optional Option instruments Cap, floor, collar 5 D. LAUTIER - UE 109 - 2021-22 5 Section 2. The organisation of trading 2.1. Organized markets 2.2. Over The Counter markets (OTC) 6 D. LAUTIER - UE 109 - 2021-22 6  2.1. Organized Markets Trading of futures, options and swaps 7 D. LAUTIER - UE 109 - 2021-22 7 Volume and open interest in 2020 Volume % Open Interest % (Billions) / 2019 (Millions) / 2019 Futures 25.5 + 33 246 -0.8 Options 21.2 + 39 741 13.6 Total 46.7 +35.6 987 9.7 2020 is a record year : + 126.8% since 2011 Reasons : - Growth in emerging markets - Intervention of new traders Source : FIA 8 D. LAUTIER - UE 109 - 2021-22 8 Options versus futures Source : WFE 9 D. LAUTIER - UE 109 - 2021-22 9  Breakdown by regions Source : FIA 10 D. LAUTIER - UE 109 - 2021-22 10 Breakdown by regions 11 D. LAUTIER - UE 109 - 2021-22 11 2.1. Organized Markets Trading of futures, options and swaps Electronic trading 12 D. LAUTIER - UE 109 - 2021-22 12  2.1. Organized Markets Trading of futures, options and swaps Electronic trading Centralization : clearing house or CCP (Central Counterparty) - Trade facilitation and market liquidity - Management of Counterparty risk The main organized markets 13 D. LAUTIER - UE 109 - 2021-22 13 Top 5 derivative exchanges 14 D. LAUTIER - UE 109 - 2021-22 14 NSE: National Stock Exchange of India B3: Brasil Bolsa Balcao CME : Chicago Mercantile Exchange ICE: InterContinental Exchange Nasdaq: National Association of Securities Dealers Automated Quotations 15 D. LAUTIER - UE 109 - 2021-22 15  2.1. Organized Markets Trading of futures, options and swaps Electronic trading Centralization : clearing house or CCP (Central Counter Part) - Trade facilitation and market liquidity - Management of Counterparty risk The main organized markets Evolution of the transaction volumes 16 D. LAUTIER - UE 109 - 2021-22 16 Total volume of exchange traded derivatives over time Source : WFE 17 D. LAUTIER - UE 109 - 2021-22 17 Evolution by underlying asset, billions of contracts (1) Source : WFE 18 D. LAUTIER - UE 109 - 2021-22 18  Evolution by underlying asset (2) Source : WFE 19 D. LAUTIER - UE 109 - 2021-22 19 20 D. LAUTIER - UE 109 - 2021-22 20 21 D. LAUTIER - UE 109 - 2021-22 21  22 D. LAUTIER - UE 109 - 2021-22 22 23 D. LAUTIER - UE 109 - 2021-22 23 24 D. LAUTIER - UE 109 - 2021-22 24  25 D. LAUTIER - UE 109 - 2021-22 25 2.2. Over The Counter Markets OTC Markets “Over the Counter” Informal network of agents Bilateral relations Transactions between – Protection sellers (financial institutions) – Protection buyers (fund managers, corporate treasurers…) Negotiated contracts: forwards, options (1st and 2nd generation), swaps, caps, floors, collars, and other structured products 26 D. LAUTIER - UE 109 - 2021-22 26 2.2.1. Evolution of all contracts 2.2.2. Distribution by underlying asset 27 D. LAUTIER - UE 109 - 2021-22 27  2.2.1. All contracts, highlights Gross market value of the OTC market in December 2020: USD 15.8 trillions 1 trillion = 1,000 billions 1 billion = 1,000 millions Open (outstanding) positions: 598 trillions Worlwide GDP in 2020: USD 84.4 trillions Decline in activity since 2014, due to trade compression. Trade compression : - bilateral netting - multilateral netting (central counterparts CCP) 28 D. LAUTIER - UE 109 - 2021-22 28 Bilateral netting (compensation) Before compensation USD 500,000 A B USD 400,000 After compensation USD 100,000 A B 29 D. LAUTIER - UE 109 - 2021-22 29 30 D. LAUTIER - UE 109 - 2021-22 30  Definitions Notional amount: - notional value of all derivative contracts not yet settled - determines contractual payments Gross market value: - sum of the absolute values of all open contracts, with either positive or negative mark-to-market values, at current market prices - the cost of replacing all existing contracts at current market prices Gross credit exposures : - measure of the exposure to counterparty credit risk - gross market values after legally enforceable bilateral netting but before collateral 31 31 32 D. LAUTIER - UE 109 - 2021-22 32 OTC Derivative markets: the shift to central clearing Dec. 2018, % of outstanding OTC derivatives against central counterparts (CCP) - 60% overall - 75% for interest rates - 55% for credit derivatives 33 D. LAUTIER - UE 109 - 2021-22 33  34 D. LAUTIER - UE 109 - 2021-22 34 35 D. LAUTIER - UE 109 - 2021-22 35 Non centralised bilateral netting 36 Source: Cont 2015 D. LAUTIER - UE 109 - 2021-22 36  Non centralised Bilateral Netting: Gross notional amount: 100 + 50 + 80 + 120 = 350 Exposure of A: 180 Exposure of B: 150 Exposure of C: 200 Exposure of D: 170 37 D. LAUTIER - UE 109 - 2021-22 37 Non centralised netting versus cleared OTC 38 Source: Cont 2015 D. LAUTIER - UE 109 - 2021-22 38 Cleared OTC Net exposure of A: 20 (D) Net exposure of B: 50 (C) Net exposure of C: 40 (C) Net exposure of D: 70 (D) Net exposure of the Clearing House: 0 Gross exposure of the market: 180 39 D. LAUTIER - UE 109 - 2021-22 39  Conclusion Organized markets: - Between 1972 and 2020, transactions in futures contracts rose from USD18.3 millions to USD 47 billions - Importance of the Asian markets (42% of the total volume) OTC Markets - Over 50% of traded instruments are swaps - Contraction of transactions under the pressure of the regulation - Shift to central clearing 40 D. LAUTIER - UE 109 - 2021-22 40 Section 3. The main economic functions of the derivatives markets 3.1. Risk Management 3.2. Speculation and arbitrage 3.3. Price Discovery 3.4. Volatility Discovery 3.5. Efficiency of Transactions 41 D. LAUTIER - UE 109 - 2021-22 41 3.1. Risk Management Primary function: hedging, risk management Risk transfer (neither pooling nor diversification) Derivatives markets = zero-sum games Risk “divided" into several parts and reallocated between operators 42 D. LAUTIER - UE 109 - 2021-22 42  3.2. Speculation and arbitrage Speculation Objective : generate return / profit Risk-taking based on anticipation Critical function: it allows hedging 43 D. LAUTIER - UE 109 - 2021-22 43 3.2. Speculation and arbitrage Speculation Objective: generate return/profit Explicitly risky operation based on an expectation Critical function: it allows coverage Arbitrage 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 44 D. LAUTIER - UE 109 - 2021-22 44 3.3. Price discovery Price discovery is the process through which the futures markets reveal information relating to future spot prices Futures prices: - public - free - comparable - 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 45 D. LAUTIER - UE 109 - 2021-22 45  3.4. Volatility Discovery 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 46 D. LAUTIER - UE 109 - 2021-22 46 3.5. Efficiency of transactions Direct and free access to a competitive market Creating a reference point (benchmark) D. LAUTIER - UE 109 - 2021-22 47 47