Derivatives

We view them as time bombs both for the

parties that deal in them and the economic system ...

In our view ... derivatives are financial weapons of

mass destruction, carrying dangers that, while now

latent, are potentially lethal

Warren Buffett

1. Before reading the text, try answering the following questions:

What are derivatives mainly used for?

Is there any Romanian derivatives Stock Exchange?

Do derivatives hedge the risk of owning things that are subject to price fluctuations? If

yes, what would be those “things”?

Do derivatives encourage fraudulent trading?

2. Match the following terms with their correspondent explanations: futures, forward,

option, swap, put option, call option, margin-equity ratio, exercise price (strike price)

The right, but not the obligation, to buy or sell a specific amount of a given stock,

commodity, currency, or debt, at a specified price during a specified period.

A contract obliging one party to buy and other party to sell equities, commodities or

currencies at a specific future date.

The price at which the holder of a call/put option may buy/sell the underlying security.

It is the exchange of one security for another one because investment objectives have

changed.

An option contract that gives the holder the right to sell a certain quantity of an

underlying asset to the writer of the option, at a specified price up to a specified date.

A standardized, exchange-traded contract that requires delivery of a commodity, bond,

currency, at a specified price, on a specified future date.

An option contract that gives the holder the right to buy a certain quantity of an

underlying asset from the writer of the option, at a specified price up to a specified

date.

It is a term used by speculators, representing the amount of their trading capital that is

being held as spread at any particular time.

The derivatives markets are the financial markets for derivatives.

Over-the-counter (OTC) derivatives are contracts that are traded directly between two

parties, without going through an exchange or other intermediary.

Exchange-traded derivatives are those derivatives products that are traded by means of

derivatives exchanges. Derivatives exchanges act as intermediaries to all transactions.

A derivative is a financial contract:

Trading assets (such as commodities, shares, bonds)

Taking into account the performance of interest rates, exchange rates, but according to

consumer price indexes, stock market indexes.

Futures contract

A futures contract is a standardized contract, traded on a futures exchange, to buy or sell

certain types of assets, at a certain date in the future, at a pre-set price.

The future date = the delivery date

The pre-set price = the futures price

The price of the underlying asset on the delivery date = the settlement price

The futures price converges towards the settlement price on the delivery date.

Future Forwar Options

Exchange tradederivatives

Over-the-counterderivatives

Derivatives market

Swap

Types ofDerivative

s

FUTURES

OPTIONS

SWAPS

FORWARDS

Futures contracts are highly standardized, to ensure that they are liquid. The

standardization usually involves specifying:

The type of settlement, e.g. cash

The amount or units of the underlying asset e.g. bonds, foreign currency, wheat, oil

The currency in which the futures contract is quoted.

The type of the deliverable (in case of e.g. bonds), quality and location of delivery

(e.g. in case of goods).

The delivery month

The last trading date

The value of a contract when traded could be zero, but its price continually fluctuates.

This creates a credit risk to the exchange. To minimize this risk, the exchange demands that

contract owners come up with a form of collateral commonly known as margin. There are two

kinds of margins: maintenance margin and initial margin.

3. Fill in using maintenance margin or initial margin:

…..is paid by both buyer and seller. It represents the loss on that contract, as

determined by past price changes

Because a series of unfavorable price changes may wear out the……., a further

margin, usually called……., is necessary to the exchange. This is calculated by

agreeing a price at the end of each day, called the settlement price of the contract.

4. Read the short paragraph below and choose each time the best option out of two:

Traders would rarely hold 100% of their capital as margin. The probability of losing their

entire capital someday would be low/high. By contrast, if the margin-equity ratio is so

high/low as to make the trader’s capital equal to the value of the futures contract itself, then

they would not profit from the leverage contained in futures trading. A conservative trader

might hold a margin-equity ratio of 15%/40%, while a more aggressive trader might hold

15%/40%.

Forward contract

A forward contract is an agreement between two parties to buy or sell an asset at a pre-agreed

future point in time. Therefore, the trade date is not to be confused with delivery date. A

forward contract is used to control and hedge risk, e.g.:

Currency exposure risk (e.g. forward contracts on USD or EUR);

Or commodity prices (e.g. forward contracts on grains, oil).

5. Decide which option out of the two is the best one:

In a forward transaction, no cash changes hands. If the transaction is backed up by some sort

of collateral, exchange of margin/capital will take place according to an arranged/pre-

agreed schedule. Otherwise, no asset of any kind actually changes hands, until the

maturity/deadline of the contract.

Futures vs. Forwards

6. Complete the gaps in the following text by using the terms futures and forward:

The main differences between futures contracts and forward contracts are:

…..are always traded on an exchange, whereas …..always trade over-the-counter

…...is unique, ……are highly standardized

The price at which the contract is finally settled is different:

……are settled at the settlement price fixed on the last trading date of the contract

……are settled at the price agreed on the trade date

The credit risk of futures is much lower than that of forwards:

The profit or loss on a…..position is exchanged in cash every day. After this, there is

no credit exposure.

The profit or loss on a ……contract is only realized at the time of settlement, so the

credit exposure can keep increasing

Option

An option is a contract where the holder or buyer has the right but not the obligation to

buy securities, currencies, commodities on or before a future date (the exercise date). The

writer or seller has the obligation to honor the contract. Since the option gives the buyer a

right and the seller an obligation, the buyer has received something of value. The amount the

buyer pays the seller for the option is called the option premium.

The holder of the option has the right but not the obligation to buy (call option) or sell

(put option) a specified amount of a security within a specified period.

7. There are different types of options. Match each type with the proper explanation:

real option, exchange traded option, vanilla option, exotic option

It is a simple option; examples would be European options and American options on

stock and bonds.

It is a choice that an investor has when investing in the real economy. This option is

the opportunity to change production inputs. It is not very liquid.

It has a systematic pricing and is settled through a clearing house.

It is an option where the underlying instrument is more complex than simple equity or

debt; examples would be Asian options.

The option contract

For the option holder, the option:

Offers the right, but no obligation

to buy (call option) or sell (put option)

a specific quantity

of a given financial underlying (e.g. bonds)

at an agreed price (exercise or strike price)

on one or more call dates

in exchange for a premium (option price).

The option seller has an obligation to fulfill the contract if the option holder exercises

the option. In return, the option seller receives the option premium.

If you expect the value of a share that you own to fall below its current price, you can

buy a put option at the respective price or you could write a call option giving someone else

the right to buy the share at the current price: if the market price is below the respective price,

no one will take up the option and you earn the premium.

If you think a share will rise, you can buy a call option giving the right to buy at the

current price, hoping to resell the share at a profit. You can also write a put option giving

someone else the right to sell the shares at the current price: if the market price is above the

respective price, no one will take up the option and you earn the premium.

A call/put option has intrinsic value if its exercise price is below/above the current

market price of the underlying share. Call options with an exercise price below the underlying

share’s current market price and put options with an exercise price above the share’s market

price are describes as being “in -the -money”.

Call options with an exercise price above the underlying share’s current market price

and put options with an exercise price below the underlying share’s market price are “out-of-

the-money”.

8. Match the three statements with their respective halves:

Buyers and sellers of exchange-traded options do not usually interact directly…..

The seller guarantees that he can fulfill his obligation………

The risk for the option holder is limited……….

the futures and options exchange acts as intermediary

he cannot lose more than the premium paid

if the buyer chooses to execute

Swap

Swaps are often used to hedge certain risks, for instance interest rate risk. Another use

is speculation.

Swaps are negotiated outside exchanges. They cannot be bought and sold like

securities or futures contracts, but are all unique. As each swap is a unique contract, the only

way to get out of it is by either mutually agreeing to tear it up, or by reassigning the swap to a

third party, obviously with the approval of the counterparty.

9. There are different types of swaps; match them with the explanations provided

below: total return swap, commodity swap, basis swap, interest rate swap, equity

swap

…….is the most common type of swap. It exchanges fixed rate payments against

floating rate payments. Exceptions exist, such as floating-to-floating swaps, known

as….

……is a swap, where one entity pays the total return of an asset, and a different entity

makes periodic interest payments. The entities involved have exposure to the return of

the underlying assets, without having to hold the underlying assets.

……..is a contract in which entities agree to exchange payments related to indices, at

least one of which is a commodity index.

……..has a stock, a basket of stocks, or a stock index as the underlying asset; in this

case you do not have to pay anything before, but you do not have any voting rights.

10. Establish whether the statements written below are true or false:

The price of forward contracts is determined the moment the contract is signed.

Swaps are used to exchange fixed with floating interest debts.

Futures contracts are non-standardized contracts.

A call option with an exercise price below the underlying share’s current market price

is in “in-the-money”.

You could write a call option giving someone else the right to sell the share at the

current price.

Hedging also means speculating.

If you expect the value of a share that you hold to increase above its current price, you

can buy a put option.

Task

Work in pairs and establish which kind of investment you would choose to make and

what kind of contract you would conclude for each type of asset.