International Finance

Derivative Markets

Lecture 2
Baku,2023 (spring semester)
 Derivatives market
A derivative is a security that derives its value from the value of another
security or a variable (underlying asset) at some specific future date. The value
of underlying asset is the source of risk.
Derivatives are similar to insurance in that both allow for the transfer of risk
from one party to another. Derivatives change the party bearing the risk,
however the risk itself does not change. Derivatives allow for this same type of
transfer of risk.
Like insurance, derivatives pay off on the basis of a source of risk.
Derivatives generally trade at lower transaction costs than comparable spot
market transactions, are often more liquid than their underlying's, and offer a
simple, effective, and low-cost way to transfer risk.
 Derivative Contract

Derivatives are created in the form of legal contracts. They involve two parties
—the buyer and the seller (sometimes known as the writer)—each of whom
agrees to do something for the other, either now or later.

The buyer, who purchases the derivative, is referred to as the long.

The seller is referred to as the short.
A derivative contract always defines the rights and obligations of each party.
 The Structure of Derivative Markets
Derivative instruments are created and traded either on an exchange trade or on the
OTC market (over-the-counter market).

Exchange-traded derivatives are standardized and backed by a clearinghouse.

(futures and options)
A dealer market with no central location is referred to as an over-the-counter
market. They are largely unregulated markets and each contract is with a
counterparty. The owner of a derivative may face the default risk (when the
counterparty does not honor their commitment).

To standardize a derivative contract means that its terms and conditions are precisely
specified by the exchange and there is very limited ability to alter those terms.
 Primary differences between exchange-traded and OTC derivatives.
Exchange-traded derivatives are:
• Traded at a centralized location, an exchange.
• Traded by exchange members (market makers).
• Based on standardized contracts and have lower trading costs.
• Subject to the trading rules of the exchange (i.e., are more regulated).
• Backed by the central clearinghouse to minimize counterparty credit risk. They also require deposits by both parties at
initiation, and additional deposits when a position decreases in value.
• More liquid.
• More transparent, as all transactions are known to the exchange and to regulators.
OTC derivatives (not subject to the central clearing mandate) are:
• Custom instruments.
• Less liquid and have higher transaction costs.
• Less transparent.
• Subject to counterparty risk.
• More difficult to clear and settle.
• Subject to higher trading costs.
• Not subject to requirements for the deposit of collateral.
 Classes of derivatives
A forward commitment is a legally binding promise to perform some action in the
future.
- Forward contracts,
- Futures contracts,
- Swaps.
Forward commitment contains an obligation to carry out the transaction as planned.

A contingent claim is a claim (to a payoff) that depends on a particular event.

- Options
- Credit derivatives
Contingent claim contains the right to carry out the transaction but not the
obligation.
 Forward Contracts
In a forward contract, one party agrees to buy and the counterparty to sell a physical or financial asset at a specific
price on a specific date in the future.
A forward contract can be used to reduce or eliminate uncertainty about the future price of an asset it plans to buy
or sell at a later date.

Typically, neither party to the contract makes a payment at the initiation of a forward contract. If the expected
future price of the asset increases over the life of the contract, the right to buy at the forward price (the price
specified in the forward contract) will have positive value, and the obligation to sell will have an equal negative
value.

If the expected future price of the asset falls below the forward price, the result is opposite and the right to sell (at
an above-market price) will have a positive value.

The party to the forward contract who agrees to buy the financial or physical asset has a long forward position and
is called the long.
The party to the forward contract who agrees to sell or deliver the asset has a short forward position and is called
the short.
 Futures Contracts
A futures contract is similar to a forward contract. Future contract is standardized and
exchange traded. Future contracts are trade in a liquid secondary market, are subject to greater
regulation. Futures are backed by a central clearinghouse and require daily cash settlement of
gains and losses, so that counterparty credit risk is minimized.
Margin – cash or other collateral that both buyer and seller must deposit on a future exchange.
This collateral provides protection for the clearinghouse. At the end of each trading day, the
margin balance in a futures account is adjusted for any gains and losses in the value of the
futures position based on the new settlement price, a process called the mark-to-market or
marking-to-market. The settlement price is calculated as the average price of trades over a
period at the end of the trading session.
Initial margin is the amount of cash or collateral that must be deposited in a futures account
before a trade may be made.
Maintenance margin is the minimum amount of margin that must be maintained in a futures
account. If the margin balance in the account falls below the maintenance margin through daily
mark to market from changes in the futures price, the account holder must deposit additional
funds to bring the margin balance back up to the initial margin amount, or the exchange will
close out the futures position. Futures margin requirements are set by the exchange.
 Example for the Future Exchange calculation
Future contract is signed for 100 kg silver with amount of 60,000 USD. (1 kg=600 USD)
Initial Margin is 1800 USD and the maintenance margin is 1550 USD. Both parties deposit the
initial margin into their accounts.
1st day settlement price falls to 598,5 USD. The seller has gains and the buyer has losses. The
exchange will credit the seller’s account: (600-598.5) x 100 = 150. Seller margin balance increased
to 1800+150=1950
Buyer’s margin balance decreased to 1800-150=1650
2nd day settlement price falls to 597 USD. The seller has gains again. Seller’s account increased
1950+ ((598.5-597) x 100)=150+1950=2100
Buyer’s balance decreased to 1650-150=1500
Since Buyer’s balance is less than the maintenance margin (minimum margin amount) the buyer
must deposit 1550-1500=50 into the margin account to return it to the initial margin amount.
 Futures vs Forwards
Futures contracts differ from forward contracts in the following ways:
- Futures contracts trade on organized exchanges. Forwards are private contracts and
typically do not trade.
- Futures contracts are standardized. Forwards are customized contracts satisfying the
specific needs of the parties involved.
- A clearinghouse is the counterparty to all futures contracts. Forwards are contracts
with the originating counterparty and therefore have counterparty (credit) risk.
- The government regulates futures markets. Forward contracts are usually not
regulated and do not trade in organized markets.

A major difference between forwards and futures is futures contracts have standardized
contract terms. For each commodity or financial asset, listed futures contracts specify
the quality and quantity of assets required under the contract and the delivery procedure.
 Swaps
Swaps are agreements to exchange a series of payments on periodic settlement dates over a
certain time period.
At each settlement date, the two payments are netted so that only one (net) payment is made.
The party with the greater liability makes a payment to the other party. The length of the swap is
termed the tenor of the swap and the contract ends on the termination date.
Swaps trade in a dealer market and the parties are exposed to counterparty credit risk, unless the
market has a central counterparty structure to reduce counterparty risk.
Swaps are similar to forwards in several ways:
• Swaps typically require no payment by either party at initiation.
• Swaps are custom instruments.
• Swaps are not traded in any organized secondary market.
• Swaps are largely unregulated.
• Default risk is an important aspect of the contracts.
• Most participants in the swaps market are large institutions.
• Individuals are rarely swaps market participants.
 Options

An option contract gives its owner the right, but not the obligation, to either
buy or sell an underlying asset at a given price (the exercise price or strike
price).
While an option buyer can choose whether to exercise an option, the seller is
obligated to perform if the buyer exercises the option.
The owner of a call option has the right to purchase the underlying asset at a
specific price for a specified time period.
The owner of a put option has the right to sell the underlying asset at a
specific price for a specified time period.
The seller of an option is also called the option writer.
The price of an option is the option premium.

There are four possible options positions:

1. Long call: the buyer of a call option—has the right to buy an underlying
asset.
2. Short call: the writer (seller) of a call option—has the obligation to sell the
underlying asset.
3. Long put: the buyer of a put option—has the right to sell the underlying
asset.
4. Short put: the writer (seller) of a put option—has the obligation to buy the
underlying asset.
American options may be exercised at any time up to and including the
contract’s expiration date.

European options can be exercised only on the contract’s expiration date.

At expiration, an American option and a European option on the same asset

with the same strike price are identical. They may either be exercised or
allowed to expire.
Before expiration, however, they are different and may have different values.
 Option profits and losses
Suppose that both a call option and a put option have been written on a stock with an exercise price of $40. The current stock
price is $42, and the call and put premiums are $3 and $0.75, respectively.
Calculate the profit to the long and short positions for both the put and the call with an expiration day stock price of $35 and with
a price at expiration of $43.

Answer:
Profit will be computed as ending option valuation – initial option cost.
Stock at $35:
• Long call: $0 – $3 = –$3. The option finished out-of-the-money, so the premium is lost.
• Short call: $3 – $0 = $3. Because the option finished out-of-the-money, the call writer’s gain equals the premium.
• Long put: $5 – $0.75 = $4.25. You paid $0.75 for an option that is now worth $5.
• Short put: $0.75 – $5 = –$4.25. You received $0.75 for writing the option, but you face a $5 loss because the option is in-the-
money.
Stock at $43:
• Long call: –$3 + $3 = $0. You paid $3 for the option, and it is now worth $3. Hence, your net profit is zero.
• Short call: $3 – $3 = $0. You received $3 for writing the option and now face a –$3 valuation for a net profit of zero.
• Long put: –$0.75 – $0 = –$0.75. You paid $0.75 for the put option and the option is now worthless. Your net profit is –$0.75.
• Short put: $0.75 – $0 = $0.75. You received $0.75 for writing the option and keep the premium because the option finished out-
of-the-money.
 Credit Derivatives
A credit derivative is a contract that provides a bondholder (lender) with
protection against a downgrade or a default by the borrower.
The most common type of credit derivative is a credit default swap (CDS),
which is essentially an insurance contract against default. A bondholder pays a
series of cash flows to a credit protection seller and receives a payment if the
bond issuer defaults.
Another type of credit derivative is a credit spread option, typically a call
option that is based on a bond’s yield spread relative to a benchmark. If the
bond’s credit quality decreases, its yield spread will increase and the
bondholder will collect a payoff on the option.
 Advantages of Derivatives
• Ability to change risk allocation, transfer risk, and manage risk
• Information discovery - Derivatives prices and trading provide information
that cash market transactions do not. Futures and forwards can be used to
estimate expected prices of their underlying assets. Interest rate futures
across maturities can be used to infer expected future interest rates and
even the number of central bank interest rate changes over a future period.
• Operational advantages include greater ease of short selling, lower
transaction costs, greater potential leverage, and greater liquidity.
• Improved market efficiency - Low transaction costs, greater liquidity and
leverage, and ease of short sales all make it less costly to exploit securities
mispricing through derivatives transactions and improve the efficiency of
market prices.
 Risks of Derivatives

• Implicit leverage in derivatives contracts gives them much more risk than their cash market equivalents.
Futures margins are typically in the 3% to 12% range, indicating leverage of 8:1 to 33:1. With required cash
margin of 4%, a 1% decrease in the futures price decreases the cash margin by 25%.
• Basis risk arises when the underlying of a derivative differs from a position being hedged with the derivative.
Basis risk also arises in a situation where an investor’s horizon and the settlement date of the hedging
derivative differ, such as hedging the value of a corn harvest that will occur on September 15 by selling corn
futures that settle on October 1. The hedge may be effective but will not be perfect, and the corn producer is
said to have basis risk.
• Liquidity risk when the cash flows from a derivatives hedge do not match the cash flows of the investor
positions. Consider a farmer who sells wheat futures to hedge the value of her wheat harvest. If the future
price of wheat increases, losses on the short position essentially offset the extra income from the higher price
that will come at harvest (as intended with a hedge), but these losses may also cause the farmer to get margin
calls during the life of the contract. If the farmer does not have the cash (liquidity) to meet the margin calls,
the position will be closed out and the value of the hedge will be lost.
• Counterparty credit risk - The seller of an option faces no counterparty credit risk; On the other hand, the
buyer of an option will faces counterparty credit risk. Both the buyer and seller of a forward on an underlying
asset may face counterparty credit risk.
• Systemic risk - Widespread impact on financial markets and institutions may arise from excessive speculation
using derivative instruments. Market regulators attempt to reduce systemic risk though regulation, for
example the central clearing requirement for swap markets to reduce counterparty credit risk.