R45 Derivative Markets and Instruments

Part 1

1. Derivatives: Introduction, Definitions, and Uses

This reading covers what is a derivative, why derivatives are needed, the different types of derivatives and how they are priced.

Derivatives: Definitions and Uses

A derivative is a financial instrument that derives its value from the performance of an underlying asset. In simple terms, a derivative is a legal contract between a buyer and a seller, entered into today, regarding a transaction that will be fulfilled at a specified time in the future. This legal contract is based on an underlying asset.

A derivative contract defines the rights of each party involved. There are two parties participating in the contract: a buyer and a seller.

• Long: Buyer of the derivative is said to be long on the position. He has the right to buy the underlying according to the conditions mentioned in the contract.
• Short: Seller of the derivative is said to be short. Remember “s” is for short and seller.

Let us take an example. Assume A is planning a family vacation to Fiji after six months and is saving money for the trip. He estimates he will need 15,000 Fijian dollars (FJD) which in today’s terms translates to 500,000 in his local currency (LCR). But he is worried that FJD may appreciate, and the 500,000 will buy less FJD after six months. So he enters into a contract with B to buy 15,000 FJD at a certain exchange rate six months from now – a week before his travel. What has A done?

In a way, he has removed any uncertainty with respect to exchange rates in the future and limited his risk. This agreement between A and the other party is a derivative where the underlying is the exchange rate. The value of the contract fluctuates based on the underlying exchange rate. A is long, and the party that agrees to deliver 15,000 FJD six months later is short on the position. This agreement is shown in the exhibit below.

Derivatives are sometimes compared to insurance as they offer protection against something. Like insurance, they have a value based on what they are protecting (usually the asset), a definite life span, and an expiration date.

Risk management is the process by which an organization or individual defines the level of risk it wishes to take, measures the level of risk it is taking, and adjusts the latter to equal the former. Derivatives are an important tool for companies to manage risk effectively.

2. The Structure of Derivative Markets

In this section, we look at the characteristics of exchange-traded and over-the-counter markets. The exhibit below shows the structure of the derivatives market.

2.1 Exchange-Traded Derivatives Markets

Derivatives traded on exchanges are called exchange-traded derivatives. Examples include stock futures, currency futures. The exchange is the intermediary between the long and short parties. It takes an initial margin from both the parties as a guarantee.

Exchange-traded derivatives are standardized. To standardize a derivative implies that the contract is bound by terms and conditions, and there is little ability to alter those terms. The contract clearly specifies when it can be traded, when it will expire, what is the lot size, a minimum amount, and settlement price. There is no room for customization. The only aspect not defined is the price. The price is determined by the buyers and sellers. For example, a gold contract on CME defines its quality (995 fineness), contract size (100 troy ounces), how it will be settled (physical), and so on.

The advantages of standardization are as follows:

• Liquidity: Standardization boosts liquidity as there is no ambiguity, unlike an OTC market. All market participants are aware when a particular currency/stock future will trade and when it will expire.
• Clearing and settlement process: Standardization facilitates in clearing and settlement. After the trade is executed, the clearing and settlement process kicks in. The flow of money and securities does not happen directly between the investors, as you can see from the diagram below. Instead, it flows through a third party called the clearinghouse. Clearing is the process by which the clearinghouse verifies the execution of the transaction and the identity of the participants. Settlement refers to the process in which the exchange transfers money from one party to another, or from a participant to the exchange or vice versa.

• More transparent: The presence of a clearinghouse makes the whole process transparent and minimizes the impact of default between the parties. All the information regarding prices, settlement, and daily turnover is disclosed within exchanges and clearinghouse which means there is a lack of privacy and flexibility.
• Credit guarantee: It goes without saying that one party loses while the other wins in a derivative contract as it is based on the performance of the underlying. Clearinghouses guarantee that the winning party gets paid by requiring participants to post a margin (cash deposit) called margin or performance bonds, and uses these deposits to make a payment in the event of default.

2.2 Over-the-counter Derivatives Markets

Unlike an exchange-traded derivative, OTC contracts are negotiated directly between two parties without an exchange. The characteristics of OTC markets are as follows:

• OTC market comprises an informal network of dealers, typically banks, linked electronically. These are also called dealer markets.
• Contracts are customized as per the client’s needs.
• Unlike an exchange-traded system where the clearinghouse guarantees settlement, OTC derivatives have credit risk. Each party bears the risk that the other party will default.

The key differences between exchange-traded and OTC markets are summarized below:

Market Makers

Market makers can operate in both exchange-traded and OTC markets. The market makers make money through the bid-ask spread. For instance, if party A wants to take a long position, the market maker will take the opposite position, i.e., a short position. The market maker will then look for another party, suppose B, with whom the market maker will take a long position. In other words, the market maker will sell to party A and buy from party B. The overall effect is cancelled out, and no matter what happens to the underlying, the market maker is covered.  The bid amount will be lesser than the ask price, and the difference between both will generate a profit for the market maker.

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