Class1 Jose Guedes 1

8/3/2019 Class1 Jose Guedes 1

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Jose Correia Guedes Master in Business - FCEE Financial derivatives

Nature of Derivative Securities A derivative security is a security whose

value derives from an underlying

variable;

Frequently the underlying variable is the

price of a traded asset; this traded asset is

referred to as the underlying security, the

underlying asset or the primitive asset.


Examples of underlying assets

Stocks and Stock Indexes;

Bonds and Bond Indexes;

Foreign Exchange Deposits;

Risky corporate debt;

Commodities: Extractive: oil, natural gas, gold, silver,

Agriculture&Forestry: wheat, soybeans, cotton,coffee, orange juice concentrate, pulp,


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Examples of underlying variables that

are not traded assets

Interest rates;

Inflation rates;

Credit ratings and indexes;

Weather conditions (temperature, quantity ofrain,..)

Binary variables associated to the occurrence ofparticular events:

Corporate defaults; Hostile acquisitions attempts;

Mergers;

Natural Disasters.


Examples of derivative securities

Forward contrats;

Future contrats;

Swaps;

Options;

Options on future contracts;

Options on swaps (swaptions); Exotics (derivative structures that cannot be

created from forward contracts plus options) Examples: binary options, barrier options


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1,19,20,54,4Equity linked contracts

8

23,4

27,2

12,8

147,4

248

3

0,06

24,6

0,6

0,1

18,2

47

Notional

amounts

2004

0,15

1,34

0,5

0,03

4,8

9,1

Gross

marketvalue

0,7

1,1

0,7

0,04

5,3

11,1

Gross

marketvalue

43

36,7

52,3

22,8

272

520

8,1

0,1

44,3

1,1

0,2

26,8

80

Notional

amounts

2008

FRAs

Credit Default Swaps

Currency swaps, forwards & forex swaps

Currency options

Interest rate options

Equity index options

Interest rate swaps

Options on interest rates (caps,loors, collars, swaptions...)

Interest rate futures

Currency futures

OTC Instruments

Equity index futures

Exchange-Traded Instruments

Source: BIS (Trillions USD)


What are derivative securitiesused for?

To hedge risk;

To speculate;

To arbitrage disallignments of prices among

related securities;

What is the commonality among the three

possible uses of derivative securities?


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Types of hybrid securities

Hybrids composed of Debtand Derivatives

Debt plus a forward contractDual -currency bondsPetrobonds

Debt plus a swapInverse floating-rate notes Adjustable-rate convertible notes

Debt plus an optionBonds with warrants

Equity warrantsCommodity & foreign exchange warrants

Convertible bonds

Principal indexed to commodity pricesPrincipal indexed to exchange rates(indexed currency option notes)Principal indexed to interest ratesPrincipal indexed to equity indexes

Bonds with indexed principal

S&P index subordinated notes (Spins)Stack index growth notes (Signs)

Option on issuers creditworthinessPuttable and extendible debtLiquid yield option note(LYON)

Option on natural disasterBonds with earthquake puts

Hybrids composed of Debtand Derivatives

Commodity interest-indexed bondsCopper interest-indexed notesSmart notes

Equity interest-indexed bondsSuns

Debt plus a package of options

Packages of interest rates optionsFloored floating-rate optionsStep-up bondsIndex amortising notes

Range notes(corridor or accrual notes)

Inflation rate interest-indexed bonds

Hybrids composed of Equityand Derivatives

Equity plus a swap Adjustable-rate preferred stock

Equity plus an optionConvertible preferredOptions on equity or on equityindex

Equity-linked preferred stockPers/Elks/Decs

Hybrids designed to decomposeequity claims

Prescribed right to income andmaximum equity (Primes)Special claim on residual equity(Scores)Super SharesUnbundled stock units

Other option typesOption on managementbehaviour - puttable stockOption on the outcome oflitigation


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Derivatives are financial weapons of mass destructionWarren Buffet, 2002 Annual Report of Berkshire Hathaway

1993 MetallgesellschaftOil futures trading resulted in losses of 1.3 billion

1994- Orange CountyInvestments in leveraged interest rate products generated losses of up to 1,7 billion USD

1995 - BaringsTrading in Nikkei-index contracts in Singapore & Osaka exchanges resulted in losses of1,4 billion USD, wiping out the banks capital

1998 Long Term Capital ManagementHedge fund with massive positions in derivatives and facing liquidity shortages, takenover by consortium of creditors in a 3,5 billion rescue operation led by the NY FED.

2006 -AmaranthLosses in natural gas futures of up to 6 billion USD. Positions in futures taken over byJPMorgan, Merril Lynch & Citadel at undisclosed prices.

2008 Bear Stearns

Fear of systemic risk stemming from massive positions in Credit Default Sawps (10trillion of notional value), prompted FED to orchestrate purchase of bank by JPMorganand open discount window to investment banks (for the first time ever). Bank lost over10 billion USD in market value within less than 2 months.


Forward Contracts

Contract that stipulates the obligation to buy

(long position) or to sell (short position) a

specific asset (underlying asset), at a

specific future date, for a specific price;

A forward is a zero-sum game: the value of

the long position is always the symmetricalof the value of the short position;

Generally, forward contracts trade in the

over-the-counter market.


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Examples of forward contracts purchase of 5000 ounces of gold @ USS400/oz.,

one year from today;

Sale of 1,000,000 @ 1,5 USS/, 6 months from

today;

return of 4% on a 1,000,000 USD deposit, for a

period of 3 months, starting in 6 months (FRA);

Sale of 1,000,000 barrels of crude @ USD52/barrel, 9 months from today;


How does a forward work?

Two parties - the party who wants to buy at futuredate and party who wants to sell at future date - agreeon a delivery price for the future transaction, suchthat the value of the contract is initially equal to zero.

Hence, when the contract is initiated, no funds haveto be exchanged between the two parties.

Funds are exchanged only at the delivery or maturitydate of contracts, to settle losses and gains.


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Example

On January 5th of 2006 a company purchases S1,000,000 @1,17 (USD/Euro) forward at 3 months, to Bank B;

The company takes a long position in USD and the banktakes a short position in USD;

At maturity date (5th of April of 2006), the spot exchangerate is equal to 0,95:

- the company must pay to the bank (1/1,17)*1,000,000= 854.701 Euros;

- the bank must pay to the company (1/0,95)*1,000,000= 1,052,632 Euros

The settlement of position is in favour of the company: thebank pays to the company 197.931 Euros


Future Contracts

Contracts traded in Derivatives Exchanges(EUREX, Liffe, CBOE-CBOT, COMEX....);

Standardized Contracts: Characteristics of underlying asset;

N of units of underlying assets per contract;

Maturity dates.


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Dow Jones STOXX 50 Futures (FSTX) andDow Jones Euro STOXX 50 Futures (FESX)

Underlying Index: 50 shares, prices weighed for the respective capitalization (it

includes the impact of technical accidents but it excludes the impact on the value

of the shares from conversion of warrants and convertible debt);

Quote Method: points of the index, with no decimals;

Value of the contract: Points of index * 10 Euros;

Expirations: the three nearest months in the cycle March, June, September and

December;

Liquidation at expiration date: financial liquidation on the basis of the price of

reference at expiration, to pay in the first working day after the last day of

negotiation;

Price of reference at the expiration: Arithmetic mean of the values of the indexbetween 11h50 and 12h00 CET of the last day of negotiation;

Tick: 1 point of the index (corresponds to 10 Euros);

Last negotiation days: 3rd Friday of the expiration month;

Margin: 250 points of the index (2500 Euros) per contract;


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Euro-BUND Futures (FGBL)

Underlying Index: National classic long-term bond emitted by the German federalgovernment, with the expiration date between 8, 5 and 10, 5 years and 6% couponrate;

Quote Method: % of the par, with two decimals;

Contract Value: 100000 Euros;

Expirations: 3 nearest months in cycle March, June, September and December;

Liquidation at expiration: the short positions deliver Treasury bonds of the Germanfederal government (Bundesanleihen) with term to maturity between 8,5 and 10,5years and with an aggregate value of emission over 2 billions Euros. The deliveryday corresponds to 2nd working day after the last day of negotiation;

Notification: members of the exchange with open short positions must notify theEUREX, indicating the specific instruments to use for delivery, after the close ofthe negotiation in the last day of negotiation of the contract;

Last day of negotiation: 2 working days before 1st working day from 10th day ofcalendar of the expiration month (inclusive);

Reference Price at expiration: weighted mean per volumes of the prices registeredin last 10 transactions until 12:30 of the last day of negotiation;

Tick: 0,01% (Euros corresponds to 10 Euros);

Margin: 1,6% (1600 Euros) per contract;


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CBOT - gold Transaction Unit: 100 troy ounces;

Tick size: $10 per contract;

Daily maximum variation: $5000 per contract relative to priors day

closing price;

Expiration Months: current month, following two months, plus

February, April, June, August, October and December;

Last day of negotiation: the 4th day before the last working day of the

expiration month;

Types of underlying accepted for delivery: Fine gold in bars of 100

ounces "assaying not less than 995 fineness";

Way of delivery: vault receipt emitted by the receiver entity in NewYork or Chicago duly authorized by the CBOT.

Initial margin per contract: $2,000;

Minimum maintenance margin: 75% of the initial margin.


Clearing House - CH

The purchaser and the seller of a future

contract do not need to know each other.

Once a buy order is matched with a sell

order (through either an electronic trading

platform or a trading pit), the CH takes

over as the counterpart of each of the twotrading parties.


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Investor A(wants to buy n contracts)

Investor B(wants to sell n contracts)

broker is not a member

of exchange

Order to buy

n contracts

broker is a member of

exchange

Order to buy

n contracts

Negotiation system(orders are matched)Order to buy

n contracts

CHbroker is a member

of exchange

Order to sell

n contracts

Order to sell

n contracts

Info. about executed orders

Order executed:

CH buys to B

n contracts

Order executed:

CH sells to A

n contracts


The CH reduces the credit risk faced by investors

trading future contracts: The counterpart to all contracts is the CH;

The CH has financial reserves (the capital of themembers of the exchange) that guarantee theperformance on its contracts;

How does the CH protects itself against creditrisk? The long and the short positions held by the CH

balance each other;

Only authorized agents are admitted to negotiation;

Traders have to keep margin accounts with theexchange;

Positions are adjusted daily.


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Daily adjustment of positions An investor purchases 10 future contracts

on January 11th (CBOT-gold), at a futures

price equal to $365 per ounce, with

expiration in February. The initial margin

is equal to $20,000 ($2,000*10) and the

maintenance margin is equal to $15,000

(75% of the initial margin).


Hypothetical adjustment of position during

the first 6 days of the life of the contract

Day Future Price Cash-flow Balance-MA Additions-MA Withdrawals-MA

1/11 365 0 20,000

1/12 362 -3,000 17,000

1/13 359 -3,000 14,000 6,000

1/14 364 +6,000 26,000 6,000

1/15 365 +1,000 21,000 1,000

1/16 367 +2,000 22,000 2,000

What happens if the investor, on January 13th, refuses to add fundsto his margin account?


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Open interest

Most investors close their positions in futures

before the maturity dates of contracts.

- Why?

- How?

The open interest" consists of the number of

positions that are open (either the sum of all long

positions or all short positions), at a particular

date;

What happens to "open interest" when an investortrades a new contract?


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Can the market be manipulated?

Cornering the marketAn investor "corners the market by simultaneously buying futurecontracts and the underlying asset, and then keeping his position infutures contracts open until the maturity of contracts.

If the available supply of the underlying asset not controlled by the investoris scarce, then the short positions will have to buy the underlying asset (tobe able to deliver it at the expiration date) from the investor at a high

price. In this case, we say that the short positions had been "squeezed".

What it can the stock market make to prevent"cornering"?

- Force the long positions to close its positions;- Suspend negotiation, and force an agreement (between long and short

positions) at a fair price.

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