Introduction to the Main Derivative Contracts Finance Essay

According to the Bank of International Settlements (1995), a derivative is defined as "a contract whose value depends on the price of underlying asset, but which does not require any investment of principal in those assets. As a contract between two counterparties to exchange payments based on underlying prices or yields, any transfer of ownership of the underlying asset and cash flows becomes unnecessary." Derivatives play a large and increasingly important role in financial markets. Derivatives markets for financial variables were developed back in 1970, and are still dominated by all financial institutions which actively market their products and services to corporate, institutional and government clients. Bodie (2009, pg 671) explains that the value of derivatives is said to be "derived" from other securities. They are also called "contingent claims" due to the fact that their payoffs are contingent on the prices of other securities. Financial institutions use derivatives in order to hedge and speculate assets which are subject to price fluctuations. Forwards, swaps and options are regularly traded outside exchanges by financial institutions and their corporate clients in what are termed the over-the-counter (OTC) market. At the same time futures are actively traded on many exchanges. The derivatives highlighted in this dissertation will fall under four main headings, namely: Forwards, Futures, Options and Swaps.

 Forwards

Forwards are binding contracts between two financial institutions or between a financial institution and one of its clients. Hull (1997, pg.2) explains that when entering into forwards contracts, one of the parties assumes a long position in the contract. This means that the party agrees to buy the underlying asset at an agreed price today at some specific date in the future. At the same time, the other party in question takes a short position as one agrees to sell the same asset at the negotiated price for the same specific date. The forward contract is worth zero when initiated due to the fact that it costs nothing to take either a long or a short position. The party who is in a short position transfers the agreed asset to the party who is in the long position in return for the delivery price. Foreign exchange forward contracts are very popular with banks. This is because they hedge exchange rates to offset any fluctuations in prices of currency. In fact most banks have a "forward desk", within a foreign exchange trading room, to carry out these contracts.

Example of a Forward Contract

Consider a farmer who grows wheat. The entire planting season's revenue depends critically on the highly volatile crop price. The miller who must purchase wheat for processing, faces the same portfolio problem as the farmer. The latter is subject to profit uncertainty because of the unpredictable future cost of the wheat. Both parties can reduce this source of risk by entering into a forward contract binding the former to deliver the wheat at a pre-agreed price, say $100, on a specified date, and say 1st January 2010, regardless of the market price. In other words we can say that the miller has a long forward contract in wheat whilst the farmer has a short forward contract in wheat.

 Payoffs from Forward Contracts

Since both parties agree on a fixed price, when the contract is signed, one of the parties involved will gain whilst the other will lose when the latter is compared to the market price on maturity. Keeping the above example in mind, if the market price on 1st January 2010 is $110, the miller is still allowed to buy the wheat at $100, thus increasing the miller's value by $10. In general, the payoff from a long position in a forward contract on one unit of an asset is St - K Equation : Payoff from a Long Position Where K, is the delivery price and St is the spot price of the asset at maturity of the contract. This equation can also be explained in figure 1, where it clearly shows that as the spot price of the asset increases the payoff for the buyer increases thus, making the value of the buyer even greater.

Futures

A futures contract is also a binding contract between two parties who agree to exchange an asset at a pre-agreed price, called the future's price, which is to be paid on maturity. Again, the trader who commits to purchase the asset on the delivery date takes a long position whilst a short position is taken by the trader who delivers the asset in question. One of the main differences between forwards and futures, noted by Hull (1997, pg 3), is that futures are not traded over-the-counter but through an exchange. Thus, standardised features must be included in order to make trading possible. Another difference, also explained by Hull (1997, pg 3,) is that the two parties do not necessarily know each other due to having an exchange mechanism in between. This exchange provides a guarantee that the contract will be honoured on maturity date.

Specification of the Futures Market

Since future contracts mostly deal with commodities, the exchange must specify in some detail the exact nature of agreement between the two parties. Specifications are mainly found in the following alternatives which are also shown in Appendix 1: - Asset: as we are dealing with commodities, variations in quality may be found. Therefore, the exchange stipulates a benchmark grade in order to classify the quality of the product. Product size: the exchange denotes the exact amount of the commodity that needs to be delivered. Delivery arrangements: these arrangements are very important and are clearly explained by the Chicago Mercantile Exchange Group (CME). The clearing house defines the exact procedure of settlement between the parties. The timeline, obligations for the buyer and seller, delivery costs, payment instructions, etc are all explained in detail to eliminate any misunderstandings. Price quotes: the future's price is quoted in a way that makes it easy to understand for any user. For example on the New York Mercantile Exchange (NYMEX), Natural Gas is quoted in dollars per 10,000 million British Thermal Units (mmBtu). Daily price movement limits: keeping Natural Gas as an example, the minimum and maximum price fluctuations are also given by the NYMEX. In fact this commodity has a $0.001 per mmBtu as a minimum price fluctuation whilst a $3.00 per mmBtu for all months as the maximum price fluctuation. Position limits: an investor can only hold a specified amount of contracts. The CME positions the limit at 1000 contracts per speculator, who cannot receive more than 300 contracts within one month.

Characteristics of the Futures Market

One of the main features of a futures market is that the contract takes place through a broker or an exchange. The latter will require a deposit by both the buyer and the seller. This is a risk-reducing mechanism as the deposit amount serves as an element that bounds both parties not to default. Futures contracts are also valued on a daily basis, thus "marking the market". For example: Day 0 1 2 3 4 5 Total Price $100 $101 $102 $101 $100 $99 Buyer +1 +1 -1 -1 -1 -$1 Seller -1 -1 +1 +1 +1 +$1 Table : Marking the Market On day 1 the buyer makes $1 profit; another $1 on day 2; makes a loss of $1 on day 3; loses $1 on day 4 and finally loses another $1 on day 5. Over the 5 days the buyer lost a $1 from the beginning till the end of the contract whilst the seller gained $1 from the contract. During this period, the accounts of the parties in question were being charged and credited in accordance with the fluctuation in the contract. This is why a futures contract is normally said to be a string of one day forward contracts. Futures contracts must be standardised. They cannot be tailor-made according to the buyer as in the case of forward contracts. Also when entering into futures, the buyer knows that if one wants to purchase corn, the trader would know the common characteristics for each and every commodity. Futures contracts are also very liquid due to the fact that buyers may decide to terminate the contract earlier than maturity by simply selling back the contract to the broker, where the latter will find another trader.

Payoffs from a Future Contract

When the broker provides a full detailed description as to when, where and what will be delivered, the party with the short position, according to Hull (1997, pg 29), sends a "notice of intention to deliver" to the exchange. The price paid is normally the settlement price. The exchange will then select a party with an outstanding long position to accept delivery.

Options

According to Aristotle (1952, pg.453), an option can be described as "a financial derivative which involves a principle of universal application." These contracts have initiated since 1973 when the Chicago Board Options Exchange (CBOE) began listing companies on the national exchange. Bodie (2009, pg 671) states that when these contracts were introduced on the markets they were a huge success, crowding out the previously existing OTC trading in stock options. An option is a different contract to forwards and futures. The differences are summarised by J.P Morgan and Arthur Andersen's as stated in Reynolds (1995) who said "the advantage of options over swaps and forwards is that options give the buyer the desired protection while allowing him to benefit from a favourable movement in the underlying price." Thus options give the right and not the obligation to buy or sell an underlying asset, for a pre-determined price and by a certain date in the future. Since this derivative is based on rights, the holder will not exercise the contract if it is not profitable. In exchange for this right, the holder is bound to pay a premium which would be lost if the contract is not exercised. Nowadays, options are traded on many exchanges all over the world, starting from OTC by banks and also by many other financial institutions. The underlying assets can vary from stocks, stock indices, commodities, currencies, securities in warrants, etc. One major distinction between American and European options is that the former options can be exercised at any time up to the expiry date, whilst the latter options can only be exercised on the date of maturity. There are two types of options which will be explained in the following sub-headings.

Call Options

Willmott (1998, pg 22) defines a call option as "the right to buy a particular asset for an agreed amount at a specified time in the future." A call option can also be divided into a Buy or a Sell call. A buy call is the right to buy the underlying asset at an agreed price today at some agreed day in the future. When considering a sell call, the holder has the obligation to sell the asset, at a fixed price and date, when the buy call holder decides to exercise the call option. If the buy call holder decides that it is better to purchase the asset from the market, the seller of the call will gain the premium paid by the buy call holder.

Swaps

Coyle (2000, pg2) states that swaps were developed in 1979 by major commercial and investment banks to serve as an instrument for debt management and interest rate management. Willmott (1998, pg 419) defines a swap as "an agreement between two parties to exchange, or swap, future cash flows." The exchange is made up of a stream of payments which are pre-negotiated over an agreed period of years. Therefore, the study of swaps, as mentioned by Bodie (2009, pg 804), is a multi-period extension of forward contracts. Thanks to swaps, Oldani (pg 2) explains that new investment opportunities were invented to hedge against any risk and also to speculate.

Types of Swaps

Swaps can be sub-divided into three categories. These are: Equity Swap The two counterparties agree to exchange an amount of payments based on the performance on an equity index. The total return on the index measures this equity component. Commodity Swap In this type of swap both parties exchange cash flows based on commodity prices. One party agrees to pay a floating price based on the commodity's average price over a period whilst the other party pays a fixed price on an underlying quantity of the commodity. Credit swaps Credit swaps are sub-divided into: Currency swaps According to Willmott (1998, pg 424) these swaps are exchanges of interest payments in one currency for payment in another currency. The interest payments swapped can be either fixed, floating or one of each. It is important to note that there may be an exchange of the principal at the beginning and the end of the contract. Consider that two companies, A and B one in US and the other in UK respectively, enter into a currency swap for a principal amount of $50 million. The exchange rate at the date of the currency swap is: $ 1.25 = 1.00 $ 1.00 =  0.80

As mentioned earlier, the firms exchange the principal amounts at both the beginning and end of the year, thus as shown in the following figure, A pays B $ 50 million whilst B pays 40 million. Figure : Currency Swap (a) During the period both parties are assumed to pay interest on the loan to each other. The intervals of when interest payments are specified in the swap agreement, and let us consider that both parties agreed to pay fixed interest rates annually based on the following rates. Dollar-dominated interest rate is 8.25% Euro-dominated interest rate is 3.50% Company A is receiving a euro loan and thus is bound to pay 40 million x 3.50% = 1400000 in interest. Company B is receiving a dollar loan and thus is bound to pay A $ 50 million x 8.25% = $ 4125000 in interest. Due to hedging oneself from future fluctuations in exchange rates, at the termination of the contract, both parties would simply pay back the original principal amounts as shown in figure 10.

Figure : Currency Swap (b) Interest rate swap According to McCaffrey (2009), the most common and simplest swap is the "plain vanilla interest rate swap". These types of swaps call for one party to pay interest at a fixed rate to a second party, whilst the latter pays the former a floating interest rate. In the types of swaps, the two cash flows are paid in the same currency. Muscat (2009, pg 34) explains that the cash flows being exchanged are not exchanged between the two parties, thus there is no need to borrow money. Consider that company A and B enter into a five year swap where A agrees to pay B a fixed rate of 5% on a notional principal of $ 10 million. On the other hand B agrees to pay A floating interest rate of LIBOR = 2 % to A on the notional principal of $ 10 million.

Figure : Interest Rate Swap Both parties agreed to pay interest annually and thus at the end of the year A has to pay B $ 10,000,000 x 5% = $ 500,000 as interest. At the same date the one-year LIBOR rate was 5.7%, thus B has to pay A (5.7% + 2 %) x 10,000,000 = $ 770,000 as interest. In this case in order to eliminate unnecessary transactions, the amounts are off-set resulting B paying $ 22,000 to A only.

 The Black-Scholes Model

Pricing a derivative is relatively hard and complex. In fact many financial economists searched for years for a workable option-pricing model. In 1997, Scholes and Merton shared a Nobel Prize in Economics as they managed to come up with the Black-Scholes pricing formula. With the CAPM as a background, Black (1987, pg 637) said that "I started working on a formula for the value of a warrant. The equation I wrote simply that the expected return on a warrant should depend on the risk of the warrant in the same way that it does for a common stock." The final formula for a call option is: C0 = S0 N(d1) - X e-rT N(d2) Equation : Black-Scholes Pricing Formula Where d1= d2 = d1 - and C0 = current call option value. S0 = current stock price. N(d) = the probability that the random draw from a standard normal distribution will be less than d. X = exercised price. r = risk-free interest rate. T = time of expiration of option. = standard deviation of the annualized continuously compounded rate of return of the stock.

Assumptions of the Black-Scholes Model

The assumptions of the Black-Scholes Model are: Constant volatility: the stock chosen should be stable in constant terms in the short run. Efficient markets: this model suggests that people cannot consistently predict the direction of the market or an individual stock. Sholes and Merton assume that the markets, prices have equal probability of going up or down. This is called Random Walk. No dividends: during the option's life no coupons will be paid out. Interest Rates are known: like volatility, this model also assumes that the interest rate are constant throughout. Such an example can include the risk-free rates such as the rate on a government treasury bill. Log normally distributed returns: the returns are assumed to be normally distributed. European-style options: the model is only based on the European stocks which can only be exercised on the pre-determined date. No commissions and transaction costs: it is assumed there are no fees paid for buying and selling options and stocks and no barriers to trading. Liquidity: markets are assumed to be perfectly liquid. Chapter 3 - Prior Literature about the Use of Derivatives

Regulatory Regime Concerning Credit Derivative Markets

The market of derivatives has undergone rapid growth in the last decade. According to figures issued by the Bank of International Settlements (BIS) report (2009), Over-the-Counter contracts stand at a national amount of $605 trillion up to the end of June 2009, which is 10% more than the previous six month period. Notional contracts are defined as the amount of contractual deals which has not yet been settled up to the reporting date. The question of an adequate regulatory regime which supports for derivative markets comes to mind. Miller (1991) states that regulatory arbitrage enhanced the early activity in derivative markets. In 1992, the United States adopted the Futures Trading Practice Act which triggered growth in the global derivatives markets. This act enabled the derivative markets to be fostered with legal certainty and also allowed the Commodity Futures Trading Commission to issue OTC contracts from the Commodity Exchange Act. The existing regulatory regime is mainly based on self-regulatory initiatives as Ayadi and Behr (2009) explain that the latter could also be seen as "market discipline" as it seeks the standardisation of derivative transactions while at the same time accommodating the instruments' inherent complexity. This was precisely recommended by the Basel Committee in the BIS report on Credit Risk Transfer (2005) where it is stated that "All market participants need to continue paying careful attention to the legal documentation relating to credit derivatives, such as the range of credit events covered by the instruments and the clear and unambiguous identification of the underlying reference. Standardisation should also continue in a market where innovative financial instruments are mushrooming.

Moreover, there is a need for market participants to encourage due diligence necessary to clearly identify their legal responsibilities to the counter party or customer. It is crucial to foster further transparency when marketing structured and complex CRT products. Organisers and dealers should foster a complete understanding of the nature and material terms, conditions and risks involved and should not solely rely on external ratings as a measure of risk associated with the transaction. Before entering in a CRT transaction, investors should ensure their capacity both on the outset and on an on-going basis to obtain the necessary information to properly evaluate and manage the risks associated with their investment. Information on the risk profile of the investment should be accessible to them on a continuous basis." However, it is quite easy to write factors which are aimed at a hybrid regulatory regime but the recent financial crises has led to market disturbances which led to reduced liquidity and ultimately forcing central banks to act as lenders of last resort. This was proven by Elsinger (2008) who stated that JP Morgan's invention of credit derivatives brought about a "$58 trillion elephant in the room" which she believes was the main cause of the autumn wreckage on Wall Street. Derivatives are still essential in the financial system as long as there is the implementation of effective self-regulatory regimes together with strict supervision in order to prevent harmful misusing which would ultimately destruct not only the liquid position of the institution but the universal financial system.

Use of Derivatives in Foreign Countries

The use of derivatives can vary from either speculative purposes which aim for profit maximisation or else for hedging. The aim for the use of derivatives differs according to the nature of the firm as well as the size of the country.

 Use of Derivatives by Foreign Non-Financial Companies

The usage of derivatives plays an important role for non-financial firms. In a study conducted by Guay (2002), it is reported that non-financial firms also make use of derivatives due to the fact that firms also face currency, interest rate and commodity price fluctuations. Though, Guay (2002) also reported that the derivative position held by these firms is relatively small when compared to their overall risk exposure. Guay (2002) also argues that non-financial entities use derivatives only when the benefits exceed the costs, and thus are not used for the primary cause of hedging. Studies such as Judge (2002) investigated various aspects surrounding the use of derivatives by non-financial companies in United Kingdom. The information for this study was collected from the FT UK500, whic includes the largest 500 companies in the United Kingdom. The latter reported that 67% of non-financial businesses have derivative contracts listed on their annual reports whilst 78% responded a yes to the use of derivatives. When comparing these results to United States firms', many studies such as Phillips (1995), Gay and Nam (1998) and Howton and Perfect (1998) all report that more than 60% of non-financial firms in the United States use derivatives. An important point stated by Kedia and Mozumdar (2002), is that hedging practices by United States companies are mainly associated with foreign currency debt. This puts forward the idea that firms make use of strategies to manage risk which can include both on-balance sheet financial and operational policies as well as hedging based on derivatives. Thus as Judge (2002), explains if a company is stating that it does not make any use of derivative contracts it can imply that the firm has managed its exposure through an on-balance sheet method and thus the effect is netted. A paper issued by Brunzell et al (2009), reports that Nordic countries, mainly Denmark, Finland, Iceland and Sweden, potentially have smaller reasons to hedge interest rate risk and exchange rate risk due to their size. Though, the paper reported a 61.6%, which represents the use of derivatives of these Nordic countries, which is ultimately stands in equilibrium to the usage by the larger countries mentioned earlier.

Use of Derivatives by Foreign Financial Companies

Commercial banks are said to enter into derivative contracts in order to hedge thier position. The extent of speculation is more difficult to determine becuase specualtive-type risks may arise from certain dealer activities which may not be reported. Financial companies make up the foundation of the OTC derivative market. This is becuase their derivative desk caters to customers, trading between one another to elimiante risks as well as to be innovative by developing new instruments. As mentioned earlier, the introduction of credit derivatives in the late 1990's brought about a new dimensions in portfolio credit assessment. The principle use of credit derivatives, as noted by Minton et al (2006), is that it enables banks to manage efficiently the credit risk portfolio. This is because they can use these contracts to transfer a part or all of the credit risk to another party. During a speech, Greenspan (2004) stated that "The new instruments of risk dispersion have enabled the largest and most sophisticated banks in their credit-granting role to divest themselves of much credit risk by passing it to institutions with far less leverage." The figures issued by the BIS, mentioned earlier, show that the market of derivatives has experienced a dramatic growth over the past years. This is also in line with what the Comptroller of the Currency Administrator of National Banks report which states that large countries such as the United States hold $203.5 trillion notional amount of derivatives in the second quarter of 2009. This report also proclaims that the largest sector of credit derivatives is in the credit default swap which represents 98%. Wharmby (2005) reports that the United Kingdom has an average daily turnover of $580 billion in OTC derivatives whilst Mallin et al (2001) reports that the United Kingdom is exposed to approximately 60%.

Conclusion

Derivatives are the widest financial innovation of the last thirty years. As seen forwards, futures, options and also swaps can be used by anyone who is interested to hedge risk. With the help of the Black-Scholes Pricing Model investors can price options easily. Though they seem easy to conduct; they are actually complex to maintain. This is why in the following chapters we will be comparing the results obtained from local banks and non-financial companies with what the literature has provided about the amount and the main reasons behind the use of derivatives.

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