CA. Adithya Kiran F.C.A. C.F.A (U.S.A), CCO (IIBF).

DERIVATIVE MARKETS AND INSTRUMENTS

A. Types of Derivatives
1. A derivative is a financial instrument that offers a return based on the return of some
other underlying asset. A derivative contract is a way of offering insurance against
financial losses. Accordingly, derivatives must have low transaction costs, otherwise
they would not exist. In fact, the most likely reason derivative markets have
flourished is that they have relatively low transaction costs.

2. Exchange-traded contracts have standard terms and are traded on a futures exchange
or an options exchange. They are created, authorized and traded on a exchange. They
are regulated by the exchange and government.

3. Derivatives can be classified into two categories: Forward Commitments and

Contingent Claims.

4. Forward Commitments consists of exchange-traded contracts (Futures) and over-the-

counter contracts (Forwards and Swaps). A swap with a single payment is equivalent
to a forward contract.

5. Unlike in case of forwards, with futures contracts, profits and losses are charged and
credited to participants accounts each day. For forward contracts, losses accumulate
until the end of the contract.
Forwards and Futures also differ in their ability to engage in offsetting
transactions. Forward Contracts are generally designed to be held until expiration.
However, a party can engage in opposite transaction prior to expiration. In such a
case the risk is eliminated, but both transactions remain in place and are subject to
default. On the other hand, the reversal of futures position completely eliminates
any further financial consequences of the original transaction.

6. Options:
a) Option premium is sometimes known as the option price.

b) Seller of any type of option is not subject to the buyer defaulting.

c) Convertible bonds offer the holder an option like feature that enables the holder
to participate in gains on the market price of the corporation’s stock without
having to participate in losses on the stock.

d) More advanced options are often referred to as exotic options.

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e) Deregulation of exchange rates lead to market for forward contracts in foreign

currencies.

f) The commercial and investment banks that make markets in derivatives transactions
are called derivative dealers.

B. MEASURE OF THE SIZE OF DERIVATIVES MARKET

1. Futures and options exchanges influence their own volume by designating a
contract’s size.

2. For the OTC derivatives, notional principal is the most widely used measure of
market size. It can give a misleading impression by suggesting that it reflects the
amount of money involved. Deliberate tactics designed to make the industry look
larger calls for increased scrutiny of the industry by the government authorities.

3. Market value indicates the economic worth of a derivative contract and represents
the amount of money that would change hands if these transactions were
terminated at the time of the report. Nonetheless, market value is subject to greater
errors in estimation and thus is a less reliable measure than notional principal.

4. Primary function of future markets: Price discovery

a) With geographically dispersed markets, many different spot prices could exist for
assets. In the futures markets, the price of the contract with the shortest time to
expiration often serves as a proxy for the price of the underlying asset. Futures
price substitutes for the uncertainty of the price. When exploring the pricing of
derivative contracts, they improve the market efficiency for the underlying asset.

b) Options do not so much reveal prices as they reveal volatility.

c) In short derivative markets serve:

i. Price discovery.
ii. Risk management.
iii. Making markets more efficient.
iv. Lowering transaction costs.

5. Risk Management: Hedging or Speculation

 Risk management is a process of identifying the desired level of risk and

determining the actual level of risk, and altering the latter to equal the former.

 Hedging refers to reduction in risk or elimination of risk.

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 All one needs to hedge or speculate is a party with opposite beliefs or opposite risk
exposure.

 Though hedgers are somehow seen as on the high moral ground than speculators,
there need be very little difference between hedgers and speculators.

 Market value of a fixed rate loan is more volatile than a floating rate loan.

6. Criticisms of derivative markets

a) Much of the criticism has stemmed from a failure to understand the

complexity of derivatives.

b) By providing a means of managing risk, derivatives make financial markets

work better. Organized gambling does not, however, make society function
better, and it arguably incurs social costs.

7. Principles of Derivative Pricing

a) The principle that no arbitrage opportunities should be available is often referred

to as the law of one price.

b) Prices are set to eliminate the opportunity to profit at no risk with no

commitment of one’s own funds.

c) Eliminating arbitrage opportunities requires that participants be vigilant to

arbitrage opportunities. Without participants watching closely, prices would
surely get out of the line and offer arbitrage opportunities.

d) Markets in which arbitrage opportunities are either nonexistent or are quickly

eliminated are relatively efficient markets.

The combined actions of many investors engaging in arbitrage results in rapid price
adjustments that eliminate arbitrage opportunities, thereby bringing prices back in line
and making markets more efficient.

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FORWARD MARKETS AND CONTRACTS

1. Introduction
The buyer is often called the long and the seller is often called the short.

2. Delivery & Settlement

a) The choice of delivery or cash settlement is not an option available at expiration.

It is negotiated between the parties at the start.

b) Cash-settled contracts are more commonly used in situations where delivery is

impractical. They are known as NDF’s or non-deliverable forwards.

3. Default risk.

a) Neither party pays money at the start. The parties might require some collateral
to minimize the risk of default.

b) Regardless of whether the contract is for delivery or cash settlement, the

potential exists for a party to default.

c) Forward contracts are structured so that only the party owing the greater amount
can default.

4. Termination

a) To avoid the credit risk, an offsetting contract can be entered into with the same
counterparty with whom original contract is entered.

b) The termination of offsetting with the same party is desirable, even if the parties
might get better terms from another counterpart. If the offsetting contract is
entered into with the same counterparty, the party owing the greater amount
pays the market value to the other party, resulting in the elimination of the
remaining credit risk. If such an offsetting contract is entered into with other
party, both original and new transactions will be in place, thereby leaving both
transactions subject to credit risk.

5. Dealers

a) They are called as wholesalers of risk (buyers and sellers).

b) They are ready to take either side of the transaction, quoting a bid and ask price.

c) They do not want to hold the exposure. Rather they find another party to offset
the exposure with another transaction.

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d) They use their technical expertise, vast network of contracts, their access to
critical financial market information to provide a more efficient means for end
users to solve a risk management problem.
They may lose money on some standard transactions, hoping to make up losses
on more-complicated, nonstandard transactions, which occur less frequently but
have higher bid-ask spreads.

6. Equity forwards.

a) They can be used on individual stocks, specific stock portfolios or stock indices.

b) Portfolio of a high-net-worth individual may be concentrated in a small number

of stocks (family stocks or stocks of self promoted companies).

c) As entering into a separate forward contract on each stock requires more

administrative costs, a manager may enter into a contract on the overall
portfolio, by providing a list of the stocks and number of shares of each stock to
the dealer and obtains a quote.
A portfolio of options is not the same as an option on a portfolio, but a
portfolio of forward contracts is the same as a forward contract on a portfolio,
ignoring administrative costs.

d) Whosoever wants to protect the value of their portfolio and to eliminate the risk
for which a particular index is a sufficiently accurate representation of the risk
they want to eliminate, may enter into a forward contract on that index. A
forward contract on a widely accepted benchmark would result in a better price
quote. It is a good way to manage the systematic risk. Index contracts are nearly
always cash settled.

e) Equity forward contracts typically have payoffs based only on the price of the
equity, value of the portfolio, or level of the index. They do not ordinarily pay
off any dividends paid by the underlying stocks. An exception is that some
forwards on indexes are based on total return. The variability of the prices is so
much so greater than the variability of dividends that managing price risk is
considered much more important than worrying about the uncertainty of
dividends.

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7. Bonds vs. Equity forwards.

a) Like stocks, a bond (other than ZCB) may pay a coupon.

b) Unlike a stock, a bond matures. Therefore, a forward contract on a bond must

expire prior to the bond’s maturity date.

c) Unlike stocks, bonds may have special features such as calls and convertibility.

d) Unlike a stock, a bond carries a risk of default. A forward contract written on a

bond must contain a provision to recognize how a default is defined, what it means
for the bond to default, and how default would affect the parties to the contract.

8. Bonds for forward contracts.

a) The primary bonds for which forward contracts are considered shall be default-free
ZCB’s typically T-Bills.

b) In case of such bonds the interest is deducted from the face value in advance,
which is called discount interest.

c) 360 days convention is used to calculate the interest.

d) T-Bill is usually traded by quoting the discount rate not the price. Price for $1 face
value of a bill would be, price = 1- (Discount rate/360)*Tenure of the bill.

e) A government issued ZCB typically have no default risk and reinvestment risk.
However, if the bond is liquidated before maturity, some market value risk exists
in addition to the risk associated with reinvesting the market price.

9. Forward rate Agreement:

a) It is a forward contract in which one party, the long, agrees to pay a fixed interest
payment at a future date and receive an interest payment at a rate to be
determined at expiration. The notion of 3 x 9 (three by nine) implies that the
contract expires in three months and the underlying rate is based on 6 months
which expires 9 months from the date of entering into the contract.

b) The underlying is neither a bond nor a deposit but simply an interest rate.

c) The parties identify the rate at expiration.

d) The contract actually pays the difference between the actual rate that exist in the
market on the contract expiration and the agreed-upon rate at the initiation of the

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contract, adjusted for the tenure of the underlying and multiplied by the notional
principal and also discounted with the underlying rate at expiration.
FRA Payoff = Notional Principal { [ (A-B)*(C/360) ] / [ 1+A(C/360)] }
Where,
A = Underlying rate at expiration.
B = Forward contract rate and represents the rate the two parties agree will be paid.
C = Days in underlying rate and refers to the number of days to maturity of the
instrument on which the underlying rate is based.

The negative payoff implies gain to the short position and loss to the long position.
When the party expects a cash inflow and expects a fall in rates, may take short position.
In such a case, the gain on the contract will offset the reduced interest rate that can be
earned when rates fall. The long position gains when the interest rates increase.

e) Non-standard instruments are called off the run.

f) FRA market is large, but not as large as the swap market. A swap is a special
combination of FRA’s.

10. LIBOR.

a) Eurodollar is a dollar deposited outside the US.

b) Eurodollar is a time deposits, which are essentially short-term unsecured loans

borrowed by one bank from another bank.

c) The rate on such loans is called LIBOR.

d) Although there are rates for both borrowing and lending in the financial markets, the
lending rate called the LIBOR is commonly used in derivative contracts.

e) LIBOR is considered to be the best representative rate on a dollar borrowed by a

private, high-quality borrower.

f) Like the T-bill, interest is quoted using 360 days convention. In contrast to the T-bill
market, the interest is added to the face value and is called as add-on interest.

g) The British Bankers Association publishes a semi-official Eurodollar rate, compiled

from an average of the quotes of London Banks.

h) The Eurodollar instrument described has nothing to do with the European Currency
known as the euro. Eurodollars, Euroyen, Eurosterling, have been around longer than
the euro currency.

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i) Euro-euro is a euro denominated loan in which one bank borrows euros from another.
Two rates on such euro deposits are EuroLIBOR compiled in london by BBA and
Euribor compiled in Frankfurt and published by the ECB.
11. Currency forwards have been evolved due to relaxation of government controls
over the exchange rates.

12. Other forward contracts may be based on commodities (oil, precious metal),
sources of energy (electricity or gas) or on weather in which the underlying is a
measure of the temperature or the amount of disaster damage from hurricanes,
earthquakes, or tornados. They are difficult to understand, price and trade.

FUTURES MARKETS AND CONTRACTS

1. A futures transaction is reported (except the identity of the parties) to the futures
exchange, clearing house and at least one regulating agency. The price is recorded
and available from the price reporting services and even on the internet.

2. In a futures contract, the price is the only term established by the two parties; the
exchange establishes all other terms including the underlying and the mode of
settlement (Cash or delivery).

3. There can be four specifications as to expiration dates i.e., month, how far the
expirations go out into the future, day of expiration and the timing of trading.

4. The exchange also decides on the price quotation unit. For example, Treasury bond
futures are quoted in points and 32nds of par of 100.

5. The ability to trade a previously opened contract allows participants in futures

market to offset the position before expiration, thereby obtaining exposure to price
movements in the underlying without the actual requirement of holding the
position to expiration.

6. MTM results in paper gains and losses being converted to cash gains and losses
each day. It is also equivalent to terminating a contract at the end of each day and
re-opening it on the next day at the settlement price.

7. Because of the ability to offset, futures contracts are said to be fungible, which
means that any futures contract with any counterparty can be offset by an
equivalent futures contract with counterparty.

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8. Margin in the stock market is quite different from margin in the futures market.
Unlike in the stock market, both the buyer and the seller of a futures contract must
deposit margin.

9. Other names for margin in the futures market are good faith money, collateral or a
performance bond.

10. In the securities market, margin requirements are normally set by federal
regulators. In futures markets, margin requirements are set by the clearing houses.
Unlike in securities markets, futures margins are expressed in dollar terms and not
as a percentage of the futures price.

11. In spite of the differences in margin practices for futures and securities markets,
the effect of leverage is similar for both. However, given the tremendously low
margin requirements of future markets, the magnitude of leverage effect is much
greater.

12. The traders in futures market can withdraw funds in excess of the initial marginal
requirement. Virtually all professional traders are able to deposit interest-earning
assets, although many other account holders are required to deposit cash. If the
deposit earns interest, there is no opportunity cost and no obvious necessity to
withdraw money to invest elsewhere.

13. Price limits are usually set as an absolute change over the previous day.

14. There are three forms of delivery viz., closeout, cash settlement and physical
delivery. If the contract terminates in delivery, the clearinghouse selects
counterparty, usually the holder of the oldest long contract, to accept delivery.
Parties usually prefer a closeout or cash settlement over physical delivery because
of the transaction costs of delivery. In case of physical delivery the short has the
sole right to make decisions about what, when and where to deliver. The right to
make these decisions is known as delivery option.

15. In an Exchange for Physicals (EFP) transaction, the parties settle their contract
outside of the exchange’s normal delivery procedures, which would be satisfactory
to the exchange.

16. If a contract is designated as cash settlement, it implies that the buyer of the
contract never intended to actually take possession of the underlying asset. Some
legislators and regulators feel that this design is against the spirit of the law, which
views a futures contract as commitment to buy the asset at a later date.

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17. In a futures exchange shareholders are its members. Memberships are called as
seats. Each member acts as either a floor trader or a broker. Floor traders / locals
are market makers standing ready to buy and sell by quoting a bid and ask price.
Futures Commission Merchants (FCM’s) execute transactions for other parties off
the exchange.

18. There exist three distinct styles of trading by locals. Scalper holds position for only
a brief period of time, perhaps just seconds. A day traders closes all positions at the
end of the day. A position trader holds positions overnight. While the latter two
attempts to profit from the anticipated direction of the market, scalpers attempt to
profit by buying at the bid price and selling at the higher ask price.

19. Each trader is required to have an account at a clearing firm. The clearing firms
are the actual members of the clearing house. The CH deals only with its members,
who in turn deal with individuals and institutional customers.

20. Treasury bill features:

a) International Monetary Market index (quoted price) is represented as 100 – rate

priced in to the contract. Actual price (A) = B [100 - (C * D/360)].

Where,
B = Face value of the contract,
C = Rate priced into the contract
D = Tenure of the contract

b) Each basis point move is equivalent to $25.

c) The minimum tick-size is one-half basis points or $12.5.

d) While the rates on T-bills are considered to be heavily influenced by US

government policies, and Federal Reserve monetary policy, Eurodollar contract
reflects the interest rate on a dollar borrowed by high-quality private borrower.

e) T-bill futures as well as Eurodollar time deposits settle in cash rather than
physical delivery.

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21. Eurodollar Futures:

a) The final settlement price is the official rate quoted on a Eurodollar time deposit by
the British Bankers Association (BBA).

b) While interest on Eurodollar time deposit is computed on an add-on basis to the

principal, interest is deducted from the principal in computing the futures price.

c) The minimum tick size for Eurodollar futures is 1 basis point or $25.

d) Eurodollar futures expire on the second business day on which London banks are
open before the third Wednesday of the month and terminate with a cash
settlement.

e) The expirations of Eurodollar futures go about 10 years, a reflection of their use by

OTC derivatives dealers to hedge their positions in long-term interest rate
derivatives.

22. Intermediate and Long-Term Interest rate futures contracts.

a) T-bill and Eurodollar futures are short-term futures contracts. T-notes and T-bonds
futures are intermediate and long-term futures contracts respectively.

b) Unlike in the case of Eurodollar time deposit, the identity of the underlying is not
clear in case of a futures contract on a long-term T-bond. This futures adds an
element of uncertainty to the pricing and trading of this contract. Complexity creates
opportunities for gain for those who understand what is going on and can identify the
cheapest bond to deliver.
It has to be noted that unlike long-term bond futures, there is an exact
specification of the underlying in case of intermediate term government bond
futures.

c) The choice that short can deliver whatever bond he chooses from among the eligible
bonds gives the short a potentially valuable option and puts the long at a
disadvantage.

d) To reduce the confusion as to the underlying, the exchange declares a standard or

hypothetical version of the deliverable bond, which has a 6% coupon. If the short
delivers a bond with a coupon greater than 6%, the short receives an upward
adjustment to the price paid for the bond by the long. The adjustment is done by
means of a device called the conversion factor. The amount the long pays the short at
expiration is the contract price multiplied by the conversion factor. Adjustment shall

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also be made for the accrued interest, as the custom in US bond markets is that the
quoted price does not include the accrued interest.

e) When making the delivery decision, the short compares the cost of buying a given
bond on the open market with the amount she would receive upon delivery of that
bond. If the former exceeds the latter, there will be a loss to the short. The bond that
minimizes this loss is referred to as the cheapest to deliver bond.
Determining the amount received at deliver is straightforward; it equals the
futures price times the conversion factor. To determine the amount the bond would
cost at expiration, forward price of the bond positioned at the delivery date shall be
calculated. Forward calculation gives a picture of circumstances as they currently
stand and identifies which bond is currently the cheapest to deliver. As time passes
and the interest rates change, the cheapest to delivery bond can change.

f) These futures expire on the 7rh business day preceding the last business day of the
month and call for actual delivery.

g) Prices are quoted in points and 32nds.

h) The minimum tick size is 1/32.

i) Intermediate and long-term bonds give the best indication of the long-term default-
free interest rate.

23. Stock Index Futures Contracts.

a) The quoted futures price is multiplied by the multiplier to produce the actual price.

b) The contracts expire on the Thursday preceding the third Friday of the month.

c) Given the impracticability of delivering a portfolio of the stocks in the index

combined according to their relative weights in the index, the contract is structured
to provide for cash settlement at expiration.

d) Virtually every developed country has a stock index futures contract based on the
leading equities of that country.

24. Currency Futures Contracts.

a) They are referred to as the first financial futures contracts, and their initial success
paved the way for the later introduction of interest rate and stock index futures.

b) Compared with forward contracts on currencies, currency futures contracts are

much smaller in size.

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c) Because of the large number of Yen per dollar, the Japanese yen futures price is
quoted without two zeros that ordinarily precede the price. E.g., 0.008205 is quoted
as 0.8205.

d) The specific expiration is the second business day before the third Wednesday of
the month.

e) They call for actual delivery through book entry, of the underlying currency.

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