Derivatives

• Forward contract

  A contract between a buyer and seller to exchange an underlying asset at a future date, at a price agreed today

  • Traded Over-the-counter
  • Under ISDA contract rules
• Futures Contract

  Exchange-traded forward, with standardised contract specifications
• Futures vs Forwards:

  Futures:

  • Exchange-traded
  • Standard contract
  • Liquid
  • Low credit risk

  Forwards:

  • OTC
  • Negotiable
  • High credit risk
• Swap

  A contract for difference

  • Traded OTC

  Agreement to exchange a series of cashflows
• Option

  • Buyer and seller have the right to exchange an underlying asset for a pre-agreed price, if they choose
  • Exchange-traded OR OTC
• Clearing Houses

  Clearing houses act for exchange-traded derivatives

  • They act as central counterparties and guarantee the performance of contracts

  Margin: Goodwill deposit (initial margin), or daily marking-to-market of contracts (variation margin)
• Margins

  Clearing houses (intermediaries) make sure that the buyer and seller honour their contracts

  • The margin is the collateral that investors have to pay to cover credit risk
  • The initial margin can be viewed as a good faith assurance that the trader can afford to hold the trade until it is closed
• Trading futures contracts


  A future is a contract between two parties to make / take delivery of:

  • A quantity or quality of a specified asset
  • On a fixed future date
  • At a price agreed today
• Futures

  Buyer - Long

  Seller - Short
• Futures

  Basis = Cash price - Futures price

  • The futures price will decrease as time moves closer to delivery date

  
• Uses of futures contracts

  • Hedging
  • Speculation
• Long bond futures

  For example, to make or take delivery of 100,000 nominal GBP of a UK gilt (high-grade bond issued by the Government)

  • physically delivered at the specified date
  • The actual Government liability delivered can be any security within the specificities of the futures contract

  Cheapest to deliver (CTD) security
• Equity Index Futures

  E.G., FTSE100 future

  Cash difference settled
• Options contracts

  They give the right, but not the obligation, to buy or sell a particular asset, at a particular price, on OR before the specified date
• European-style option

  Can only be exercised AT expiry
• American-style option

  Can be exercised ON or BEFORE expiry
• Long Call

  Go 'long', with a premium paid at the start of the contract.

  • Gives the buyer the right to buy an asset for a specific price at a specific time
• Short Put

  A trader sells the right to sell short the option's underlying asset for a specified price 

  • The seller will benefit from an increase in the underlying price
• Straddle

  A straddle combines a put and a call on the same underlying, with the same expiry and the same strike price
• Strangle

  Combines and put and a call on the same underlying, with the same expiries but DIFFERENT strike prices
• Covered call

  A covered call is where you sell a call against an existing contract, or simultaneously purchases a long on the underlying

  • E.G., an investor is long a share, and sells a call
• Protective put

  Buying a put against an existing long, or purchasing the underlying simultaneously
• Hedging a portfolio

  Number of Contracts needed = Face value of cash exposure / Face value of futures contract

  • Selling contracts to hedge a portfolio, relative to the market, and therefore to Beta
• Options Premiums

  Premiums are paid at the contract start date, to cover the difference between the intrinsic value + time value, and the price

  Total premium = Intrinsic Value + time Value
• Time Value

  Decreases as the option moves closer to maturity

  • Decreases at an increasing rate
• Factors impacting an options premium

  factors which measure how sensitive option premiums are to changes in these factors include Vega (volatility of share price):

  • Delta (cash price)
  • Theta (time to expiry)
  • Vega
  • Rho (discount rate)
• Stock Lending

  Securities temporarily transferred from a lender to a borrower for a fee

  • Borrowers provide lenders with collateral
  • Legal title is transferred to the borrower
• Short selling

  Borrowing securities and selling them, with a promise to buy them back later; hopefully at a lower price
• Contracts for difference

  A financial contract that pays the difference between the open and closing trades

  • Interest rate swaps
  • The exchange of a fixed rate of interest and a variable rate (usually SONIA)
  • E.G,., wanting to remove exposure to a rise in SONIA, so you buy a swap
• Equity Swaps

  A contract for difference

  • One party pays another the return on equities (or an index) in exchange for a fixed return
  • E.G., a fund manager removing equity exposure
• Inflation Swaps

  • Transfer inflation risk
  • Variable rate reset by reference to an inflation index

  An inflation swap is an agreement between two counterparties to swap fixed rate payments on a principal amount, for floating rate payments linked to an inflation index (e.g., CPI)
• Currency Swap

  A transaction in which two parties exchange an equivalent amount of money with each other but in different currencies

  • Loaning each other money, and will repay the amounts at a specified date, and exchange rate

  Used to hedge underlying liabilities in respective currencies
• Convertible Bonds

  Preference Shares

  • Allow investors to convert their holding into a pre-specified amount of equity
  • Generally, these trade at a higher price than equivalent non-convertible bonds, and hence a lower yield

  Conversion Value = Share Price * Conversion Ratio
• Warrants


  Gives the holder the right to buy a certain number of new shares in the issuer at a fixed price

  • So, on exercise, the number of issued shares increases
• Traded options


  Gives the holder the right to buy a certain number of existing shares in the issuer at a fixed price

  • So, on exercise, the number of issued shares does not increase

  generally shorter lives than warrants
• Covered Warrants


  Issued by investment banks

  Call and put covered warrants available
• Credit Derivatives

  Credit default swap:

  • A buyer pays a premium to a seller for protection against bond default
  • If default occurs, the seller receives the bond and pays the face value to the buyer, OR
  • The seller pays an agreed notional principle to the buyer