Trading and Pricing Financial Derivatives

A Guide to Futures, Options, and Swaps

Patrick Boyle, Jesse McDougall

• Publisher: De|G Press
• Year: 2018
• ISBN:
  9781547401215
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Trading and Pricing Financial Derivatives is an introduction to the world of futures, options, and swaps. Self-study investors who are interested in deepening their knowledge of derivatives of all kinds will find this book to be an invaluable resource. The authors delve into the history of options pricing; simple strategies of options trading; binomial tree valuation; Black-Scholes option valuation; option sensitivities; risk management and interest rate swaps in this immensely informative yet easy to comprehend work.

Using their vast working experience in the financial markets at international investment banks and hedge funds since the late 1990s and teaching derivatives and investment courses at the Master's level, Patrick Boyle and Jesse McDougall put forth their knowledge and expertise in clearly explained concepts. This book does not presuppose advanced mathematical knowledge and is designed for a general audience, suitable for beginners through to those with intermediate knowledge.

Chapter 1

Introduction to Derivatives

A financial derivative is an economic contract whose value depends on or is derived from the value of another instrument or underlying asset. Derivatives are categorized by the relationship between the underlying asset (the “underlying”) and the derivative such as a forward, option, or swap1); the type of underlying asset (such as equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives, or credit derivatives); the market in which they trade (such as exchange-traded or over-the-counter); and their pay-off profiles.

Derivatives can be used for speculative purposes or to hedge. A speculator is a trader who is taking positions with the goal of making a profit. A hedger is a trader who already has an economic exposure who takes an offsetting position (a hedge) in order to reduce a risk they already have exposure to. Very commonly, companies buy currency forwards (agreements to make trade a currency exchanges at a future date) in order to limit (hedge against) losses due to fluctuations in the exchange rate of two currencies, this is an example of hedging. Third parties sometimes use publicly available derivative prices as educated predictions of uncertain future outcomes, for example, the likelihood that a corporation will default on its debts.

The Uses of Derivatives

Derivatives are used by investors for the following purposes:

–Hedging or mitigating risk in an underlying. By entering into a derivative contract whose value moves in the opposite direction to their underlying position, hedgers aim to reduce their risk.

–Speculate and make a profit if the value of the underlying asset moves the way they expect.

–Obtain exposure to an underlying where it is not possible to trade in the underlying (e.g., weather derivatives).

–Provide leverage, such that a small movement in the underlying value can cause a large difference in the value of the derivative.

–Define their risk—traders can use options to give them quite defined risk exposures, such as setting a maximum loss for a position.

–Tailored exposures—derivatives traders can take positions that profit if an underlying moves in a given direction, stays in or out of a specified range, or reaches a certain level.

Derivatives Underlyings

There are numerous underlyings for derivatives available right now, and new ones are being developed every year.

–Equities of companies listed on public exchanges, such as General Electric, Citigroup, or Vodaphone.

–Fixed income instruments, such as government bonds, corporate bonds, credit spreads, or baskets of mortgages.

–Commodities, such as gold, oil, silver, cotton, or electricity.

–Indices, such as the FTSE 100, Hang Seng of Hong Kong, or Nikkei of Japan.

–Foreign exchange.

–Weather, such as the average temperature at a defined location or the amount of rainfall.

–Events, such as football games or shipping catastrophes.

Derivatives Market Participants

Hedgers

Hedgers are often producers or consumers of an underlying. They can be companies that are required to typically have exposure to particular underlying in the normal running of their businesses. Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another. For example, a corn farmer and a cereal manufacturing company like Kellogg’s could sign a futures contract to exchange a specified amount of cash for a specified amount of corn in the future. Both parties have reduced a future risk, and thus are hedgers. Both parties reduce their exposure to sudden variations in the price of corn which could materially affect their respective businesses.

Another example would be if a corporation borrows a large sum of money at a specific interest rate and that interest rate resets every six months. The corporation is concerned that the rate of interest may be much higher in six months. The corporation could buy a derivative called a forward rate agreement (FRA), which is a contract to pay a fixed rate of interest six months after purchase on a pre-agreed upon notional amount of money. If the interest rate after six months is above the contract rate, the seller will pay the difference to the corporation, or FRA buyer. If the rate is lower, the corporation will pay the difference to the seller. The purchase of the FRA serves to reduce the uncertainty concerning interest rates and stabilize earnings. This allows the company’s management to make better long-term business plans.

Speculators

Speculators are usually individuals who seek exposure to risky assets with the aim of making a profit. They are often pension plan managers, insurance companies, or asset management companies. Financial speculation can involve trading (buying, holding, selling) and short-selling of stocks, bonds, commodities, currencies, collectibles, real estate, derivatives, or any valuable asset to attempt to profit from fluctuations in its price irrespective of its underlying value. Many texts attempt to differentiate the concept of speculation from investing, but for this text a speculator and investor are the same thing. They are individuals or companies who take a derivatives position with the goal of profiting from it, rather than with the goal of reducing their risk or hedging their exposure. In the derivatives markets, the ratio of hedgers to speculators is constantly changing and will vary significantly based upon the type of derivative and type of underlying. In most markets however, speculators are both more numerous and trade higher volumes than hedgers.

Arbitrageurs

Arbitrage is the practice of taking advantage of a price difference between two or more markets. It usually involves the simultaneous purchase and sale of an asset, the profit being the difference between the market prices. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time. When used by academics, an arbitrage is a transaction that involves no probability of a negative cash flow at any point in time and a positive cash flow in at least one state—in simple terms, it has the possibility of a risk-free profit at zero cost. In industry the term arbitrage is more loosely used, often by marketers to describe trading strategies that in no way meet these standards. For the purposes of this book we will be using the academic definition, as this concept is extremely important as you will see later as a theoretical underpinning of almost all of our derivatives pricing methods.

Arbitrage is possible when one of three conditions is met:

1. The same asset does not trade at the same price on all markets (“which would be contra to the law of one price”).
2. Two assets with identical cash flows and identical risk do not trade at the same price.
3. An asset with a known price in the future does not today trade at its future price discounted at the risk-free interest rate (or, the asset does not have negligible costs of storage—for example, this condition holds for commodities but not for securities).

Arbitrage is not simply the act of buying a product in one market and selling it in another for a higher price at some later time. To be considered a genuine “arbitrage,” the offsetting transactions must occur simultaneously to avoid exposure to market risk, or the risk that prices may change on one market before both transactions are complete. In practical terms, this is generally possible only with securities and financial products that can be traded electronically. Even then, as each leg of the trade is executed, the prices in one of the venues may have moved. Missing one of the legs of the trade, and subsequently having to trade it soon after at a different price, is called “execution risk” or “legging risk.” In practice, true arbitrages, risk-less, costless profitable opportunities, almost never occur, and any trading strategies that uses the term “arbitrage” is referring to near-arbitrage, or quasi-arbitrage situations, where the risk of financial loss is ultimately borne by the traders.

Middlemen

Middlemen are usually investment banks, market makers or brokers. They trade derivatives with the goal of earning either a commission or the bid-ask spread between customers undertaking opposing positions. A broker is an individual or brokerage firm that arranges transactions between buyers and sellers, and gets a commission when the deal is executed. A market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the difference—the bid-ask spread. These market participants typically are not aiming to accurately predict or profit from movements in the price of the underlying, they just aim to profit from the commission or spread. While in the ordinary running of their businesses they can end up holding a position which causes a profit or loss, they typically aim to avoid this and will usually hedge any residual exposures they are left with, if possible. Middlemen benefit from churn, a high volume of activity, in markets rather than from accurate directional positioning of their portfolios.

How are Derivatives Traded?

There are two groups of derivative contracts, which are distinguished by the way they are traded in the market: Over-the-counter derivatives and exchange-traded derivatives.

Over-the-counter derivatives (OTC)

Over-the-counter derivatives are contracts that are traded directly between two parties, without going through an exchange. Products such as swaps, forward rate agreements, exotic options—and other exotic derivatives—are typically traded in this way. The OTC derivatives market is the largest market for derivatives. The OTC market is largely made up of banks, large corporations, and other highly sophisticated parties. Knowing the size of the OTC market is not easy as trades can occur in private, without the activity being visible on any exchange. According to the Bank for International Settlements, the total outstanding notional amount of OTC derivatives is US$532 trillion as of June 2017. Of this total notional amount, approximately 67% are interest rate contracts, 8% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are classified as “other.” Because OTC derivatives are not traded on an exchange, there is no central counter-party. Thus they are subject to counter-party risk, the risk of one party defaulting at settlement or closure of the contract, like any ordinary legal contract. Despite the complexity risks of OTC trading, most transactions are quite standardized, with standardized documentation.

There is a large push from governments and financial regulators, post-2008, to bring a sizeable proportion of the OTC markets onto “clearing” platforms. Controllable, transparent, and measurable market flows with clearinghouses providing trade completion assurance to all counterparties adds to overall financial stability.

Exchange-traded Derivatives

Exchange-traded derivatives are those that are traded via a specialized derivatives exchange such as the CME group or Eurex Exchange. A derivatives exchange is a market where standardized contracts that have been defined by the exchange are traded. A derivatives exchange acts as an intermediary to all related transactions, and takes margin payments from the customers who trade with them to act as a guarantee. According to the Bank for International Settlements, the combined turnover in the world’s derivatives exchanges totaled $8,989 billion in June 2018. Some types of derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments such as convertible bonds and/or convertible preferred stock may be listed on stock or bond exchanges. Warrants or rights may be listed on equity exchan...