Derivative Markets - Futures, Forwards, Options, Swaps, Caps and Floor Markets

Plekhanov Russian Academy of Economics

International Economics

DERIVATIVE MARKETS

FUTURES, FORWARDS, OPTIONS,

SWAPS, CAPS AND FLOOR MARKETS

Prepared by: Zagorskaya Ksenia

1. OVERVIEW OF DERIVATIVE MARKET

Derivatives are financial instruments whose value is derived from the value of something else. They generally take the form of contracts under which the parties agree to payments between them based upon the value of an underlying asset or other data at a particular point in time. The main types of derivatives are futures, forwards, options and swaps.

Derivative instruments are used as financial management tools to enhance investment returns and to manage such risks relative to interest rates, exchange rates, and financial instrument and commodity prices. Several local and international banks, businesses, municipalities, and others have experienced significant losses with the use of derivatives. However, their use has increased as efforts to control risk in complex situations are perceived to be wise strategic decisions.

The main use of derivatives is to minimize risk for one party while offering the potential for a high return (at increased risk) to another. The diverse range of potential underlying assets and payoff alternatives leads to a huge range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), bonds, interest rates, exchange rates, or indices (such as a stock market index, consumer price index (CPI) — see inflation derivatives — or even an index of weather conditions, or other derivatives). Their performance can determine both the amount and the timing of the payoffs.

Derivatives are financial instruments whose value is derived from the value of something else. They generally take the form of contracts under which the parties agree to payments between them based upon the value of an underlying asset or other data at a particular point in time. The main types of derivatives are futures, forwards, options, and swaps.

One use of derivatives is as a tool to transfer risk by taking an equal but opposite position in the futures market against the underlying commodity. For example, a farmer will buy/sell futures contracts on a crop from/to a speculator before the harvest since the farmer intends to eventually sell his crop after the harvest. By taking a position in the futures market, the farmer minimizes his risk from price fluctuations.

2. SPECULATION AND ARBITRAGE

Of course, speculators may trade with other speculators as well as with hedgers. In most financial derivatives markets, the value of speculative trading is far higher than the value of true hedge trading. As well as outright speculation, derivatives traders may also look for arbitrage opportunities between different derivatives on identical or closely related underlying securities. Derivatives such as options, futures, or swaps, generally offer the greatest possible reward for betting on whether the price of an underlying asset will go up or down. For example, a person may believe that a drug company may find a cure for cancer in the next year. If the person bought the stock for $10.00, and it went to $20.00 after the cure was announced, the person would have made a 50% profit and have a return on investment of 100%. If he borrowed money to buy the stock in U.S. (in U.S. law the general maximum he could borrow would be $5.00 or half of the purchase price), he would have used only $5.00 dollars of his own money and thus made a 50% profit with a ROI of 100% and, "return on cash employed," or some such description, of 300%. However, if he paid a 1 dollar option premium to buy the stock at 11 dollars, when it shot up to 20 dollars he could have received the difference (9 dollars) and thus make a 45% profit and a return of 90%.

Other uses of derivatives are to gain an economic exposure to an underlying security in situations where direct ownership of the underlying security is too costly or is prohibited by legal or regulatory restrictions, or to create a synthetic short position. In addition to directional plays (i.e. simply betting on the direction of the underlying security), speculators can use derivatives to place bets on the volatility of the underlying security. This technique is commonly used when speculating with traded options. Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings Bank, made poor and unauthorized investments in index futures. Through a combination of poor judgment on his part, lack of oversight by management, a naive regulatory environment and unfortunate outside events like the Kobe earthquake, Leeson incurred a $1.3 billion loss that bankrupted the centuries-old financial institution.

3. TYPES OF DERIVATIVES

3.1. OTC AND EXCHANGE-TRADED

Broadly speaking there are two distinct groups of derivative contracts, which are distinguished by the way they are traded in market:

Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivatives market is huge.

3.2 EXCHANGE-TRADED DERIVATIVES

Exchange-traded derivatives are those derivatives products that are traded via specialized Derivatives exchanges or other exchanges. A derivatives exchange acts as an intermediary to all related transactions, and takes Initial margin from both sides of the trade to act as a guarantee. The world's largest derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), and CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade). According to BIS, the combined turnover in the world's derivatives exchanges totalled USD 344 trillion during Q4 2007. Some types of