Derivative Instrument and Derivative Market Features

This reading defines derivatives, their basic features and their uses, and compares exchange-traded derivatives with those traded over the counter. A candidate must be able to compute the payoff of a forward to each side, distinguish hedging from speculation and deliverable from cash-settled contracts, and contrast exchange-traded and OTC markets, including the role of central clearing.

LOS 70.a — What a derivative is and its basic features

A derivative is a contract whose value comes from (is derived from) the value of something else at a specified future date. That something else is the underlying: most often a stock or bond price, a stock or bond index, or an interest rate, but also a currency, a commodity, credit, or even the weather, a cryptocurrency or longevity.

Every derivative contract spells out four basic features:

The forward price is normally chosen so that the contract is worth zero to both parties at initiation, and neither side pays anything to enter it.

Long and short exposure

• The buyer of a forward agrees to buy the underlying. She has long exposure and gains when the spot price at settlement is above the forward price.
• The seller agrees to deliver the underlying. He has short exposure and gains when the spot price at settlement is below the forward price.
• One side's gain equals the other side's loss (a zero-sum outcome before costs).

Because neither side pays anything to enter the contract, this payoff is also each party's profit or loss on the forward.

• If the spot price at settlement is $74, the buyer pays $300\times 62=\$18,600$ for shares worth $300\times 74=\$22,200$ and gains $\$3,600$. The seller loses $\$3,600$.
• If the spot price at settlement is $50, the buyer loses $300\times (62-50)=\$3,600$ and the seller gains the same amount.

Deliverable versus cash-settled

• A deliverable contract requires the underlying to be exchanged for the contract price at settlement.
• A cash-settled contract exchanges only the net gain or loss: the losing side pays $|S_T-F|\times \text{size}$ to the winning side. With a settlement price of $50 in the example above, the buyer pays the seller $\$3,600$ in cash instead of paying $\$18,600$ for shares worth $\$15,000$. Ignoring trading costs, the two methods are economically the same.

Hedging versus speculating

• Hedging: a party with an existing risk uses a derivative to offset it, fully or partially. A holder of shares who sells them forward locks in the sale price.
• Speculating: a party with no existing exposure takes one on through the derivative, which increases its risk.
• A useful rule for hedgers: take the derivative position now that matches the trade the party must make later in the cash market. A firm that will receive foreign currency will have to sell it, so it sells the currency forward. A firm that must pay foreign currency buys it forward.

Why use derivatives instead of a cash market trade?

• Exposure can be obtained with little cash, so the position is highly leveraged.
• Transaction costs can be much lower than for the equivalent cash trade.
• Entering the position may move the price of the underlying less than an equivalent cash trade would.

Underlyings and the main derivative types

A higher interest rate benefits the buyer of an interest rate forward but hurts the buyer of a bond forward, because bond prices fall when rates rise. Commodities may be hard (mined or extracted, such as gold and oil) or soft (grown, such as coffee and cattle). Currency forwards are quoted as price currency per unit of base currency: USD/EUR 1.10 means one euro costs 1.10 US dollars. The long side agrees to buy the base currency (here, euros) at the forward rate and pays the price currency; the short side sells the base currency.

The main derivative types are forwards, futures, options and swaps. A call option lets its buyer purchase the underlying on a later date at a price set today, with no obligation to do so; a put option gives its buyer the same kind of right to sell. In a plain interest rate swap, the two sides exchange periodic payments on the same notional amount: one pays a fixed rate, and the other pays a floating rate set from a market reference rate (MRR). The fixed-rate payer is in effect borrowing at a fixed rate to hold a floating-rate bond. In a credit default swap, one party makes fixed periodic payments, and the other pays only if the issuer of the underlying credit instrument defaults.

LOS 70.b — Derivative markets: exchange-traded versus OTC

Exchange-traded derivatives

Futures, some options and some other derivatives trade on organized exchanges; the largest by trading volume are the National Stock Exchange of India, B3 (Brazil) and CME Group (United States). The exchange writes standardized contracts (size, underlying, dates) and the rules of trading. Exchange members (market makers or dealers) mainly earn the bid–ask spread rather than speculating.

The central clearinghouse (CCH) steps in between the two traders and becomes the buyer to every seller and the seller to every buyer (novation). It therefore guarantees that each side's obligations will be performed. To back that guarantee, it collects deposits from both sides when a trade opens and further deposits when a position loses value, which keeps counterparty credit risk very low.

Standardization makes exchange contracts more liquid, more transparent and cheaper to trade, and it makes it easy to exit a position by taking an offsetting one. It also simplifies clearing (recording the trade and handling payments) and settlement (final delivery or payment at maturity).

Over-the-counter (OTC) dealer markets

Forwards, most swaps and some options are customized contracts that dealers create in a market with no central trading venue, the over-the-counter (OTC) market. Size, underlying, settlement date and delivery method can be tailored, and the trade can be kept private. Without a central clearinghouse, each side bears the other's counterparty credit risk. Dealers trade with end users and also with each other to lay off their exposure to price changes in the underlying.

Since 2008, a central clearing mandate has required many swaps to be cleared through a central counterparty (CCP). Trades reported on a swap execution facility (SEF) are replaced by two trades with the CCP. This lowers counterparty risk but concentrates it in the CCP.

OTC trades that fall under the central clearing mandate have lower counterparty risk and more disclosure, but they remain customizable dealer contracts.

Exam convention: exchange-traded derivatives are standardized, liquid, transparent and margined through the clearinghouse, while OTC derivatives are customized, less transparent, largely unregulated, not subject to collateral deposit requirements and carry more counterparty risk. Current practice: trading outside a CCP does not mean trading outside regulation or without collateral. Bilateral collateral is set by the contract and the counterparties, and for many covered counterparties uncleared-swap margin rules require both initial and variation margin.