Financial Derivatives: Mechanics of Futures, Swaps, and Options

Introduction to Financial Derivatives

Definition of a Derivative

Financial instruments allow contracting parties to buy or sell an underlying asset at a future date at a price agreed upon at the time of contracting. The underlying asset may be an equity asset, bonds, currencies, interest rates, commodities, and more. The effective purchase is only made on the maturity date and settlement, in some cases by physical delivery and in others by cash settlement for differences between the price originally agreed and that prevailing on the date of settlement or maturity of the transaction.

With these types of derivative instruments, it is possible to act in a leveraged manner since their purchase or sale does not require the availability of funds or liquidity corresponding to the amounts on which they operate, as they represent future purchase or sale commitments on the same asset.

Types of Derivatives

History of Derivative Instruments

Derivatives serve as a way of ensuring prices in the future. Their history dates back to 2000 B.C. in Bahrain, Greece, and Rome. In the 17th Century, Italy, Holland, and Belgium saw the rise of the "LETTRE DE FAIRE" (letter of intent). In 1570, the Royal Exchange was established in London. During the 17th and 18th Centuries, landowners in Osaka, Japan, traded rice. In the 19th Century, wheat trading grew in France and England. In 1848, the Chicago Board of Trade (CBOT) was created for trading wool, grains, salt, wine, coal, and fish. In 1864, the New York Stock Exchange introduced futures on gold. By 1868, contracts were standardized and typified at the CBOT. In 1972, the Nixon government eliminated dollar convertibility, leading to floating rates and CBOT Currency Futures. In 1975, interest rate futures launched on the CBOT. In 1978, the European Options Exchange (EOE) opened in the Netherlands. In 1979, the London International Financial Futures Exchange (LIFFE) was established. In 1985, MATIF (Marché à Terme International de France) launched, followed by SOFFEX (Swiss Financial Futures Exchange) in 1988, and MEFF (Mercado Español de Futuros Financieros) in 1989. In 1990, the DTB (Deutsche TerminBourse), today known as EUREX, was founded. In 1993, the MIF (Mercato Italiano Futures) began. Between 1999 and 2000, various mergers and strategic agreements occurred (ICE, CME, etc.).

Types of Trading Markets

• Exchange-Traded: The Exchange Central Clearing House (CCH) acts as the counterparty on both sides of the transaction. This involves credit risk exposure to the CCH, margins as required by CCH rules, a limited number of standardized products, transparent end-of-day valuation, and simple liquidation.
• OTC (Over the Counter): Private transactions between two parties. These create counterparty credit risk to be managed, with collateral negotiated between the parties. Valuation is based on models using various and sometimes differing assumptions. Negotiated liquidation and early termination are more complex outside of bankruptcy and sometimes skewed within bankruptcy.

Purposes and Uses of Derivatives: Speculation, Hedging, Leverage, Risk transfer, Investment, Exposure to different markets, and changing an asset’s balance sheet character.

Futures and Forward Contracts

A Futures contract obligates a party to buy or sell an asset, commodity, security, or financial instrument (or a basket of them) at a set price on a set date in the future. These are standardized contracts (exchange-traded) that only trade specific contracts supported by the exchange; they are usually cash-settled. Futures carry market risk due to daily re-margining through the exchange.

• Share Future: Obligation to buy/sell a share in the future at a traded price.
• Index Future: Obligation to buy/sell an index (usually settled by difference) in the future at a traded price.

Risks in Futures Trading

1. Market Risk: The main risk is market risk, as the contract is designed to pay the difference between the opening and closing price of the underlying asset. Futures are traded on margin, and the leveraging effect increases this risk significantly.
2. Liquidation Risk: If prices move against an open position, an additional variation margin is required. The Clearing House may call upon the party to deposit additional guarantees due to volatility. In fast-moving markets, this may happen at short notice. If funds are not provided, the Clearing House may liquidate positions at a loss.
3. Counterparty Risk: Because these are Clearing House-traded derivatives, there is virtually no counterparty risk. The relationship between dealers is anonymous. The Clearing House manages potential default through margin requests and daily mark-to-market.

The Central Clearing House (CCH)

The existence of a Clearing House has relevant implications for financial management: 1. Daily profit and loss recognition (daily mark-to-market). 2. Contribution of guarantee margins. 3. Fixed maturities of operations. 4. Elimination of counterparty risk.

Some implications make it difficult to use these as hedging instruments in asset management. The advantage of eliminating counterparty risk faces drawbacks: 1. Requirement of liquidity to respond to possible losses. 2. Limiting the necessary maturities of hedges. Consequently, there is a greater tendency to use OTC forward transactions to hedge exchange rates, interest rates, and raw materials.

Forwards: Currencies and Interest Rates

Forwards are agreements to buy or sell an asset at a specified future time and price, customized between parties and not exchange-traded. They entail credit risk exposure and market risk unless re-margining is negotiated.

• Currency Forwards: These allow parties to fix purchase/sale prices for transactions whose settlement is deferred, eliminating uncertainty in quotations.
• Interest Rate Forwards: A lending/borrowing deal for period X and a borrowing/lending for period Y generates an implied forward rate. Under a non-arbitrage environment, the return from 0 to Y must equal the return from 0 to X reinvested from X to Y.
• Forward Rate Agreements (FRA): Synthetically replicates lending/borrowing deals. There are no principal flows, only cash settlement. An FRA is an agreement for exchanging a fixed rate and a floating rate for a specific period.

Risks in Interest Rate Forwards: 1. Interest Rate Risk: Rates rising when borrowing is needed. 2. Liquidity Risk: The capability of obtaining funding (not hedged by FRA). To hedge multiple periods, one can use a chain of FRAs or an Interest Rate Swap (IRS).

Understanding Financial Swaps

A Swap is a cash-settled OTC derivative between two counterparties to exchange two streams of cash flows. The fundamental purpose is to change the character of an asset or liability on a balance sheet without liquidating it. These are usually subject to ISDA documentation.

Common Types of Swaps: Interest Rate Swaps, Currency (FX) Swaps, Commodity Swaps, Credit Default Swaps (CDS), Equity Swaps, and Total Return Swaps (TRS).

Interest Rate Swaps (IRS)

In an Interest Rate Swap, each counterparty agrees to pay either a fixed or floating rate denominated in a particular currency. Developed in 1981, they alleviate mismatches on capital rates and investment returns. Banks and corporations use them to reduce mismatched exposure or speculate on rate movements. They are highly liquid.

An IRS is a synthetic FRA chain. While they traditionally didn't require guarantees, Credit Support Agreements (CSA) have become standard to mitigate credit exposure through daily mark-to-market. The cash flow is calculated as:

Fixed Rate × Notional Amount × Accrual Factor

Floating Rate × Notional Amount × Accrual Factor

• Buying an IRS: Pay fixed / Receive floating.
• Selling an IRS: Pay floating / Receive fixed.

Uses of IRS: 1. Speculation: Taking bullish or bearish positions with high leverage. 2. Hedging: Neutralizing interest rate risks. 3. Arbitrage: Exploiting pricing imperfections between futures, spot rates, or FRAs.

Currency Swaps (CCS)

A Cross Currency Swap (CCS) involves exchanging periodic interest and principals in different currencies. Unlike an IRS, there is an exchange of principals and exchange rate risk. Categories include:

• Floating Rate Currency Swap (Basis Swap): Exchange of variable interest in one currency for variable interest in another.
• Cross Currency Coupon Swap: Exchange of fixed interest in one currency for variable interest in another.
• Standard Currency Swap: Exchange of fixed interest in one currency for fixed interest in another.

Commodity and Equity Swaps

Commodity Swaps: One party pays based on the change in a commodity's price while the other pays a fixed/floating amount. These are cash-settled; commodities are almost never transferred. They protect users from price swings.

Equity Swaps: One party pays based on the price change of an equity security or index. These are used to gain exposure to equities, avoid transaction costs, or hedge investments. Dividend Swaps are a subset where fixed payments are exchanged for floating amounts equal to dividends paid by a company.

Total Return Swaps (TRS) and Credit Default Swaps (CDS)

Total Return Swaps (TRS): The buyer pays interest on a notional amount of a reference asset and receives the total return (income plus capital gains/losses) of that asset. This allows investment in assets without having them on the balance sheet.

Credit Default Swaps (CDS): The buyer makes periodic payments to the seller for protection against a "Credit Event" (Bankruptcy, Failure to Pay, etc.). If an event occurs, the seller compensates the buyer. CDS are used to hedge credit risk or engage in capital structure arbitrage.

Options: Mechanics and Payoff Structures

An Option gives the holder the right, but not the obligation, to buy (Call) or sell (Put) a security at a set strike price (K) on or before expiration. European Style options are exercisable only at maturity, while American Style can be exercised at any moment.

Payoff Formulas:
Call = Max(0, Underlying Price(S) − Strike Price(K))
Put = Max(0, Strike Price(K) − Underlying Price(S))

Options are also embedded in Convertible Bonds and Structured Notes. They can be traded in OTC markets (carrying counterparty risk), through Clearing Houses (higher liquidity, no counterparty risk), or the Warrants market.

Asymmetry in Options: The buyer has a right (limited risk), while the seller has an obligation (unlimited risk). This is compensated by the Premium. The premium incorporates Volatility, which estimates the movement capability of the underlying asset against the fixed strike price.