Derivative Markets

Derivatives are high leverage contracts that require a small amount of capital to initiate a derivative related contract.

There are two categories of markets where derivatives are created: Exchange-traded derivatives markets and Over-the-counter derivatives markets (OTC).

The OTC contracts are customized contracts, and they are less liquid than exchange-traded derivative contracts. They are also relatively less transparent.

Derivatives can be classified into two main groups: forward commitments, and contingent claims. Forward commitments impose an obligation on both sides of the contract to engage in a future transaction as agreed upon previously, whereas contingent claims give the right but not the obligation to do so.

In brief, forward commitments have the following characteristics:

• They are customized contracts so to suit both involving parties’ needs i.e. grade, time, and place of delivery.
• There is no specific location or address to trade forward contracts.
• Any type of commodities can be traded via forward contracts.

There are three different types of forward commitments: Forward, Futures, and Swaps contracts.

It is an OTC contract in which a buyer and a seller commits each other to do a transaction on a specific underlying asset at a future date at a previously determined fixed price.

Futures contracts are the same as forward contracts except that futures contracts are organized, regulated and managed by an exchange. In other words, futures contracts are standardized.

Unlike forward contracts, futures contracts require the existence of a legally recognized futures exchange that provides, manages and organizes these contracts. On the exchange, not all types of derivatives are allowed, only certain contracts are authorized for trading. Futures contracts can be accessed through both physical locations as well as through an electronic system. The derivative exchange has a mechanism that offers the two parties a guarantee against any default. An organized Exchange has a Clearing house through which it settles daily the losses and gains of futures contracts and protects itself against loss.

While transacting on the futures market, it is required that both involving parties must deposit a minimum sum of money as an initial margin in their margin account, typically less than 10% of the futures price to cover possible future losses.

A swap contract can be defined as an OTC contract between two parties who agree to exchange cash flows on regular dates, where one party pays a variable payment, and the other party pays either a fixed or variable amount calculated on a different basis.

In comparison to futures contracts, swaps contracts are more prone to default risk in the following aspects: First, a performance bond is not required in swaps contracts, whereas a margin is required in futures contracts, and this tends to give swaps slightly more default risk than futures contracts. Second, the counterparty in swaps contracts are generally a commercial or investment bank, whereas in futures contracts the clearinghouse is considered the counterparty and commercial or investment bank are more prone to default than a clearinghouse. Third, futures contracts are daily marked-to-market and the entire gain or loss is settled from day to day, whereas the settlement in swaps contracts are longer payments is longer i.e. six months.

LIBOR stands for London Interbank Offered Rate, which is the floating rate used in swap contracts.

Similar to futures and forward contracts, swap contracts do not require money exchange at the beginning of the contract, the initial value of a swap contract is zero.

A contingent claim is a derivative that provides a buyer of option the right to buy or sell an underlying asset at a price previously agreed upon on a specified future date.

Unlike forward commitment contracts, contingent claims give the holder of the contract the right, not the obligation to buy or sell an underlying asset. Its payoff also depends on the performance of the underlying asset.

Options are contingent claim contracts that provide the right but not the obligation to buy an asset at a specific price at a later date in the future. In other words, the buyer pays a sum amount of money, known as premium, to the writer of a contract to receive the right to either buy or sell an underlying asset at a specific price at a later date in the future.

Call option is the right to buy an underlying asset. It offers unlimited upside return with limited downside risk.

Put option contracts grand their buyers the right but not obligation to sell the underlying asset.

The value of a swap at the start of contract is typically zero, and the swap price is determined through replication. The swap price is simply the PV of all net cash flow payments from the swap. Throughout the life of a swap contract, the value of a swap also changes.

The option-pricing models are mathematical formulas or calculation processes that use certain variables to calculate the theoretical value of an option. In the option pricing models, the output is the theoretical actual value of an option. If the model works well, the market price (option premium) of the option will be equal to its theoretical actual value. Option-pricing models provide us with the fair value of an option.

Knowing the estimate of the fair value of an option, finance professionals could adjust their trading strategies and portfolios. Therefore, option-pricing models are powerful tools for finance professionals involved in options trading. Binomial Option Pricing Model and Black Scholes Option Pricing Model are commonly used models for option pricing.

The simplest method to price the options is to use a binomial option-pricing model. Under the binomial model, we consider that the price of the underlying asset will either go up or down in the period. Given the possible prices of the underlying asset and the strike price of an option, we can calculate the payoff of the option under these scenarios, then discount these payoffs and find the value of that option as of today.

The main variables used in the Black-Scholes model include:

• Price of underlying asset, which is a current market price of the asset
• Strike price, which is a price at which an option can be exercised
• Volatility, which is a measure of how much the security prices will move in the subsequent periods. Volatility is the trickiest input in the option-pricing model as the historical volatility is not the most reliable input for this model
• Time until expiration, which is a time between calculation and option’s exercise date
• Interest rate, which is the risk-free interest rate.