The derivatives market
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1 Chapter : The derivatives market Study outcomes The objective of this chapter is to provide an overview of the concepts, instruments and participants in the derivatives market with particular reference to South Africa. When you have studied this chapter you should be able to define derivative instruments understand the characteristics of the derivatives market defineand discuss the features and application of forwards, futures, options and swaps list the participants in the derivatives market and understand their roles discuss the risk management of derivatives explain derivatives market information. 1
2 Introduction Overview Financial weapons of mass destruction? Derivatives defined Characteristicsof derivatives markets Participants Risk management of derivatives Published market information Financial weapons of mass destruction? Table.1 Notional outstanding value of global derivatives market (USD trillion) (Textbook page 396)
3 Financial weapons of mass destruction? Table. Number of derivatives contracts traded on global exchanges (in millions) (Textbook page 397) Derivatives defined 3
4 Characteristics of derivatives markets Forwards and futures Options Swaps 4
5 Forwards and futures Definition Forwards versus futures contracts Example of a forward transaction Figure.1 Payoff diagram of a long and short forward position (Textbook page 4) 1, 1, Short position Long position Profit/lo ss,,, 1, 1, 8,7 8,8 8,9 9, 9,1 9, 9,3 9,4 9, 9,6 9,7 9,8 9,9 Price of underlying asset (USD/ZAR) Forwards and futures Examples of futures transactions Hedging Speculating Pricing futures and forwards F..1 F.. F..3 Box.1 Basis Contango and backwardation
6 Options Figure. Payoff diagram for a long call option (Textbook page 46) Profit/lo ss Strike price R Breakeven R Price of underlying asset 1 Figure.3 Payoff diagram for a short call option (Textbook page 47) Options Profit/lo ss Strike price R Price of underlying asset 1 6
7 Figure.4 Payoff diagram for a long put option (Textbook page 47) 3 Options Profit/lo ss 1 1 Strike price R Price of underlying asset Figure. Payoff diagram for a short put option (Textbook page 48) Options 1 Profit/lo ss -1 1 Strike price R Price of underlying asset 7
8 Options Table.3 Effects of changing market conditions on the value of options (Textbook page 48) Swaps Interest rate swaps Figure.6 Hedging interest rate risk (Textbook page 49) Asset 7,% Company Alpha 6,% Six-month JIBAR plus credit Ban k Debt liability spread Six-month JIBAR plus credit spread 8
9 Swaps Currency swaps Hedging exchange rate risk Figure.7 Hedging exchange rate risks (Textbook page 411) America n parent compan y Exchange of principal USD 1 million Interest receipt of 3% on USD 1 million Re-exchange of principal USD 1 million Ban k Exchange of principal ZAR 1 million Interest payment of 8% on ZAR 1 million Re-exchange of principal ZAR 1 million South African subsidiar y Swaps Reducing the cost of financing Table.4 Borrowing rates of Alpha and Beta (Textbook page 41) 9
10 Figure.8 Reducing the cost of financing (Textbook page 41) Swaps Exchange of principals Borrows R7m at 6,4% Debt 3,4% mark et Borows USD7m at Compan y Alpha USD7 m R7 m Ban k USD7 m R7 m Compan y Beta 6,4% p.a. ZAR Exchange of interest Debt mark et 3,4% p.a. USD Compan y Alpha 3,% p.a. USD 6,4% p.a. ZAR Ban k 3,4% p.a. USD 6,7% p.a. ZAR Compan y Beta Equity swaps Hedging equity positions Figure.9 Hedging equity positions (Textbook page 4) Equity portfoli o ALSI return Collective investme nt scheme 8,9 % ALSI return Ban k Gaining entry to foreign markets Benefiting from market imperfections 1
11 Other derivatives Exotic derivatives Credit derivatives Weather derivatives Insurance derivatives Derivatives instruments and leverage Figure.1 Use of leverage impact on position payoff files (Textbook page 416) Profit/loss in rand Futures market position (1 x leverage) Cash market position (no leverage) Market price in rand Table. Use and effect of leverage (Textbook page 417) 11
12 Participants Hedgers Speculators Arbitrageurs Risk management of derivatives Table.6 Historic derivatives trading losses (Textbook page 419) 1
13 Published market information Table.7 Published market information for derivatives (Textbook page 41)
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