Appendix 11 Derivatives

Transcription

1 Appendix 11 Derivatives An aura of mystery surrounds derivatives something to do perhaps with the popular image of the trader as rocket scientist immersed in his cabalistic calculations, poring over equations that cover several pages, or the fact that these products have given rise to their own inscrutable vocabulary of Black Scholes, contangos, pips, puts, naked calls and longs, etc. Indeed these most esoteric of financial products have the reputation of being so complex that they can only be understood by the most intellectually gifted among us: derivatives surely are something for other people, not even for your average financial services practitioner, and certainly not for Compliance Officers! It is true that some derivatives transactions appear alarmingly complex at first sight! But Compliance Officers should not fear it is always worth going back to first principles when things get a little confusing because at a fundamental level, all derivatives products boil down to the following: one person is buying and another person is selling; one person is concerned that prices will rise and the other person is concerned that prices will fall. You do not have to understand the complex maths that might be involved, or even all of the specialized vocabulary used, to understand the above fundamentals of every trade. The three basic types of derivative are: futures / forwards; options; and swaps. No matter how complex a transaction may seem, all are based on one of the above products or a combination thereof. (Warrants are also sometimes classed as derivatives, but strictly speaking they are securities and have been covered in Appendix 8 on equities.) Derivatives are so called because their value is derived from the performance of an underlying asset i.e. an asset traded in the cash or physical market (e.g. the markets in physical commodities, actual shares or FX). Derivatives can be based on many different types of underlying asset, some of the most common of which are: foreign exchange; stock market indices; bonds; interest rates; individual shares; and commodities. 1

2 Some of the commodities most commonly used as the basis of a derivative product are: metals; sugar; oil; gas; electricity grain; coal; and pork bellies. The remainder of this section provides basic information on how some of the most frequently used derivatives work before going on to highlight some of the key issues of which the derivatives Compliance Officer should be aware of. Product Futures and forwards Basic characteristics What is a future? A future is a contract issued by an exchange that constitutes an agreement to buy/sell a set quantity of a given asset; at a prearranged price; on a prearranged date. People who enter into a futures contract are obliged to honour the agreement they have entered into (unlike an option, where one party has a choice as to whether they want to exercise their rights under the contract or not). A person who has bought a future is said to be long the future. A person who has sold a future is said to be short the future. A forward is an OTC contract which is drawn up bilaterally between two counterparties allowing them to implement a bespoke arrangement tailored to their individual needs. It may be structured to mirror a futures contract in all essential aspects, but will be settled directly between the two counterparties. Purpose Broadly speaking futures may be used for four reasons: speculation you expect the value of an asset to rise/fall and you want to make a profit from this anticipated price movement; hedging you are actually long or short a particular asset in the cash or physical markets and you are worried that prices will move against you so you take out a futures contract to protect you from this risk; commercial purposes you will need to buy/sell a particular commodity at a future date and you want to lock in today s known price for the future; or arbitrage you try to identify and take advantage of price inconsistencies between cash market prices and derivatives market prices. 2

3 Who buys futures? Who sells futures? How does a future work? These objectives are essentially the same as those underpinning the use of options. Some examples of basic futures transactions are provided below. Futures are bought by people who believe or are concerned that the price of an asset will rise. Futures are sold by people who believe or are concerned that the price of an asset will fall. Buying or selling a future allows a person to lock in today s futures price for delivery and settlement at a future date: If someone needs to buy an asset at a future date and is concerned that the price of the asset will rise, they will buy a future (initiate a long position in the futures contract that expires closest to the point in time they expect to complete the physical transaction) to enable purchase of the asset at the prevailing futures price, no matter how high prices in the cash market rise. If someone needs to sell an asset and is concerned that prices will fall, they will sell a future (initiate a short position in the futures contract that expires closest to the point in time they expect to complete the sale of the cash position), allowing them to sell their asset at the prevailing futures price no matter how far the price of the asset on the cash market falls. After buying/selling a futures contract a person has two choices: take/ make delivery of the underlying asset, which in reality rarely happens; or cancel out, or offset, their position by taking out an equal and opposite contract, meaning that there will be no delivery of the underlying asset and that only cash will change hands to represent the amount of profit or loss that was made. One of the key elements of the futures market is gearing, also referred to as leverage. As a result of gearing, futures market participants are able to make very large profits or losses on the basis of entering into a contract referenced to underlying assets, without having to make any investment of capital in those assets. Another key feature of the futures market is the use of margin, or collateral. This works as follows: when you take out a futures contract, either buying or selling, you must deposit something called initial margin which is a set percentage of the notional value of the contract (normally quite low, say 5% of the notional value of the position in the contract, to cover one day s expected price movement in the underlying asset); throughout the life of the contract additional variation margin may have to be paid in response to a margin call if the market moves against your position, to serve as collateral for your obligation under the futures contract; if you put up 10 in margin for entering into the contract, you may be required to pay far more on closing it out because the market has moved against you; alternatively, if the market moves in your favour a very large profit may be made in relation to the amount of margin placed on 3

4 deposit (and you will get the initial margin back). To give a more familiar example of gearing, consider the purchase of a house using a mortgage: the house may be worth and your deposit may be with the remaining being borrowed from your bank; if the value of your house rises to 1m you have made a 500,000 profit after having repaid the bank on the basis of an investment of only ; alternatively, if the value of your property falls to zero you will be left with a bank debt of and a capital loss of Risk profile The risks involved with a futures contract can be unlimited as a result of gearing (see above). Being exchange listed, futures involve relatively little counterparty risk as all contracts will normally settle through a clearing house (see Appendix 2) which acts as a counterparty to both buyer and seller. Clearing houses are generally very secure because they have insolvency funds to which all members must contribute. As forwards trade OTC they are generally considered to be more risky than futures because: no clearing house is usually involved so there is greater risk of counterparty default; and OTC contracts are not readily tradable. And there is always the risk that if you buy a tin futures contract, for example, and forget to close it out, you will be looking at taking delivery of a rather large amount of metal! Regulated status under FSMA (RAO) The status of futures under the RAO is not quite straightforward: futures that are entered into for commercial purposes are not regulated; but futures that are entered into for investment purposes are always regulated. Indications that a trade has been entered into for commercial purposes include; prices are individually negotiated between the two parties without reference to standard lot size or delivery dates; there is an intention that physical delivery will take place; one or both of the parties is a producer or end user of a commodity that underlies the transaction. Indications that a trade has been entered into for investment purposes include: the contract is exchange traded; the contract is a look-alike contract designed to mirror an exchange contract. By way of example: a farmer agreeing a future price for grain that he will sell to a food processing business will not be deemed to be trading a regulated contract; a financial services firm trader who speculates that the price of a metal will rise and who opens an exchange traded futures contract 4

5 on the basis of this opinion, with no intention of actually receiving any metal, will be deemed to be trading a regulated contract. Tradability Futures contracts are highly tradable/ liquid and are traded either via screens and phones or by open outcry in the pit of the exchange. Forwards are entered into directly between two parties, are not normally novated (transferred) to other parties and are therefore a largely illiquid investment. However, it is possible for an agreement to be novated to another person if both of the parties to the initial contract agree. Exchange involvement As we have seen, futures trade on exchange whereas forwards are OTC contracts. There are many futures exchanges throughout the world which issue contracts with standard terms. People wanting to participate in the futures market may transact directly on the exchange (normally the preserve of large corporates and financial services firms). People who are able to do this are exchange members. Non-exchange members are able to buy/sell exchange contracts through another entity that does have a clearing membership. Clearing and settlement Futures will clear through the clearing house associated with the exchange they trade on. Forwards are settled directly between the two parties involved. In some instances OTC contracts may be cleared though a clearing house. With futures contracts it is quite common to enter into a give-up agreement for clearing purposes. This happens when a non-exchange member has a futures contract executed on their behalf by an executing broker, and then asks that executing broker to transfer their position or give it up to a clearing broker. Give ups may take place for several reasons, of which the most basic is that the client has a clearing arrangement with one broker but requires execution services from several others. Frequently the customer s investment manager is also involved with a give-up arrangement as it is likely to be the manager who has decided who can best provide its clients with the various services involved in trading futures. In these cases, the investment manager will also be shown as a party to the agreement and for confidentiality purposes the underlying client will only be identified by an account number or other identifier. Evidence of ownership For forwards the contract will be evidenced by means of a confirmation note setting out the details of the trade and signed by both parties. For futures the contract will be documented by means of a notification from the exchange in the form of a daily position summary. Trade reporting A trade report must be sent to the relevant exchange for all futures (exchange only) traded on that exchange. Forwards are not subject to trade reporting requirements. Transaction reporting A transaction report must be sent to FSA for all futures and for 5

6 (to FSA) Documentation forwards whose value is derived from a debt or equity related product that is traded on a regulated or prescribed market. Futures trades are confirmed using confirmations. During the life of a futures contract additional margin may be called and accounted for using a margin statement. Trading relationships that will involve the ongoing use of forwards may be subject to an umbrella OTC derivative agreement such as the: ISDA Master Agreement see Appendix 20; or FOA Master Netting Agreement see Appendix 20. Where a give-up arrangement is involved, then a specific give-up agreement will also be used (see Appendix 20). Pricing Duration Different types of future and forward Nondeliverable forwards (NDFs) Contracts differences for Single stock futures Universal stock futures When a futures contract is entered into it will be referenced to the current futures price, i.e. the price at which the futures contract was executed, for the purposes of determining the initial margin payment. During the life of the future, its mark-to-market value will depend on price movements of the underlying asset: the value of a long futures position will rise in line with a rise in price of the underlying; and the value of a short futures position will rise in line with a fall in the price of the underlying. The minimum amount by which a futures contract may move in price is called a tick and the amount of money represented by a tick is called the tick value. Tick size and value are set by the exchange. Futures contracts have standard maturities usually quoted for monthly expiries in the months immediately forthcoming and subsequently on a quarterly or annual basis. All the futures contracts from a particular series generally mature on similar dates (i.e. the third Friday of the month). Forwards may be for any duration agreed between the two parties involved. With both futures and forwards it is possible to roll over a position so that settlement does not take place at the scheduled date and instead the contract is renewed at maturity. This of course can only happen with the agreement of both parties. Like a standard forward currency contract, except that at maturity the parties settle the fx profit or loss on a net basis rather than exchanging the full currency principal. A contract for difference is a purely synthetic cash settled contract which refers to underlying instruments for reference prices only, with no intention of physical delivery. A single stock future is a future based on the performance of a single company s share instead of an overall index. A Universal stock future is the name for a single stock future issued by EURONEXT.LIFFE. 6

7 Some basic illustrations of how futures contracts work Hedging a long position tin I own tin and I am concerned that the market price of tin will have fallen by the time I want to sell it in the future. So, I decide to hedge my long physical position, and lock in today s futures price, by selling a tin future which matures in 3 months time around the time I want to sell my physical tin. It does not now matter how much the price of tin falls in the physical market because my short futures contract will always increase in value by exactly the same amount. If the price of tin falls, my long physical position will be hedged because my futures contract will have increased in value. Alternatively, if the price of tin rises, I benefit from the rise in value of the physical tin that I own but I incur a loss on the futures contract, which is now trading at a negative mark to market value. By contrast, a future buyer of tin will have the opposite concern that the price of tin may rise and so might hedge this by buying a futures contract equal and opposite to the one I have sold. Seller of tin future The seller of the future (for example a producer of tin) is concerned that the value of the tin he is producing will fall. Thus he decides to go short the number of futures contracts necessary to offset the quantity of physical tin he will be selling. Potential loss: infinite. (In theory there is no limit to how high the price of tin might go, but the futures seller will still be obliged to sell at their contracted futures price.) Any losses on the futures position are offset by the increase in value of the physical position, so that the overall realised price for the physical tin sold will equal the price at which the futures contract was entered into. Buyer of tin future The buyer of the future (e.g. an industrial producer using tin as a raw material) is concerned that the value of tin will rise. Thus to offset his exposure to tin prices he goes long tin on the futures market for the quantity of physical tin he will be purchasing in the future. Potential loss: difference between the tin price on trade date and zero i.e. the price of tin may theoretically fall to zero, but the futures buyer will still be obliged to buy at his contracted futures price. Any losses incurred on the futures position are offset by the lower cost of buying the physical tin in the market. Hedging a long position shares I own a portfolio of the shares the composition of which mirrors that of the FTSE 100, and I think that the value of the index will fall in future. So, I decide to hedge my long position by selling a FTSE future, locking in today s futures price. It does not matter how far the value of the FTSE falls as the mark to market value of my futures contract will increase in direct proportion. - I will settle the futures contract for cash and take the profit to compensate me for the fall in value of my portfolio of shares. Thus the net value of the combined position should mirror the execution price of the futures contract. Alternatively, if the overall values of shares quoted on the FTSE 100 rises, I benefit from the rise in value of my portfolio, but this gain is offset by the losses on the futures contract. By contrast, a fund manager looking to buy a portfolio of FTSE 100 shares at a future date will 7

8 have the opposite concern that the price of shares may rise and so might hedge against a rise by buying a futures contract equal and opposite to the one I have sold. Seller of FTSE The seller of the future is concerned that the value of shares will fall. future Potential loss infinite (in theory there is no limit to how high the index might rise but the futures seller will still be obliged to sell at their contracted futures price.) Any losses are offset by the increase in value of my portfolio of shares, so that the overall net loss/ gain will be nil. Buyer of FTSE future The buyer of the future is concerned that the value of shares will rise. Potential loss difference between the futures index value at execution and zero i.e. the value of the FTSE may theoretically fall to zero, but the futures buyer will still be obliged to buy at his contracted futures price. Any losses are offset by the lower cost of buying shares in the market. Hedging a short position grain I work for a large food manufacturer and I know that in 6 months time I will have to buy a certain amount of grain. I am concerned that the price of grain will rise relative to today s price so I buy a grain future, thus locking in the current futures price. No matter how high the price of grain rises in future, the final purchase price will mirror the price at which I executed my long futures position. If the price of grain does indeed rise I will benefit from a corresponding rise in the mark to market value of my futures contract. Alternatively, if the value of grain falls I will benefit from being able to buy grain at a lower price. However, this gain will be offset by losses on my futures contract. By contrast, the future seller of grain will have the opposite concern that the price of grain may fall and so might hedge by selling a futures contract equal and opposite to the one I have sold. Buyer of grain future Seller of grain future The buyer of the future is concerned that the value of grain will rise. Potential loss: difference between the price of grain on trade date and zero i.e. the value of grain may theoretically fall to zero, but the futures buyer will still be obliged to buy at his contracted futures price. Any losses on the futures position are offset by the lower cost of buying grain in the physical market. The effective purchase price for the grain will be the price at which I executed the long futures position. The seller of the future is concerned that the value of grain will fall. Potential loss: infinite (in theory there is no limit to how high the price of grain might rise but the futures seller will still be obliged to sell at their contracted futures price). This is offset by the increase in value of the physical position, so that the overall net loss/ gain is nil. The realised sales price of the grain will be the execution price of the futures contract. Hedging a short position currency I work for a British importer and I know that I will have to pay for a large delivery from the US in dollars later on in the year even though my operating currency is sterling. I am concerned that the value of the dollar will rise relative to the value of sterling which will 8

9 mean that it will be more expensive to buy dollars with my sterling when the time comes to pay for my delivery. As a result I sell a sterling forward that will effectively allow me to buy dollars at today s forward price, no matter how high the value of the dollar rises. If the price of the dollar does indeed rise I benefit from being able to buy it at the price at which I entered the forward contract. Alternatively, if the price of the dollar falls, I benefit from being able to buy dollars in the cash market at a lower rate. However, I have incurred a loss on my forward position, offsetting the gains from receiving a better rate in the cash market. By contrast, a future US payer of sterling will have the opposite concern that the dollar may fall against sterling and so might hedge this by buying a forward sterling contract against sterling equal and opposite to the one I have sold. Buyer of the sterling forward Seller of the sterling forward The buyer of the forward thinks that the value of the dollar will fall. If the value of the dollar rises, the buyer of the forward position makes a loss. If the value of the dollar falls, the buyer of the forward position makes a profit. Potential loss: difference between the price of sterling on trade date and zero i.e. the value of sterling may theoretically fall to zero, but the forward buyer will still be obliged to buy at his contracted forward price. The buyer of the sterling forward is long sterling, hence by definition short dollars and will benefit from any rise in sterling vs. the dollar. As the US payer of sterling is concerned that the GBP/USD will get stronger, he will hedge his future liabilities with a long sterling forward. The seller of the forward is concerned that the value of the dollar will rise. If the value of the dollar falls the forward seller will make a loss. If the value of the dollar rises, the forward seller will make a profit. Potential loss: infinite (in theory there is no limit to how high the price of sterling might rise but the forward seller will still be obliged to sell at their contracted forward price). The importer is short dollars at a future date. To hedge this, the importer needs a long dollar position. This is achieved by going short the sterling. Any gains from being able to buy dollars at a better rate will be offset by losses from the forward. Trades involving speculation would work in the same way as in the hedging examples above; the difference would be that the person taking out a contract would not have a need to protect a position or a future trade requirement, but would be acting purely on the basis of attempting to make a profit from their forecast of future price movements. Contrast this with an arbitrage trade, which in principle will involve buying and selling short two related instruments at the same time, in an attempt to take advantage of a mispricing observed in one of the two: e.g., a trader might detect mispricings of futures contracts, such that the costs of carry of an index future are set too low: he would then sell short the physical basket of shares mirroring the index and buy futures. The deposit rate earned from investing the cash receipts from the stock sale should exceed the notional amount of the long futures position, enabling the arbitrageur to buy the portfolio back at the futures price and book the difference between the deposit yield and the implied financing rate as profit. 9

10 Differences between futures and options At a basic level futures and options have some major similarities: o both involve significant levels of gearing; o both involve the ability to make a profit regardless of whether the markets are rising or falling; and o both derive their value from an underlying asset. There are, however, some very fundamental differences, of which the most crucial are that: o options create a right for the holder of the contract whereas futures always create an obligation; and o options have a predetermined exercise price, but also an upfront cost called the premium. Therefore an option does not necessarily expose the holder to movements in the underlying market as it can be allowed to expire without being exercised, but at the cost of losing the premium. Futures create a definite obligation on both parties and expose both to risk associated with market movements but by contrast do not require the payment of a premium. Product Options Basic characteristics What is an option? An option is a contract that gives the holder the right but not the obligation to buy or sell an underlying asset at a predetermined price, known as the strike price or exercise price. By contrast the person who sells (or writes ) the option has an obligation to honour the contract if it is exercised by the holder. There are four basic variations of an option contract a person may: write an options contract which gives them the obligation to buy an asset at a future date; write an options contract that gives them the obligation to sell an asset at a future date; buy an options contract giving them the right to buy an asset at a future date; buy an options contract giving them the right to sell an asset at a future date. The price at which the options contract can be exercised (enforced by the holder) is known at the time that the options contract is entered into. An options contract that gives the buyer the right to buy is called a call option. An options contract that gives the buyer the right to sell is called a put option. Purpose Broadly speaking options may be used for four reasons: speculation You expect that the value of an asset or the associated price volatility will either rise, fall or stay the same and you want to make a profit from your belief about future price levels or price action; hedging You are actually long or short a particular asset and you are worried that prices will move against you, so you use options to protect you from this risk; commercial purposes you will need to buy/sell a particular commodity at a future date and you want to control the risk that future prices will 10

11 Who buys options? Who sells options? How does an option work? move against you; arbitrage You try to identify and take advantage of price inconsistencies between cash market prices and derivatives market prices. These objectives are essentially the same as those underpinning the use of futures. Some examples of basic options contracts are provided below. A call option will be bought by a person who believes or is concerned that the future price of the underlying asset will rise. A put option will be bought by a person who believes or is concerned that the future price of an asset will fall. A call option will be sold by a person who believes or is concerned that prices will either fall, or stay the same as they are today. A put option will be sold by a person who believes or is concerned that prices will either rise, or stay the same as they are today. Option buyer After buying an option a person has three choices: to exercise it and take or make delivery of the underlying asset; to sell the option on; or to let the option expire unexercised. An option will always be exercised by the holder if it is in the money, i.e. the spot price of the underlying asset is higher than the strike price (for call options) or the spot price for the underlying asset is below the strike price (for put options). Option seller After selling an option a person has only one course of action open to him in its regard i.e. to wait to see if it is exercised against him. (He may of course hedge himself against the losses associated with this eventuality.) Gearing One of the key elements of the options market is gearing, also referred to as leverage, which means that a huge profit or loss can be made on the basis of a very small initial investment. Option buyers gain exposure to significant movements in the underlying asset in return for payment of a premium equivalent to a small percentage of the value of the assets concerned, and can let their option expire unexercised if the market moves against them. The effect of gearing on option writers is more severe than for buyers because for receipt of the same small percentage they acquire a definite exposure to movements in the underlying. Risk profile The risk profile of an option depends on whether you are the buyer or the seller. The buyer of the option (both calls and puts) has limited risk he pays his premium to buy the option and at the worst, decides not to exercise his rights under the option contract and lets the agreement lapse. The seller of a call option has potentially unlimited risk as, if the option is exercised by the holder, he will be obliged to sell the underlying asset at the exercise price no matter how high its cash market price goes. 11

12 Regulated status under FSMA (RAO) This risk is greatest if the option writer has sold a naked call which means that he does not own the underlying asset he could be called upon to sell an asset at 20 that he has to go out and buy for 1m for example. (Note that if the writer of the option does own the underlying asset, this is referred to as a covered call )- The seller of a put option has limited although possibly extensive risk. If the option is exercised by the holder, he will be obliged to buy the underlying asset at the exercise price no matter how low its cash market price goes. For example, he may be required to buy for 1m an asset that is now worth 20. However, as the cash market price cannot go below zero his maximum loss is restricted to the difference between the exercise price and zero. The regulated status of an option depends on the asset on which the option is based, for example options on the following are designated investments: securities; currencies; gold; and silver. Tradability Options contracts that are taken out with an exchange are highly tradable, either via screens and phones or by open outcry in the pit of the exchange. OTC options that are entered into between two parties are not normally novated (transferred) to other parties and are therefore a largely illiquid investment. However, it is possible for an agreement to be novated to another person if both of the parties to the initial contract agree. Exchange involvement Clearing and settlement There are many options exchanges throughout the world although many contracts are also drawn up bilaterally between two parties. Exchange options contracts will all have standard terms, whereas OTC options contracts can be written to meet the specific needs of the two parties involved. People wanting to participate in the exchange-traded options market may transact directly with the exchange (normally the preserve of large corporates and financial services firms). People who are able to do this are exchange members. Non-exchange members are able to buy/ sell exchange contracts through another entity that does have a clearing membership. If an option is traded on an exchange it will clear through the clearing house associated with that exchange. OTC options are settled directly between the two parties involved. With exchange-traded options contracts it is quite common to enter into a give-up agreement for clearing purposes. This happens when a non-exchange member has an exchange options contract executed on his behalf by an executing broker, and then asks that executing broker to pass their position or give it up to a clearing broker. Give ups may take place for several reasons of which the most basic is that the client has a clearing arrangement with one broker but requires execution services from several others. Frequently the customer s investment manager is also involved with a give-up arrangement as it is likely to be the manager who has decided who can best provide its clients with the various services involved in trading listed options. 12

13 Evidence of ownership Trade reporting (exchange only) Transaction reporting (FSA In these cases, the investment manager will also be shown as a party to the agreement and for confidentiality purposes the underlying client will only be identified by an account number or other identifier. For OTC options the contract will be evidenced by means of a confirmation note setting out the details of the trade and signed by both parties. For exchange-traded options the contract will be documented by means of a daily position statement provided by the exchange. A trade report must be sent to the relevant exchange for all exchange-traded futures. OTC options are not subject to trade reporting requirements. Options transactions are reportable to FSA although there are a number of exceptions. only) Documentation Options trades are confirmed using confirmations. During the life of an option additional margin will be called and accounted for from the option writer using a margin statement. Trading relationships that will involve the ongoing use of OTC options may be subject to an umbrella agreement such as the: ISDA Master Agreement see Appendix 20; or FOA Master Netting Agreement see Appendix 20. Where a give-up arrangement is involved, then a specific give-up agreement will also be used (see Appendix 20). Pricing The price (premium) of an option depends on a number of factors and is notoriously complex. These factors include: price volatility of the underlying asset; time to maturity; exercise price in relation to cash market price; and interest rates. Duration Exchange options have standard maturities. OTC options may be for any duration agreed between the two parties involved. Different types of option There are many variations in option types and characteristics. A few of the most common are described below. European style An option that may be exercised only on expiration date. American style An option that may be exercised at any time between purchase and expiration date. Flex An exchange-traded option with OTC aspects: the strike price is negotiable between buyer and seller Asian style An option that is settled against the average price of the underlying asset during the pricing period of the contract. I.e. an Oct09 ICE Brent option contract entered into in December 2008 would be settled against the average of the daily closing prices of the nearby ICE Brent futures contract prices in October Traditional A London Stock Exchange product which always has an equity as the options underlying. More flexible than traded options as they can be written in relation to any 13

14 quantity of underlying shares, on any listed share and can have a variety of exercise and expiry dates. There is no secondary market. Swaptions Combination of an option and a swap. The buyer of the option obtains the right to enter into a swap at a predetermined swap level. Examples of the four basic types of option are provided below. I write a call I am long a stock whose price is relatively stable, and I do not expect it or the market that it trades in to experience much price volatility in the next few months. In order to extract some benefit from this situation I decide to write an American-style call option, which will allow the option buyer to purchase the stock at a strike price, ideally set just out of the money at any time in the next three months, until the option expires. In exchange I receive a premium which reflects the intrinsic value (or moneyness ) of the option (the difference between the cash and strike price), and the time value of the option essentially the probability that the stock may rise in value and exceed the strike price over the life of the contract. If the price of the stock does go up and I am assigned (i.e. my counterparty, if the option is OTC, or the exchange clearing house if the option is listed, informs me that the option is being exercised), then I can sell the stock I hold to settle the option. If the option is exercised, I will have to sell the stock I hold at the strike price to the option holder and, assuming a rational option holder, I will incur an opportunity loss of selling the stock at the prevailing market price. (This may not be an actual loss, as the price I am obliged to sell at may still be higher than the price at which I bought the stock.) If the market price equals the strike price plus the up front premium (ignoring the time value of money), this will allow me to break even from an opportunity cost point of view. If the price of the stock stays the same or drops, the option will probably not be exercised and I will have benefited from gaining additional income from selling the option. Risk for call writer The share price may exceed the strike/exercise price, in which case the option will be exercised and the writer will have to sell his stock holding for less than its cash market value. Potential (opportunity) loss: infinite. In theory there is no limit to how high the share price might rise yet the option writer will still have to sell my shares at the predetermined strike/ exercise price. As the option writer holds the shares concerned he does not, at least, have to go into the market to buy them at their new price in order to satisfy the option contract. This is called a covered call, i.e. the call and the associated risks are covered by holding the underlying asset which can be delivered against any exercise of the options written against it. Risk for call buyer Limited to the premium paid: the buyer has unlimited potential for upside gain but can lose no more than the premium. He has no obligations. It should be noted that options are risky and levered 14

15 investments for the holder as well, as unlike with stocks, there is a very real probability that the options may be worthless at expiry and thus 100% of the investment is lost. I write a put I have identified a stock whose price is proving to be relatively stable, and I do not expect it or the market that it trades in to experience much price volatility in the next few months. In order to extract some benefit from this situation I decide to write an American-style put option, which will allow the option buyer to sell the stock at a strike price which is below what I consider the minimum level at which the stock will trade at any time in the next 3 months, i.e. before the option expiry date. In exchange I receive a premium which reflects the intrinsic value (or moneyness ) of the option (the difference between the cash and strike price), and the time value of the option essentially the probability that the stock may fall below the strike price over the life of the contract. If the price of the stock does fall and I am assigned (i.e. my counterparty, if the option is OTC, or the exchange clearing house if the option is listed, informs me that the option is being exercised), then I will have to buy the stock to settle the option. If the price of the stock does drop and the option gets exercised, I may still break even if the stock settles at a price level equalling strike price minus the premium received (ignoring time value of money). Thus premium offsets the loss I will incur from buying the stock at a price level above the cash market value. If the stock has dropped lower than I anticipated, I will make a loss on the option. If the price of the stock stays the same or rises, the option will probably not be exercised and I will have benefited from generating additional income in the form of the premium received. Risk for put writer The share price may fall below the strike/ exercise price, in which case the option will be exercised and the writer will have to buy stock for more than its cash market value. Potential loss: the difference between the strike price and zero, less premium received i.e. the put writer may have to buy the shares far above the current market price which could theoretically drop to zero. Risk for put buyer Limited to the premium paid: the buyer has limited potential for downside gain (the difference between strike price and zero) but can lose no more than the premium. He has no obligations. I buy a call I am interested in holding a certain stock but have observed that its price is volatile, and I think that it may be cheaper to buy in a few months time. However I know that it may become more expensive by the same token. So, I buy an American-style call option which will allow me to buy the stock at a certain price at any time over the next 3 months, no matter how high its market price may go. If the stock price does go up in the period then I will probably exercise the option, having paid a premium to have the opportunity to buy below the future spot market price. Risk for call buyer Limited to the premium paid. The buyer has unlimited upside opportunity but no obligations. 15

16 Risk for call writer Unlimited: see above. Theoretically the value of the stock could rise to 1m or more, but the call writer would still have to sell it to the call buyer at the contracted option strike/ exercise price. The risk is increased if the call writer does not own the share in order to sell the share to the call buyer, he may have to go out into the market and buy it at a very high price in order to sell it to the call buyer at a much lower strike/ exercise price. I buy a put I hold shares in a specialized company which I hope will exhibit significant share price growth, but recent reports about the industry in which the company operates make me concerned that the stock will decline in price in the immediate future. However I don t want to sell my shares now in case the company does go on to do well. Therefore, I decide to buy a put option, which will allow me to sell my shares at a certain price over the next 3 months, no matter whether their market price drops to zero. If the stock price does drop sharply, I will be able to sell my shares at the strike price, and if I wish can reinvest in a larger proportion of the share capital of the company in order to benefit if and when it rallies. Risk for put buyer Risk for put writer Limited to the premium paid. The buyer has limited potential for downside gain (the difference between strike price and zero) but no obligations. Limited to the difference between strike price and zero (less premium received): see above ie the value of the share could theoretically drop to zero but the put writer would still have to buy it at the agreed option exercise/ strike price. Product Swaps Basic characteristics What is a swap? A swap is, in economic terms, a kind of future or rather series of forward contracts, but taking the form of a bilateral OTC contract. Under this contract the two parties agree to exchange payments based on the performance of one or more underlying assets. Purpose The original purpose of swaps was literally to allow companies paying out interest on different bases (fixed as opposed to floating for example) to swap their interest rate obligations with each other, so that one company paying fixed rate interest on its borrowings could receive floating rate interest from a counterparty for the same notional amount. Their uses have long since expanded to take in other reference points and prices, for example equities and bonds. Who buys Swaps are bought by firms or individuals looking to benefit from the swaps? upwards performance of a certain benchmark (e.g. a benchmarked interest rate or an equity price) without having to buy the relevant asset outright, or make or buy an appropriate loan. The swap buyer pays to the swap seller a rate of interest (the floating rate) and any downwards performance in the benchmark rate or price concerned. Who sells Swaps are sold by firms or individuals looking to benefit from the 16

17 swaps? How does a swap work? downwards performance of the same benchmark, often to hedge a separate long exposure. The swap seller pays to the swap buyer any upwards performance in the benchmark rate or price concerned. Most swaps perform in a standardized way irrespective of their underlying reference asset: all refer to a set notional amount; at a pre-agreed frequency one party (the buyer) pays a rate of interest and makes or receives payment based on the performance of a reference asset or level of a reference rate; the other party (the seller) makes or receives payment on the reference asset in return for receiving interest from the buyer. Swaps can be transacted to cover a wide range of underlying assets or liabilities. The following are among the most common: interest rate; currency/fx; equity; commodity; cross currency; and credit default swaps (see below section on credit derivatives). Summaries of some of the main variations of the standard swap structure are provided below. Risk profile Swaps are dependent on underlying assets and benchmarks and share the risk profile of these. They also carry counterparty risk in that mark-to-market gains are accrued over time and owed by one party to the other without the involvement of an exchange or clearing house. Swaps are normally reset regularly to prevent the generation of large counterparty credit exposures and to adjust for current prevailing rates of interest on the floating rate side. Regulated status under FSMA (RAO) Tradability Exchange involvement Clearing and settlement Evidence of ownership Trade reporting (exchange only) Transaction Swaps are designated investments under FSMA. Swaps are bespoke bilateral contracts and are not generally tradable. They may be assigned but, being bilaterally cash settled in most cases, do not have a tradable value as such. None, all swaps trade OTC Swaps are usually settled bilaterally between the two parties to the transaction. Some clearing houses offer central counterparty services for swaps even though they have been traded OTC. Examples are LCH.Clearnet s SwapClear service and the Chicago Mercantile Exchange Group s Swapstream service. Written confirmation executed by both parties to the swap. No trade reporting requirement. Transaction reporting to FSA is a requirement for swaps on most underlying 17

18 reporting (FSA assets (exclusions are: interest rates, units, currency). only) Documentation Normally documented under an ISDA Master Agreement see Appendix 20. Some specific domestic-market swap agreements in certain jurisdictions (e.g. Germany) Pricing Normally by reference to the closing market price of the underlying asset. Duration May be of any duration agreed between the parties. Risks for swap Both parties to a swap are exposed to price fluctuation in the underlying asset in buyers much the same way as if they were the owner or short seller of the asset. Risks for swap sellers Benefits for Buyers of swaps gain exposure to upward price movements in the underlying swap buyers Benefits for swap sellers Different types of swap asset without having to own the asset, usually at no up front cost. Sellers of swaps earn a return from the buyer and can offset exposure on their physical positions without renouncing any rights of ownership (eg as a shareholder). Many different kinds of asset or liability can be swapped. A few of the most common types of swap are described below. Interest rate The traditional type of swap where buyer and seller exchange payments based swap on a fixed versus a floating rate of interest. Asset swap A package comprising a bond and a corresponding interest rate swap that converts the cash flows of the bond (typically fixed coupon) to floating rate, usually indexed to a benchmark rate of interest. Total Return An all-in swap which takes into account coupon (for bonds) and dividends (for Swap equity) in addition to market price performance. Relative A swap referenced to two different assets e.g. two unrelated equities or two Performance equity indices. The parties will normally make payments based on the net Swap relative performance of the two assets. I buy a swap I think that a certain stock is going to perform well in the immediate future but have no interest in holding that stock physically for example, I don t want to tie up my capital in the investment, I just want to participate in any performance it experiences. So, I buy a swap from a broker, I make no initial outlay to participate in the performance of the share. I merely pay a rate of interest to the swap seller to compensate him for the costs of covering his position. In addition I pay him any downwards performance on the stock. Risk for swap The performance of the share does not exceed the rate of interest paid to the buyer Risk for swap seller swap seller. The reverse: the share outperforms the rate of interest received from the swap buyer. I sell a swap I am receiving a fixed rate of interest from a borrower but have outgoings referenced to a certain benchmark, the floating base rate (e.g. LIBOR). I want to receive interest at the same variable base 18