- Yair Mark
Today I spend the day in the last of the introductory derivatives training. It went more in depth into the other 3 types of derivatives (future, swap and option).
The main points that stood out for me were:
- This is basically identical to a forward except that it is traded on an exchange
- as it is on an exchange there are mechanisms to mitigate credit risk
- if the future goes up in value the seller has to pay the difference to a margin account
- if the future goes down in value the buyer has to pay this change to a margin account
- when entering into a future the buyer has to put up an upfront maintenance margin
- the buyer can sell the future at any time and the responsibility of paying drops in price go to the new purchaser
- if either party defaults on margin payments there is a margin call. This is where the trader calls them to try get the money. If they cannot pay the future may be closed with repucusions
- another huge difference between this and forwards is that forwards are quoted as yields while futures are quoted as price (they are basically inverse of each other). So if a forward has a yield of 7% then the future would be 100-7 = 93. This is a big difference as you use one to hedge against increases and the other against decreases. So if you are worried that the interest rate will go up you buy a forward to lock the rate in. If you are speculating that it will go down you buy a future
- one of the issues with a future is the margin payments. For example if you are a farmer using this to hedge against crop price fluctuations the margin payments monthly could kill your cash flow before the future can actually save you from severe changes in crop prices
- This is a series of forwards and hence is an OTC derivative.
- There is a buyer and seller which corresponds to the swap legs.
- A leg can be fixed or floating where this refers to a fixed rate or floating (changing) rate respectively.
- The legs can be any combination of fixed and floating so you may have a swap with a fixed to fixed legs, floating to floating legs and fixed to floating legs.
This is calculated for this by calculating the FV for each of the forwards making this up.
There are a number of different swaps. The name of the swap normally indicates what the underlying series of forwards is for example:
- IRS: an interest rate swap will have FRAs or other instruments that are linked to the interest rate.
- OIS: an overnight index swap is linked to banks overnight rate
- This is where the buyer pays an upfront premium which gives them the choice to exercise buying at the agreed option at some point in future
- This is like an insurance plan where you pay the fee upfront.
- Example: An imported knows they will need to buy $100k in 6 months but are worried about currency volatility.
- So they get an option together to fix the Rand Dollar rate at say 11.70.
- In 6 months time if the rand weakens to 12.10 they can exercise this option and will have saved.
- They will have saved more than the difference + the fee they paid upfront.
- If the price went the other way say to 11.50 they don't exercise their option and the most they have lost is the option fee they paid initially.
This is largely based on probability.
- The bank tries to work out the probability that the client will exercise the option within the time frame.
- In a nutshell the higher the volatility in the market, the longer the option tenor and the higher the amount they want to be able to exercise the higher the upfront fee.
- The bank uses this fee to hedge their risk
Individuals managing risk using derivatives
- Do nothing: Individual can do nothing and just pay the floating interest rates
- Fix the rate: If they are worried about the interest rate changing they can fix the interest rate by getting something like a forward/future
- Insurance: If they want insurance that they can get a number of things at a specific rate they would take out an option
Why go through a bank for derivatives instead of do it yourself
- Cheaper: having to worry about hedging yourself can be both costly (if you mess up) and difficult (as most people lack the experience/background)
- Easier: banks do this all the time and therefore have the experience and expertise
- Faster: it is generally faster to get somone who does this all the time to put a derivative together than to do it yourself
Cost of derivative:
- spot price + cost of carrying
- spot price: the price that the underlying instrument is going for at the time of pricing
- Cost of carrying: refers to the different things a bank has to do to hedge the risk of a derivative
Some of the ways banks mitigate risk
- Back to back: the market maker finds another market maker willing to buy the derivative. No risk for the initial bank and they make the fee but nothing else. Risk can = reward
- Fees: for example with options the fee you pay upfront is the key risk mitigating mechanism the bank uses. They work this fee out based on where the market it currently at as well as the probability that the option will be exercised
- They need to work out this probablity as they cannot just simply hold for example the currency related to your option as they will not know when/if you are going to exercise it.