Derivative securities are
financial contracts that ‘derive’ their value from cash market instruments such as stocks, bonds, currencies and commodities.
Derivative security (Ingersoll, 1987).
A financial con- tract is a derivative security, or a contingent claim, if its value at expiration date T is deter- mined exactly by the market price of the under- lying cash instrument at time T.
Types of derivative securities
- Futures and forwards.
- Options.
- Swaps.
Main groups of underlying assets
Stocks
- claims to “real” returns generated in the production sector for goods and services.
Currencies
- Liabilities of governments or, sometimes, banks.
- They are not direct claims on real assets.
Interest rates:
- Are not assets.
- A notional asset needs to be devised so that one can take a position on the direction of future interest rates.
- Futures on Eurodollars, Derivatives on bonds, notes, and T-bills.
Indexes
- These are not “assets” themselves.
- But derivative contracts can be written on notional amounts and a position taken with respect to the direction of the underlying index.
Commodities:
- Soft commodities: cocoa, coffee, and sugar.
- Grains and oilseeds: barley, corn, cotton, oats, palm oil, potato, soybean, winter wheat, spring wheat, and others.
- Metals: copper, nickel, tin, and others.
- Precious metals: gold, platinum, and silver.
- Livestock: cattle, hogs, pork bellies.
- Energy: crude oil, fuel oil, and others.
Cash and carry markets
One can therefore easily build an alternative to holding a forward or futures contract on these commodities.
- One can borrow at risk-free rates (by collateralizing the underlying physical asset),
- buy and store the product, and
- insure it until the expiration date of any derivative contract.
- Gold, silver, currencies, and T-bonds
Pure cash-and-carry markets
- Information about future demand and supplies of the underlying instrument should not influence the “spread” between cash and futures (forward) prices.
- This spread will depend mostly on the level of risk-free interest rates, storage, and insurance costs.
- Any relevant information concerning future supplies and demands of the underlying instrument is expected to make the cash price and the future price change by the same amount.
Price discovery markets
- It is physically impossible to buy the underlying instrument for cash and store it until some future expiration date.
- Goods either are too perishable to be stored or may not have a cash market at the time the derivative is trading.
- Contract on spring wheat. When the futures contract for this commodity is traded in the exchange, the corresponding cash market may not yet exist.
- Cash-and-carry market strategy is not applicable
- Any information about the future supply and demand of the underlying commodity cannot influence the corresponding cash price. Such information can be discovered in the futures market.
Expiration date
The relationship between F(t), the price of the derivative, and S(t), the value of the underlying is known exactly (or deterministically), only at the expiration date T.
Forward
A forward contract is an obligation to buy (sell) an underlying asset at a specified forward price on a known date.
Forwards vs Futures
- Futures are traded in formalized exchanges.
- The exchange designs a standard contract and sets some specific expiration dates.
- Futures exchanges are cleared through exchange clearing houses, and there is an intrincate mechanism designed to reduce the default risk.
- Marked to market. Every day the contract is settled and simultaneously a new contract is written. Any profit or loss during the day is recorded accord- ingly in the account of the contract holder.
- Forwards are custom-made and are traded over-the-counter.
Repo
Repurchase agreement
- is a transaction in which one party sells securities to another party in return for cash
- with an agreement to repurchase equivalent securities at an agreed price and on an agreed future date.
- The difference between the repurchase price and the original sale price is effectively interest which is referred to as the repo rate.
- The buyer of the security acts as a lender and the seller acts as a borrower.
- The security is used as collateral for a secured cash loan at a fixed rate of interest.
- A repo can be seen as a spot sale combined with a forward contract.
Types of repos
- Overnight. A one-day maturity transaction.
- Term. With a specified end date.
- Open repo. Has no end date.
Repo transactions occur in three forms…
- Specified delivery
- Tri-party
- Hold-in-custody. (wherein the selling party holds the security during the term of the repo). Hold-in- custody is used primarily when there is a risk that the seller will become insolvent prior to maturity of the repo and the buyer will be unable to recover the securities that were posted as collateral to secure the transaction.
Repo vs Reverse Repo
- Repo
- For the party selling the security and agreeing to repurchase it in the future.
- Reverse Repo
- For the party on the other end of the transaction, buying the security and agreeing to sell in the future.
Reverse Repo
Repos are usually used to raise short-term capital. They are classified as a money market instrument.
Flexible Repo
- Repo with a (flexible) withdrawal schedule.
- Buyer could sell it partially at times before and at maturity as opposed to just at maturity (in case of a repo).
- The amounts and the time of withdrawals are flexible.
Repo vs Flexible Repo
- Convexity due to cash withdrawals.
- Formal written auction like trade.
- Enhanced documentation for credit support and bankruptcy court protection).
- Counterparties are municipal bond issuers.
Types of flexible repos
- Secured flexible repo
- the municipality receives collateral.
- Municipalities trustees would monitor and clear the collateral for the municipality.
- Collateral could be treasury bonds, GNMA bonds, agency MBS/CMO…
- The type of security to be used as collateral is explained in detail in the documentation and request for proposal (RFP).
- Collateral in most cases comes from the reverse repo market, i.e. a bank buys it from someone else with an agreement to sell it back.
- Unsecured flexible repo
- The customer does not receive collateral.
- May receive a higher spread.
- Average size 10–20 million.
- The size of a single unsecured flexible repo is usually less than a single secured one.
European-type Call Option
…on a security St is the right to buy the security at a present strike price K. This right may be exercised at the expiration date T of the option. The call option can be purchased for a price of Ct dollars, called the premium, at time t < T.
European Put Option
gives the owner the right to sell an asset at a specified price at expiration.
Options are nonlinear instruments
Note that for t < T the value of the function can be represented by a smooth continuous curve. Only at expiration does the option value become a piecewise linear function with a kink at the strike price.
Swap
The simultaneous selling and purchasing of cash flows involving various currencies, interest rates, and a number of other financial assets.
Cancelable Swap
- One or both parties has the right not obligation to cancel the swap before its maturity.
- Those dates are typically prespecified in the contract.
- Are popular among institutions with an obligation in which they can repay principal before the maturity date on the obligation, such as callable bonds.
- Can be used as a hedge. They allow institutions to avoid maturity mismatches between their assets and liabilities with prepayment options and the swaps put in place.
Types of cancelable swaps
- Callable swap
- The payer of the fixed rate in swap has the option to cancel the swap at any of those specified days before the maturity date and extinguish the obligation to pay the present value of future payments for an exchange for a premium.
- Puttable swap
- Receiver of fixed rate in swap has the option to terminate the swap at any of those specified days before the maturity date. A counterparty in a plain vanilla swap may be able to close out a swap before maturity, but only by paying the net present value of future payments.
