The Derivatives Market and Financial Derivatives
Derivatives play a vital role in today’s global economy. They are powerful and versatile tools. Derivatives enable financial institutions, large corporations, and high-net-worth individuals to manage their exposure to financial risk in its manifold forms.
The global derivatives market operates seamlessly around the clock, trading a constantly mutating variety of complex instruments on rapidly changing technology platforms.
Unlike most blogs on derivatives, which deal with the mathematical techniques and models of risk management, this blog focuses on what nonquantitative derivatives professionals need to know about the end-to-end derivatives life cycle.
It shows such professionals, who outnumber the cadre of quants by an order of magnitude in the typical derivatives organization, how to adjust successfully to the new and emerging product, technology, and regulatory conditions of the post-2008 derivatives market.
The objectives of this foundation blog are briefly to
define the financial derivative
outline the structure and size of the derivatives market and its submarkets
set out the need for derivatives and their benefits to the economy and capital markets
explore the systemic dangers and risks of derivatives
survey the ongoing regulatory changes in the derivatives market
identify the operational and technical challenges of managing derivative contracts in the emerging new regulatory landscape
discuss the importance of information technology in each area of derivatives contract management
A derivative is an instrument derived from at least one other elementary instrument known as the underlying; the value of a derivative instrument depends on the value of the underlying. Examples of underlying include stocks, bonds, exchange rates, interest rates, credit characteristics, indices, commodities, and other derivative instruments.
From a practical standpoint, the derivatives contract is simply an agreement between two parties, and its performance is derived from the underlying— hence the name derivative.
An example of a derivative is an option contract on a stock issued by some corporation, in which the value of the option is derived from the performance of the stock. Another example of a derivative is an interest rate swap, whose value is derived from the underlying interest rate index on which it is based.
Derivatives can be divided into two major categories: financial derivatives and commodity derivatives. Financial derivatives are derived from financial instruments such as stocks, bonds, interest rates, and currency rates.
Commodity derivatives, on the other hand, are derived from underlying commodities such as precious metals, agricultural products, and commodity indices. This blog is concerned only with financial derivatives.
The term derivatives and its various synonyms—financial derivative instruments, derivative contracts, contracts, derivative products, and derivative instruments—should be understood throughout this blog to refer to financial derivatives.
Derivative instruments are distinguished from other financial instruments by the following characteristics
Unlike a securities transaction (stock or bond) that is settled at once, a derivatives contract starts on a certain date and stays in effect until some later date with one or multiple settlements during that period. The lifespan of a derivatives contract may vary from a few weeks to many years.
Derivative contracts are settled either financially (cash-settled) or through physical delivery (delivery-settled). Most derivative contracts are cash-settled regardless of the underlying. This enables participants to trade various types of derivatives without owning the underlying assets.
However, a small proportion of derivative contracts are physically settled by delivering the actual underlying assets. Contract terms specify the method of settlement and eligible assets that can be delivered in case of physical delivery.
Derivatives—even those with large notional value (the nominal or face amount of contract)—typically require only a nominal investment such as an initial margin, whereas securities (such as stocks, loans, and bonds) transactions require upfront investment.
Technically, market participants do not buy or sell derivatives in the same way that they transact other financial instruments. Rather, they enter into (open) and terminate (close) derivatives positions.
During the contract term, most derivative contracts are valued using market prices; others are valued using mathematical models. Derivative contracts are often managed on a portfolio basis, combined with other assets or derivatives.
The credit risk involved in derivative transactions is different from the credit risk carried by other financial instruments. For example, with a loan, the amount at risk is the principal paid to the borrower.
The credit risk is unilateral, meaning that only the lender is exposed to risk from the borrower. In contrast, the credit exposure in most derivative transactions is bilateral. Because the value of a derivative may swing to either side, each party involved may be exposed to risk at various points over the life of the contract.
During the term of most derivative contracts, two-way cash flows are common. Most other financial instruments have only one-way cash flows.
Risk exposure. Derivatives enable participants to trade risk exposure from an underlying asset without actually owning that asset.
The risk of holding a derivatives contract may be dissimilar to the risk of holding its underlying. For instance, the risk involved in purchasing a bond is not necessarily the same as the risk involved in purchasing a derivatives contract on that same bond. As a result, managing derivative positions is quite different from managing the position in the underlying.
The Derivatives Market Structure
The derivatives market is broadly divided into two submarkets: the listed market and the over-the-counter (OTC) market. These submarkets are differentiated by their products and their regulatory and operational requirements.
The Listed Market
The listed market consists of standardized contracts traded on exchanges. A derivatives exchange is a regulated entity that provides a trading facility to its members.
The derivative products on the exchange are standardized with specific delivery and settlement terms. Today’s derivatives exchanges trade a wide variety of contracts, ranging from simple stock options to interest rate swaps. As financial instruments evolve, exchanges continue to introduce a variety of products.
The listed market is also called the exchange market, the regulated market, or the organized market. The products traded on the listed market are variously called listed derivatives, listed contracts, on-exchange derivatives, or standardized derivatives.
Traditionally, trading on exchanges took place on a physical trading floor through a face-to-face auction process. Today, most derivatives exchanges have replaced or supplemented their floor-based trading with electronic trading.
Trading on exchanges is limited to standard contracts. All listed products are cleared by a designated clearinghouse, which guarantees the fulfillment of contractual obligations. Central clearing virtually removes the credit risk from listed contracts. Since these contracts traded on exchanges, they provide higher liquidity.
The major benefits of listed markets are the following
The obligations of listed contracts are guaranteed by the clearinghouse. As the central counterparty (CCP) to a listed contract, the clearinghouse eliminates counterparty credit risk.
All contracts are highly standardized in nature. For instance, the expiration date, underlying entity, settlement style, and all other key attributes of contracts are predefined by the exchange. Hence, the exchange market is efficient and provides multilateral trading and substantial liquidity.
Exchange trading leads to lower transaction costs.
Clearinghouse and clearing members use a margining process to manage the risk. All positions are marked-to-market on a daily basis (sometimes even more than once a day).
This virtually eliminates counterparty risk. Exchange-traded derivatives have greater price transparency because all trading prices are publicly available.
Despite the many benefits of the listed market, listed contracts are still not sufficient to serve the fundamental needs of those trading derivatives. Listed contracts may not serve all the risk management needs of a portfolio in terms of duration and quantity.
In addition, in certain situations, it may be more expensive to hedge the risks that exist in a portfolio using listed contracts. The next section explains how the OTC market fulfills certain needs that are not adequately met in the listed market.
The Over-the-Counter Market
Over-the-counter (OTC) is a term used to describe a trading activity that does not take place on a regulated exchange. In the OTC market, contracts are negotiated (traded) in different ways. The OTC market divides into two parts: the bilateral OTC market and the cleared OTC market.
In the bilateral OTC market, trading takes place directly between two parties with terms designed to suit the needs of the contract seeker. Trading in OTC markets takes place over traditional channels including telephone, email, electronic, and proprietary dealer trading platforms.
Bilateral contracts—also known as negotiated, nonstandard, unlisted, or bespoke contracts—are not cleared through any clearinghouse. Both parties remain as counterparties to each other until the termination of the contract.
Typically, these contracts are traded between institutional clients and investment banks (broker-dealers) and may be customized to address any specific exposure (underlying, contract size, maturity, embedded options, and so on) of the institutional client.
In principle, bilateral contracts can be formed in an unlimited number of ways because each one can be customized. As a result, bilateral markets trade a broader range of contracts than the listed markets. However, bilateral OTC contracts carry credit risk and the risk of the counterparty defaulting on its obligations.
The Cleared OTC Market
In recent years, OTC markets have introduced cleared OTC contracts (also known as cleared contracts), which are standardized and cleared through a CCP.
These contracts are quite similar to listed contracts in that both parties in the trade use a clearinghouse as the counterparty guaranteeing the fulfillment of obligations of these contracts.
As a result of Dodd-Frank regulations that mandate the clearing of certain OTC contracts, many electronic trading platforms and CCPs have evolved to clear a wide range of OTC contracts.
Derivatives trading takes place in several major venue types:
Exchanges. Orders from buyers and sellers are matched using open outcry auctions or electronic order matching systems.
Dealer market. Dealers either act as counterparties to trades or broker (arrange) trades between customers.
Electronic trading platforms. Electronic trading platforms (ETPs) are computerized systems that bring multiple customers and dealers together and accommodate execution electronically, either automatically or through negotiation over the electronic channel. ETPs promote low transaction costs and multilateral trading (multiple market-maker bids and offers).
There are two major classes of ETPs: regulated ETPs—such as swap execution facilities (SEFs) and multilateral trading facilities (MTFs)—and unregulated ETPs—such as those run by dealers and other firms.
Interdealer Broker. This venue is a market in which only dealers can participate. Dealers trade with each other using both dedicated electronic platforms as well as traditional bilateral channels.
There is no perfect or universal method for measuring the size of the derivatives market. Commonly used measures are notional, exposure (at-risk capital), and amount of money spent (cost of transactions).
The notional measure has been widely used until recently, but it suffers from the deficiency that the actual value of exchange of assets or cash resulting from these contracts does not, in general, correspond to their notional value.
As a result, the gross market value (also known as exposure or at-risk capital) measure—representing the cost of replacing all outstanding contracts at a current market price—is increasingly used. Different organizations track different aspects of the size of the overall derivatives market.
For example, the Bank for International Settlements (BIS) reports the total global notional amounts of the derivatives market, whereas the International Swaps and Derivatives Association (ISDA) reports the transaction volumes in OTC markets.
Similarly, local agencies report on derivative markets by sector: for instance, the US Office of the Comptroller of the Currency reports the derivatives volume by all banks, and the National Association of Insurance Commissioners reports the derivatives volume by the insurance industry.
According to a June 2013 survey by BIS, the outstanding notional of global OTC derivatives was $693 trillion, and their gross market value was $20 trillion; while the outstanding notional of global exchange-traded derivatives was around $68 trillion.
The derivatives market is predominantly a professional wholesale market whose main participants are classified as banks, investment firms, insurance companies, and corporations.
The following list details the categories of market players that can be found in the derivatives market.
Buy-side firms. Buy-side firms are also known as institutional investors or end users. They include hedge funds, private clients, banks, loan portfolio managers, insurance firms, asset managers, corporate treasurers, arbitrageurs, speculators, and scalpers (day traders).
Sell-side firms. Sell-side firms are also known as broker-dealers, or simply dealers. They include all types of brokerage firms, including market makers, execution brokers, and clearing brokers (futures commission merchants).
Trading venues. Trade execution venues include derivatives exchanges and various types of electronic trading platforms such as SEFs, dealer platforms, and interdealer platforms.
Clearing firms. Institutions that clear trades and serve counter-party to both sides of the original trade as central counterparties (CCPs) are clearing firms, also known as clearinghouses.
Service providers. Institutions that provide various types of services include affirmation platforms, custodians, banks, payment processing institutions, data vendors, and transaction processing firms.
Regulatory and market associations. Various governmental and nongovernmental organizations regulate, monitor, and assist overall market function.
Note Although many retail customers participate in derivatives trading, they trade listed products through retail brokerage firms. The retail market is highly automated and standardized, which keeps transaction costs low. Retail brokers provide all the tools needed for trading and other activities. Retail trading and related topics are outside the scope of this blog.
Advantages of Derivatives
The financial markets perform a number of vital functions. The securities markets, for example, help promote trade, provide a venue for businesses to raise capital, and give opportunities for those who own capital to make a return on their money through investing.
The derivatives market plays an important role in the global economy by enabling market participants to transfer risk, providing price discovery, promoting efficient markets, and lowering transaction costs.
The following list highlights some of the beneficial roles derivatives play in the financial markets:
Hedging against risk: Corporations, financial institutions, and other market participants use derivatives to manage (hedge) risks such as market risk stemming from such fluctuating factors as the price of raw materials, exchange rates, and interest rates.
Speculation. Derivatives allow investors to take positions on either side of the market. As such, they enable investors to profit either from correctly anticipating changes in the prices of assets or interest rates or from accurately predicting when credit events will occur. As a result, speculation promotes price discovery and efficient markets.
Speculators deliberately take on the risks related to changes in prices and other market parameters for the purpose of deriving profit. They also contribute to the liquidity in the market.
Alternative investment opportunities. Derivatives provide an alternative to investing directly in assets such as stocks and bonds. They lower transaction costs while providing the risk and reward that are inherent to direct investment, thereby helping to preserve capital.
Derivatives such as credit contracts separate the credit risk component from investment, allowing institutions to transfer or trade just the risk.
Derivatives allow investors to change the nature of an investment without incurring the costs of actually replacing or trading the portfolio asset in question. In addition, derivatives allow firms to create payoff patterns that are compatible with their strategy and degree of risk aversion at a lower cost.
Asset prices depend on market conditions that affect the supply and demand. Futures contract prices in the derivatives market reflect these market conditions. The futures contract price is used in the discovery of the current (spot) price of the underlying asset.
Promotion of advanced strategies
The use of derivatives allows market participants to develop advanced strategies to manage risk and improve the performance of their portfolios.
Derivatives are cost-efficient insofar as they reduce expenses when creating portfolios with specific parameters and enhance the liquidity and price efficiency of the markets.
The ongoing expansion of cleared OTC products offers the best of both worlds: the contract variety of the OTC market and the lowered counterparty risk of the listed market.
Despite all of their advantages, derivatives contracts come with risks of their own. Collectively, derivatives may increase systemic risk in the financial markets, which is part of the reason why they have drawn widespread criticism in recent years. The “Dangers and Challenges of Derivatives” section discusses some of the drawbacks of derivatives.
Advantages of OTC Derivatives
The previous section identified the benefits of derivatives and noted that these financial instruments have drawn harsh criticism for the risks they present not only to their users but also to the global financial system. This section explains why OTC derivatives, in particular, are necessary despite their inherent dangers.
The fundamental purpose of derivatives contracts is to manage risk. Risk exposure can arise in various ways, and it is not possible to design and trade standardized derivatives that address all possible forms of risk exposure.
It is important for the investor to find the right derivative—preferably a single contract that covers almost all of the risk exposure at the least expense. OTC derivatives offer a solution that fills this need.
The OTC market provides such advantages as product flexibility, market liquidity, legal certainty, standard credit risk management support, confidentiality, and a large dealer network, elaborated as follows:
Custom products and cost. OTC contracts can be designed to manage any risk, whether that involves interest rates, inflation, or credit for any duration. As a result, overall transaction costs are less than for multiple standard contracts.
Dealer network, liquidity, and competitive pricing. OTC markets are driven by a large dealer network, and these dealers play a critical role by assuming exposure for the risks that market participants want to transfer.
Dealers also provide needed liquidity by taking the opposite position in client trades. The existence of a large network of dealers across the globe promotes competitive pricing in the OTC market.
Legal certainty and credit risk management. OTC markets have fixed many shortcomings by introducing standard contract terms as well as processes to improve the legal certainty of contracts and manage counterparty credit risk. OTC markets have resulted in the creation of legal frameworks and risk management tools, such as netting and the use of collateral.
Transaction confidentiality and anonymity. OTC derivatives contracts are confidential agreements between two counterparties. This confidentiality provides great protection for participants in the OTC market, and it also protects their business strategies.
However, recent regulations have introduced certain transparency measures while maintaining the confidentiality inherent to the OTC market.
New products. Due to the flexibility and heavy involvement of dealers, the OTC market works as an incubator for new financial products.
Dangers and Challenges of Derivatives
The financial crisis of 2008 and the consequent Great Recession provoked a furious backlash against OTC derivative instruments. Although some of this criticism may be misplaced, derivatives undeniably present multiple and potentially catastrophic risks to the financial system.
They can cause sharp changes in the value of underlying assets, lack transparency, enable speculative bets that fail, and be inappropriately marketed.
When these vulnerabilities are actualized on a large scale, derivatives can dangerously destabilize the entire financial system, especially when major participants fail (see the next section).
Dangers and challenges of derivatives include the following:
Complexity. Many derivatives are highly complex and opaque, exposing investors to irresponsible marketing and insufficient understanding of the products.
High levels of exposure. Many derivative products have the potential for large financial losses. If these instruments are used for speculative purposes or without a full understanding, they may cause serious losses.
Complex risk measures. Although derivatives are used to manage the risk, a derivatives contract itself can also create risk exposure. Failure to effectively assess and hedge that exposure may lead to major losses.
Complicated hedging strategies. Some market participants have resorted to the use of complicated hedging strategies with derivatives. If these strategies do not succeed, they may result in major losses.
Systemic risk. Some OTC market participants use too much leverage, which can create great systemic risk. In addition, lack of transparency may increase the risk in multiple folds.
Large size. The notional amount of outstanding positions in the global derivatives market is quite large. Problems in any part may result in a major impact on the total global financial system.
Regulatory complexities. Due to a lack of transparency and the complexity of products, it is hard to effectively regulate and supervise the derivatives market. However, new regulations are designed to address transparency issues.
Price discovery challenges. Lack of transparency and uniformity in the bilateral OTC market make price discovery more challenging than for exchange-traded instruments.
Over the past two decades, derivatives have been implicated in numerous high-profile corporate failures that had significant impacts on the global financial markets, such as the following:
AIG. After the asset markets collapsed in 2008, AIG was exposed to a large number of derivatives positions that brought the company to the brink of collapse. The US government intervened and rescued AIG with massive loans.
Lehman Brothers. In 2008, Lehman Brothers—a major counterparty (dealer) in the OTC derivatives market—defaulted, creating a major systemic risk. The eventual collapse of Lehman Brothers led to a default on obligations that existed under OTC derivatives contracts, among others.
Enron. In 2001, Enron filed for bankruptcy. Enron was holding derivative contracts based on the prices of oil, gas, and electricity. These transactions were largely unregulated and had no reporting requirements. Speculative derivatives losses concealed by fraud eventually led to the collapse of Enron.
Long-Term Capital Management (LTCM). In 1998, LTCM, a high-profile hedge fund, incurred massive losses when their strategies failed amid the East Asian financial crisis and the Russian bond default. The failure of the hedge fund’s derivatives strategies caused the firm eventually to collapse.
Orange County. In 1994, Orange County, California, was forced into bankruptcy when exposure of its derivatives positions to rising interest rates resulted in major losses.
The systemic effects of major failures such as these led to the introduction of new regulations and restructuring of the derivatives market, surveyed in the next section.
The Changing Regulatory Landscape of Derivatives Market
Since its inception, the derivatives market has undergone continual change to improve its efficiency and safety. In the wake of the 2008 financial crisis, governments around the world have been introducing new regulations to mitigate the dangers and challenges posed to their economies by the derivatives markets.
Listed derivative markets are regulated by national government agencies— such as the US Commodity Futures Trading Commission (CFTC) and US Securi ties and Exchange Commission (SEC), international regulatory organizations, and industry associations.
Listed markets have been around for some time and, as a result, they are well regulated within sound risk-management frameworks. In addition to the market regulations, each exchange and clearinghouse maintains its own set of rules to help promote strong and healthy markets.
The big challenge arises in OTC markets. As discussed in the two preceding sections, complexity and lack of transparency in the OTC market have been widely blamed for excessive systemic risk, market abuse and manipulation, and catastrophic failure. To mitigate risk and check abuses, regulators need transparency.
Post-2008 regulations of OTC markets notably include Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) in the United States and European Markets Infrastructure Regulation (EMIR) in Europe.
These regulations focus on oversight of OTC markets with the goal of giving regulators actionable insight into market participants’ trading activities and risk exposures by affording greater transparency and better tools for reining systemic risk.
These new regulations phase in the following key changes to OTC markets:
Certain OTC contracts—namely, cleared OTC contracts, or swaps—are standardized.
Electronic trading platforms—namely, MTFs and SEFs— are established.
All standardized OTC contracts must be executed on regulated exchanges or SEFs or MTFs and cleared through a CCP.
Each counterparty must post collateral, as required by the CCP.
All OTC derivative transactions (both cleared and non-cleared) are subject to regulatory oversight.
Central trade repositories—swap data repositories (SDRs)—are established for the purposes of recording market transactions and providing required reports to regulators and limited information to the public.
These regulatory reforms are fostering rapid growth in the cleared OTC market.
Importance of Information Technology
Today’s financial markets could not accommodate their staggering market volume, complex business models, myriad regulatory requirements, millions of market participants, and the various functions without their information technology (IT) infrastructures.
Only well-designed and well-built IT platforms can deliver the required performances, accommodate the required volumes, and comply with regulatory requirements.
In particular, technology has fueled continuous innovation in the derivatives market. Because derivatives are the most complex type of financial instruments, they rely more than any other type on technological infrastructures throughout their life cycle on.
The role technology plays in the derivatives supply chain is outlined as follows and covered in depth in later in this blog:
Structuring and pricing
The structuring and pricing of most complex products rely heavily on the use of computer models. Accurate implementation and timely execution are crucial to the successful use of these instruments by businesses.
Trading in listed markets is done completely over electronic platforms. Even pit trading relies on systems that deliver data and allow traders to stay on par with the electronic side of the trading.
OTC trades are increasingly being executed on electronic platforms, too. The impetus of the movement of the derivatives market to electronic trading is ineluctable.
Post-trade processing and straight-through processing
In listed markets, end-to-end trade processing is fully automated by straight-through processing (STP) and runs on most advanced IT infrastructures built by exchanges and clearinghouses. In OTC markets, many third-party service providers are hosting post-trade and middle-office services.
Demand for these services has been growing in response to regulatory reform. Owing to the complexity of these operations, many small and midsize firms have been moving to these service providers.
To keep costs down, service providers rely on technologically advanced systems. Automation helps to reduce transaction costs.
Central clearing is the backbone of stable markets. Timely processing of collateral is the key to the successful risk management of clearinghouses. IT infrastructure plays a major role in processing daily transactions and maintaining collateral both at clearinghouses and clearing brokers.
In today’s markets, most of the settlement process is done electronically. Most end clients, custodians, and banks are electronically connected, and their settlement processes are automated.
The most important part of managing the derivatives contract is making sure that it serves its original purpose throughout its life cycle while managing the risks associated with holding a specified derivatives position.
Contract management requires a continuous valuation, calculation of profit and loss and risk analytics, collateral management, simulations, and stress testing. The results of all these processes rely heavily on underlying models, which in turn depend on underlying IT infrastructure.
Regulations demand intensive and timely reporting of market activity. The trade repositories and clearinghouses maintain transaction warehouses in order to comply with the reporting requirements established by regulations. These warehouses cannot function without advanced technological platforms.
The derivatives market has adopted a wide range of standards and protocols—including FpML, FIX, and SWIFT —to achieve universal connectivity. The market cannot operate without the proper infrastructure to enable message processing and connectivity.
Timely data delivery
Trading, collateral management, and other activities rely on timely and accurate data. Today a very large volume of data is transmitted efficiently among market participants. The requisite speed, accuracy, and volume are impossible to attain without modern IT infrastructure.
Operational and Technological Challenges
In addition to the dangers of derivatives already considered are the following operational and technical challenges that can arise when dealing with derivatives contracts.
Post-trade processing issues
Timeliness and accuracy are crucial for successful order processing. Although most operations are automated, there are still certain areas that are in part manually done owing to the complexity of the products involved.
Because any manual involvement increases the operational risk involved, it is critical to employ automation as much as possible.
This is an important counterparty risk management tool. Systems and models must be accurate, and the underlying data must be accurate and timely to generate collateral reports. Producing the least number of mismatches is a key challenge.
The automation of electronic communication and transaction processing among all market players is essential to speed and cost efficiency. Marketwide STP is complicated by the many different types of institutions involved, each running on different technology platforms.
The widespread adoption of standardized protocols such as SWIFT, FIX, and FpML helps in addressing these challenges. Still, many firms are struggling to catch up with advances in this area.
Contract workflow automation
To mitigate operational risk, firms must adopt a robust and comprehensive workflow while supporting end-to-end automation to achieve STP.
Firms must employ knowledgeable personnel who can resolve issues and mismatches promptly to reduce operations and financial risk and avoid any compliance violations.
Costly infrastructure and resources
Derivatives processing demands more powerful and sophisticated IT infrastructure. In addition, people with derivatives expertise are in high demand.
Maintaining the electronic connectivity with various servicing institutions is critical in achieving STP. Large operational risks. As a result of complex processes and manual operations, firms are exposed to substantial operational risk.
Nonstandard OTC market operations
To manage OTC positions, each participant must own (by virtue of building or buying) technology infrastructure. Developing this infrastructure requires expensive expertise in areas such as accounting, valuation models, collateral processes, portfolio reconciliations, and derivatives analytics.
Traditional OTC bilateral markets, in which both parties directly enter into the contract; and OTC cleared markets, in which certain OTC products are traded on a registered trading venue and cleared through a clearinghouse. Most of the derivatives market is driven by large financial and non-financial institutions.
In spite of heavy criticism in the wake of the 2008 financial crisis, derivatives continue to play a major role in today’s financial and nonfinancial markets for risk management.
The regulatory reform aims to improve market transparency, to control fraud and abuses, and to codify strong financial risk and operational risk management practices that will preserve the value of derivatives as incredibly powerful financial instruments. This blog looked in particular at how regulatory reform is transforming the OTC market.
Except where otherwise indicated, each of the topics touched on in this blog. The next section delves into the various types of derivatives instruments.
The Derivative Products
Recall that the preceding section defined a derivative as “a contract whose value derived from some underlying, such as a financial instrument or asset.” By this definition, a derivative comprises two key components: the contract itself and the underlying. An essential feature of the contract is that it lasts for a prescribed time period.
During that period, the contract's value varies based on the performance of the underlying. Another essential feature of the contract is that it grants and imposes specified rights and obligations on both parties to the contract.
This blog articulates the various schemes for classifying derivative products based on fundamental characteristics such as derivatives contract class and underlying asset class.
It also supplies the basic terminology of derivative products at both general and class-specific levels. On the most general level, it distinguishes derivatives from non derivatives and from derivative-like products.
The following sections discuss the basic terminology essential to understanding derivative products.
Security vs Derivative
Common securities are stocks (equity) and bonds (debt). The fundamental objective of a securities market is to raise capital. Securities are issued by various types of corporations to raise capital. New securities are sold to the public through public offerings.
These securities are then traded in a secondary market, in which securities change hands. In addition, corporations also raise capital on a smaller scale from private clients by selling different types of securities.
The fundamental objective of a derivatives market, by contrast, is to manage risk using various types of contracts. Although derivatives transactions may result in financial settlements, they are not a source of capital for contract holders.
The secondary objective of derivatives trading is speculative gain resulting from market movements rather than capital generation.
Product vs Instrument
An instrument is a tradable derivatives contract. Each instrument instantiates a certain derivatives product type.
For instance, an IBM stock option that expires on a specific date is an instrument instantiating the product type of stock option with a specific expiry date. An otherwise identical IBM stock option but with different expiry date is a different instrument.
A derivatives agreement is a contract. Every derivatives deal is a contract, regardless of product type or market, and includes the legal prerequisites of an enforceable agreement.
This blog treats securities and derivatives as two distinct financial product categories, as is the common usage. It should be noted, however, that some treat derivatives as a type of security and use the term derivative securities to refer to derivatives.
Interest Rate Fixed vs. Floating
A fixed rate is a predetermined rate that may not change during the term of the contract. A floating rate, on the other hand, may change over the term of the contract. Typically, floating rates are pegged to the London Interbank Offered Rate (LIBOR) benchmark. They are computed at intervals and by methods specified in the contract.
Note LIBOR is the interest rate paid on interbank deposits in international money markets. It serves as a reference rate for many financial instruments.
Derivatives are variously classified according to the dimensions of interest. The following sections focus on the following dimensions: the derivative product class (including futures, forwards, options, and swaps);
the underlying assets class (including equity derivatives, interest rate derivatives, currency derivatives, credit derivatives, and commodity derivatives);
The clearing model (including listed, cleared, and bilateral contracts); the market (including futures, OTC, cleared, currency, credit, and commodities markets); and the payout complexity (including vanilla and exotic products).
A common classification is based on the type of derivatives payoff—in other words, what kind of protection is provided by the contract. For example, to lock in the price of an underlying some time in the future, one may use a futures contract.
Alternatively, to protect against unexpected price changes in an underlying, one may use an options contract. Product classes are differentiated by the behaviors that are structured into the product contracts.
The four product classes (also known as product families) consist of the following (we will discuss each class later in this blog):
Futures. A futures contract is a standardized agreement between two parties—a buyer and a seller—whereby the parties agree to transact the underlying at a predetermined price at a later date.
Forwards. A forwards contract is a futures contract that is traded in an OTC market and customized to suit individual client needs.
Options. An option is an agreement between two parties, giving one party the right to buy or sell an underlying at a fixed price in the future, as specified by the contract terms.
Swaps. A swap is an agreement between two parties to exchange cash flow(s) (payment stream) at specified future times according to predetermined conditions.
Every derivatives product is derived from some underlying, and the value of the derivatives contract depends upon the value (price) of that underlying (asset or reference). Derivative products are commonly classified based on their underlying assets into the following five classes and subtypes.
Equity derivatives. Derivative contracts whose underlying is an equity product such as stock or a stock index. Subtypes of equity derivatives include equity options, equity index options, equity index futures, equity forwards, and equity swaps.
Interest rate derivatives. Derivative contracts whose underlying value is affected by or associated with interest rates.
Also known as fixed-income derivatives, interest rate derivatives include the following subtypes: bond futures, bond options, interest rate futures, futures on swaps, options on bond futures, options on interest rate futures, bond forwards, forward rate agreements, interest rate swaps, caps, floors, and swaptions.
Currency derivatives. Derivative contracts with currencies as underlying. Also known as FX derivatives, currency derivatives include the following subtypes: currency futures, currency forwards, currency listed options, currency OTC options, and currency swaps.
Credit derivatives. Derivative contracts associated with credit risk from the obligation of one or more entities. Credit derivatives include the following subtypes: credit default swaps, credit options, credit forwards, digital default swaps, and tranche credit default swaps.
Commodity derivatives. Derivative contracts with commodity products as underlying. Commodity derivatives include the following subtypes: commodity futures, commodity forwards, commodity options, and commodity swaps.
Based on the trading venue, clearing-model contracts are classified into the following three categories:
Listed contracts. Derivative contracts traded on an exchange or other organized facility. Also called exchange-traded contracts, listed contracts are created, authorized, and traded on derivative exchanges. All terms and other characteristics of the contract are standardized.All listed contracts are cleared by the clearinghouse.
Cleared contracts. Derivative contracts traded on licensed trading venues known as swap execution facilities (SEFs) or multilateral trading facilities. Also known as OTC-cleared contracts, cleared contracts are cleared by a clearinghouse.
Bilateral Contracts. Derivative contracts that are privately negotiated directly between counterparties. Also known as OTC bilateral contracts, bilateral contracts involve no clearinghouse, and counterparties face each other.
Historically, the derivatives market comprised several distinct segments based on contract types and practices. The distinction among the segments gradually blurred as exchanges and other servicing firms expanded their businesses across product lines throughout the derivatives market.
Because the historical distinctions linger in concept and terminology, however, it is helpful to list the following traditional derivative submarkets:
Futures market. Includes all listed products traded on an exchange, including options and futures on all types of assets. Also known as the listed market.
OTC market. Includes all OTC bilateral contracts. Also known as the swap market in the derivatives world.
Cleared market. Combines a portion of the listed market and an OTC market. While OTC dealers are providing liquidity (taking one side of the trade), clearinghouses from a listed market are providing clearing services.
Currency market. Includes global FX trading and other activities involved in FX products. Also known as the FX market.
Credit market. Includes trading and other activities involved with credit products.
Commodities market. Includes trading and other activities by the numerous exchanges and service providers specializing in commodity products.
Based on the complexity of their payout structure, derivatives are considered either vanilla or exotic, defined as follows:
Vanilla. Vanilla products are characterized by simple and straight payout structure, usually with no options attached. Also known as plain vanilla products.
Exotics. Exotic products have embedded options and another custom, nonstandard, or complex features attached to them, such as amortized notional, mutual put, and callable/cancellable options. Exotics are traded in OTC markets.
A futures contract is an agreement between two parties—a buyer and a seller—whereby the parties agree to transact the underlying at an agreed price at a later date. Underlying include securities, financial instruments, indices, commodity, and currencies.
The transaction price, known as the futures price or strike price, and other characteristics of the underlying are predetermined and standardized. According to the contract, both parties are legally obligated to fulfill the transaction: one party to deliver and the other to receive.
Futures contracts are traded exclusively on exchanges. Contract terms and conditions (such as size, quality, grade, and trading months) are standardized, and contractual obligations are guaranteed by a clearinghouse.
Based on the type of underlying, futures contracts are further classified into two major groups:
Financial futures. Futures contracts based on financial instruments such as stock, foreign exchange, interest rates, and other financial indices.
Commodity futures. Futures contracts based on commodities such as grains, metals, and energy products.
Key terms associated with futures contracts include the following:
Buyer. The party of the futures contract who is agreeing to receive the underlying. The buyer is known as the contract holder, the long position holder, or the going-long.
Seller. The party of the futures contract who is agreeing to make the delivery of the underlying. The seller is also known as the contract writer, the short position holder, or the going-short.
Contract price. The price agreed upon for the transaction. Also known as the strike price.
Delivery date. The date on which a transaction is going to take place. Also known as the settlement date.
Underlying. The set of details fully defining the underlying asset, including its specifications, quality, and quantity.
Settlement method. The method for settling the transaction, whether by delivery of the actual underlying or by cash.
Initial margin. The deposit made by both the buyer and the seller as guarantees of their respective commitments. The initial margin is typically a small percentage of the current value of an underlying of the contract.
Daily settlement. The settlement made at the end of each trading day, when the contract is valued (marked-to-market) and any resulting profit or loss is settled.
Nearby futures contract. The contract with the expiry date that is nearest to the current date. Most distant futures contract. The contract with the most distant expiry date.
Active contract. The contract with the closest expiry date. Typically, futures contracts with multiple expiry dates are traded at the same time. Also known as the on-the-run contract.
Closeout. Closing the position with a contract that is equivalent to, but in an opposite direction of, the original contract. This property of futures contracts is known as fungibility. Closeout is also known as offset.
Applications of Futures
Futures offer the following benefits to the functioning of the market, of which price discovery of the underlying and hedging of risk are especially important:
Price discovery. Futures markets help market actors, producers, and consumers make better estimates of the future prices of the underlying.
Hedging. Hedging is the primary purpose of futures trading. Futures transactions are key tools for firms to hedge their risk from price movements in their inputs and outputs. Hedgers transfer price risk.
Speculation. Although speculation confers no social benefits in itself, it may, in some circumstances, have the beneficial effect of helping markets by supplying liquidity and assisting in stabilizing prices. Speculators absorb price risk.
Transaction costs. Futures trading is cheaper than trading the underlying asset itself. This allows participants to take exposure to assets (having the same effect as trading the real asset) with lower costs.
Futures contracts are available on most financial instruments and trading assets. The most common futures contracts are the following:
Equity futures. Futures contracts on stock and stock indices.
Interest rate futures. Futures contracts on interest-bearing instruments such as corporate bonds and treasury bonds.
FX futures. Futures contracts on currencies and currency instruments.
Commodity futures. Futures contracts on commodities and commodity instruments.
Forwards are OTC contracts that are quite similar to futures contracts that trade on exchanges. A forward is an agreement between two parties to carry out a transaction on a future date. Forward contracts are based on a wide variety of underlying, including any financial instrument or asset.
Because forwards are OTC contracts, they are highly customizable in their underlying and transaction details, including date, price, quantity, quality, and settlement dates.
Forwards fall into two major categories: deliverable contracts and non-deliverable contracts. Deliverable contracts need the underlying to be delivered on maturity, whereas non-deliverables are cash-settled.
In cash-settled contracts, the difference between the contract price and the prevailing price of the underlying on maturity is settled.
Types of Forwards
Common types of forwards contracts include the following:
Equity forward. A contract to buy or sell an individual stock, stock portfolio, or stock index at a later date with a predetermined price.
Bond forward. A contract to buy or sell at a predetermined rate an individual bond, bond portfolio, or bond index at a later date but before the instrument matures.
Currency forward. A contract to exchange currencies of some notional (principal amount or contract amount) at a predetermined rate on a later date.
Forward rate agreement (FRA). A contract to exchange interest payments on a specific obligation, beginning at a later date. The pay-and-receive interest rates, the notional value of obligation, and duration are predetermined. One of the interest rates is typically a floating interest rate, while the other is a fixed rate.
Commodity forward. A forward contract based on commodity, commodity portfolio, or commodity index.
An option is a derivatives contract giving the buyer a right to execute the transaction with a seller on a future date. The transaction may include the purchase or sale of some underlying such as financial instrument, commodity, and foreign currency. The party obtaining the right (buyer) pays the premium (option price) at the start.
The option contract defines characteristics of the underlying and transaction details. The contract buyer is also known as the option holder and the seller is known as the option writer.
Options are written on a wide variety of underlying items such as equities, commodities, currencies, interest rates, various types of futures, swaps, caps, floors, and other instruments.
If the option is not exercised, the option holder simply loses the premium paid. If the option is exercised, however, the option writer will be liable for covering the costs of any changes in the value of the underlying that may benefit the option holder.
Thus, options function more like an insurance policy protecting against adverse market movements. This characteristic of option contracts sets them apart from other classes of derivatives.
Option contracts with basic features are known as vanilla options. Most listed options are vanilla options. Contracts with additional features are known as exotic options.
The following list explains key terms associated with an options contract:
Option buyer. The buyer gets the right but is not obligated to exercise it (to execute transaction). The buyer is said to be a long position holder.
Option writer (seller). The seller issues the right and is obligated to fulfill the right if the buyer exercises that right. The seller is said to be a short position holder.
Strike price, exercise price, or contract price. The price of the underlying that both parties agree to execute the transaction when an option is exercised. The strike price of a call (put) option is the contractual price at which the underlying will be purchased (sold) when the option is exercised.
Expiration date (maturity). The last date that the contract is valid.
Option premium, or premium. The price the buyer pays to the seller for granting the right. This is paid at the time of the option purchase. It is not a strike price.
Put option type. A put option gives the buyer a right to sell an underlying at a strike price, as stated in the contract.
Call option type. A call option gives the buyer a right to buy an underlying at strike price, as stated in the contract.
Exercise style. Option contracts have the following variations in terms of exercise:
American style. The option may be exercised on any day during the contract period.
European style. The option may be exercised only at the expiration of contract.
Bermuda. The option may be exercised on a few specific dates prior to expiration.
Intrinsic value. The value of the option if it were exercised today, which is the difference between the strike price and the underlying asset price. It cannot be negative; if there is no value, the intrinsic value of the option is said to be zero.
Time value. The difference between the current price of the option and its intrinsic value.
In-the-money (optionality). If the strike price of a call option is less than the current market price of the underlying, the call is said to be in-the-money. A call contract holder can exercise and make profit. Similarly, the put option is in-the-money if a put option has a strike price that is greater than the current market price of the underlying.
At-the-money (optionality). If the strike price equals the current market price of the underlying, the option is said to be at-the-money.
Out-of-money (optionality). If the strike price of a call option is greater than the current market price of the underlying, the call is said to be out-of-money. Exercising such a contract would not profit the option holder.
Similarly, the put option is out-of-money if a put option has a strike price that is less than the current market price of the underlying.
Options series. Exchanges list option instruments in the form of a series. An option series represents a specific option type (put or call), expiry date, strike price, exercise style (American or European), and underlying details. Each series is treated as one type of instrument for all practical purposes.
Applications of Options
Options are one of the critical contracts in risk management. Typically, an option is exercised only if it is profitable to the holder. In case of a call option, the holder's profit potential is theoretically unlimited, where maximum profit is the difference between the price of the underlying and the strike price.
However, the loss potential is limited to the premium paid. Consequently, the call option writer's loss is unlimited and gains are limited to premiums received.
In general, market participants use option contracts in two different ways:
Option contracts enable buyers to limit their risk exposure while profiting from upside market movements. Essentially, option contracts work as insurance against adverse market movements, unlike pure hedging instruments.
Assume an asset manager is exposed to the risk that his asset value will decrease. He can buy the put option (similar to buying insurance) if exposed to the risk that some security prices increase, which would hurt the value of his portfolio, or he can buy a call option on that security.
Options provide great opportunities for speculators. Options offer an extreme leverage, such that one can be exposed to an asset without owning the asset. Although options have high risk, with proper strategies investors can limit that risk.
Speculators adapt various strategies (known as combinations or spreading techniques) that involve trading one or more contracts simultaneously. Some of the popular strategies include straddles, strangles, bull spreads, bear spreads, and butterfly spreads.
Option contracts are traded on exchanges as well as in OTC markets. Options on commodities are known as options on physicals and options on financial instruments are known as financial options.
Listed options are traded on regulated exchanges and all contract terms are standardized by the exchange. The contract is standardized in terms of underlying asset, quantity, expiration date, strike price, settlement type, and other terms. Listed options are also known as plain vanilla options.
Most listed options are a type of American or European style. Also, most options on financial instruments are cash settled, while only few involve actual delivery. Exchanges trade option contracts on a variety of underlying assets and with different maturities. The following list shows popular option contracts listed by the type of underlying:
Equity options. An option contract to buy or sell equity instruments such as stock, bond, or stock index.
Currency or FX options. Option contracts to buy or sell currency at a specific rate.
Interest rate options. An option contract based on interest rate instruments such as corporate bonds, treasury securities, and other interest rate instruments. All major exchanges write interest rate options on their 90-day interest rate futures contracts.
Commodity options. An option contracts on commodities such as wheat, oil, soybeans, or precious metals.
Options on futures. An option on various futures contracts such as equity futures, bond futures, and currency futures.
OTC markets trade a large variety of options created on various underlying including securities, interest rates, currencies, commodities, swaps, and baskets of assets.
OTC options are highly customizable, allowing customization of characteristics such as exercise price, style, maturity, settlement or delivery terms, size of the contract, and characteristics of underlying. Most OTC trades are executed by broker-dealers as a counterparty.
OTC options can be divided into two major categories—simple options and exotic options.
Simple options. Simple options are similar to listed options but have modified features such as extended maturity, size, exercise type, and delivery mechanism.
Exotic options. Options with nonstandard features are referred to as exotic options. Exotic options are usually formed with complex rules and payout structures to suit the specific needs of one of the parties.
There are many types of exotic options, not all of which are widely traded.The following list contains some of the common exotic options:
Asian option. An option where the payoff is dependent upon the average value of the underlying asset for a specified period of time. This is also known as an average option, average-price option, or average-rate option.
Barrier option. An option where the payoff depends on whether the underlying asset reaches a designated level during a designated period of time. Besides the strike price, a barrier option also specifies a trigger price, or barrier. When the trigger price is hit, the option will either become effective (appear or knock-in) or ineffective (disappear or knock-out).
Knock-out option. A barrier option that sets a cap to the level an option can reach in favor of the holder. It limits the profit potential for the option buyer and loss potential for the option writer. If the limit is exceeded, the option expires as worthless.
Knock-in option. A barrier option that becomes effective (comes into existence) only when the barrier is reached. The barrier is the minimum price limit that is in favor of an option holder.
Lookback option. An option where the payoff depends on a maximum or minimum price of the underlying during the life of the contract. This allows the holder to exercise at the most favorable price that has occurred during the life of the contract.
Binary option. An option where the payoff is a pre-determined fixed amount if it ends up in-the-money, regardless of the actual price of the underlying at the time of exercise. The resulting payoff nature is either all or nothing, unlike that of a standard option where the payoff has no limit. There are many variations in binary options.
Bermudan option. An option that can be exercised only at specific dates. These options are often embedded with other contracts such as callable or puttable contracts.
Swaption. A swaption provides the holder a right to enter into specific swap deal on a future date. It is only a right, not an obligation as in a forward swap.
Cancellable swap. A swap with an embedded Bermudan option, where the holder can cancel the swap on one of the set exercise dates.
A swap is an agreement between two parties to exchange certain financial obligations at specified periodic intervals with predetermined terms. The financial obligation may include simple cash flows, assets, liabilities, currencies, securities, or commodities.
Essentially, a swap is equivalent to a portfolio (or strip) of forwarding contracts, each with a different maturity date and the same forward price. Most swaps are cash-settled contracts.
Typically, swaps enable a holder to alter the cash flow characteristics of their assets or liabilities without liquidating. For instance, an investor holding a common stock can exchange the returns from that investment for a lower-risk, fixed-income cash flow—without liquidating his stock.
He basically owns the stock, but his returns are not linked to stock returns but rather they are fixed-income cash flows. This investor now holds two positions in his portfolio— stock and swap contract.
The swaps market is one of the important segments of an OTC market. As a result, the OTC market is also known as the swap market. The major players of the swap market are all types of bond portfolio managers, financial firms and large corporations. The driving force behind the swap market is the nature of the swap products and altering cash flow characteristics.
Most swap instruments are traded in OTC markets. Recent regulations are dividing the OTC swap market into two segments—the cleared swap and bilateral swap market.
Cleared swaps are executed on an authorized execution venue (SEF) and cleared by the CCP. This will provide the same efficiency and benefits as contracts traded on exchanges. The benefits include credit risk remediation and the ability to offset (close) a position with any counterparty.
Most terms—such as the contract month cycles, price quotation, and minimum tick size and values of cleared swaps—mirror the terms of exchange-traded instruments (mainly futures). In addition, cleared swaps are cash-settled instruments. Like futures, cleared swaps are marked-to-market daily and the margin is maintained by a clearing broker and the CCP.
Bilateral swaps are highly customizable to suit the needs of large institutions. This market is mostly driven by broker-dealers known as swap dealers. Dealers create swaps on an as-needed basis to suit the requirements of the end-clients as well as other dealers.
The following list explains the general terminology and characteristics associated with swaps:
Legs. Swaps are structured as two legs, where the first leg is one party’s obligation and the second leg is the other party's obligation.
Tenor. The tenor is the length, term, or duration of the contract.
Start date or effective date. The start date of the contract terms.
End date or maturity date. The end date of the contract term.
Settlement frequency or payment frequency.
This is how often parties exchange payments.
Notional amount or principal. The amount that swaps payments are based on—not necessarily the amount exchanged between contract parties.
Settlement date(s). Each date that parties exchange payments throughout the term of the contract.
Netting. Parties typically agree to exchange the difference between each other's due payments instead of making full payments. If the payments are in different currencies, parties usually make separate payments without netting.
Swaps can be classified into multiple categories based on the underlying asset, maturity, style, and contingency provisions. Swaps with simple terms are known as plain vanilla or just vanilla swaps. All non-vanilla swaps are known as exotic swaps.
Swaps with one month to a year in length are known as short-term or short-dated swaps. Swaps with more than a year in length are known as long-term or long-dated swaps. There are swaps in use that are up to 30–50 years long.
The following list shows the classification of swaps, based on various underlying assets:
Equity swap. Based on securities such as single security, a basket of securities, and the security index.
Interest rate swap. Based on various interest rate indices.
Currency swap. Based on various world currencies.
Commodity swap. Based on commodities such as agricultural, energy, and metals.
The following sections discuss these contracts further.
Interest Rate Swaps
In OTC markets, interest rate swaps (IRS) are widely traded instruments. An interest rate swap is a contract to exchange future cash flow streams of interest payments on a specified principal amount, for a fixed period of time. The interest rate of payment streams is based on different sources; for instance, while the first is a fixed rate, the other could be a floating rate.
The principal amount is not typically exchanged between the counterparties, rather interest payments are exchanged based on a principal. The swap principal is also known as notional amount, notional principal, or just notional.
The most popular interest rate swaps are fixed-for-floating, under which cash flows of a fixed interest rate are exchanged for those of a floating interest rate, such as LIBOR. In other words, an interest rate swap is just a series of cash flows occurring at known future dates, while cash flow amounts may or may not be known.
Typical uses of an IRS:
to convert a fixed rate liability to a floating rate liability, and vice versa
to convert a fixed rate investment (asset) to floating rate investment, and vice versa
Interest rate swaps are traded in most convertible currencies such as USD (US Dollar), EUR (Euros), JPY (Japanese Yen), and CHF (Swiss Franc). Swaps are available for maturities of up to 30 years. There are many different types of interest rate swaps; vanilla and basis swaps are the most traded.
Vanilla IRS. The simplest IRS in which one party pays a fixed rate and the other pays a floating rate, both in the same currency. There is no exchange of a national. This type of IRS is known as vanilla IRS or coupon swap. It is also known as a domestic swap if it is in local currency.
Basis IRS. In a basis swap, both sets of payments are based on floating rates. They are usually based on two different currencies and are at different points along the yield curve, for instance, LIBOR 1m vs. LIBOR 6m.
This is also known as a floating-to-floating swap, or a yield curve swap if it is in same currency. Apart from these types, there are many exotic types of interest rate swaps listed under the swap types section.
A currency swap is an agreement between two parties to exchange different currency cash flows, based on a defined principal amount, for a fixed period of time. It is similar to an interest rate swap except that the cash flows are in different currencies.
For instance, in a vanilla currency swap, one party pays a fixed rate in one currency, and the other party pays a fixed rate in another currency. Alternatively, both may pay a floating rate in their respective currencies or one party may pay a fixed rate in one currency, and the other party may pay a floating rate in another currency.
The main distinction is, in currency swaps, the notional principal is typically exchanged at the beginning and at the end of the life of swap. Unlike in an IRS, cash flows are not netted because they are in different currencies. Instead, full principal and interest payments are exchanged. Typical uses of currency swaps:
to convert a liability in one currency into a liability in another currency
to convert an investment (asset) in one currency to an investment in another currency
Currency Swap Types
A simple currency swap is also known as a cross-currency swap. In a cross-currency swap, at the beginning of the contract, the counterparties exchange equal principal amount of two currencies at the spot (current) exchange rate.
During the life of the swap, the counterparties exchange fixed or floating rate interest payments in the swapped currencies and at maturity. At maturity, principal amounts are again swapped at a predetermined rate of exchange (usually at the initial spot rate).
Note Spot rate is the current exchange rate at which a currency pair can be bought or sold.
There are four types of basic currency swaps: fixed for fixed, fixed for floating, floating for fixed, and floating for floating.
In OTC markets, currency swaps are traded in many flavors. Currency swap contracts are also traded in many exotic forms. Most exotic swaps are discussed under the swaps section. Note that the current interest rate swap is not the same as the FX swap discussed in the FX derivatives section.
An equity swap is an agreement between two parties to exchange a set of payments, determined by a stock or index return, with another set of payments from an instrument such as an interest-bearing (fixed or floating rate) instrument or another stock or index. The main distinction is that with an equity swap, at least one party pays the return on a stock or stock index. The cash flows in equity swaps are typically netted.
Equity swaps involve three possible combinations—one party paying a fixed rate, a floating rate, or return on equity, while the other party pays an equity return. A simple equity swap is also known as a contract for difference (CFD).
The other popular swap type is total return equity swap. According to this contract, capital gains, as well as dividends, are paid to the counterparty (total return receiver).
No principal is exchanged and payments are based on contract notional. An equity swap is used to substitute a direct transaction in stock. Equity swap can alter the cash flows from equity holdings (assets).
Just as currency and other swaps, swap contracts are traded on commodities as well. In a commodity swap, cash flow streams are exchanged between two parties and at least one of the cash flow streams is dependent on a commodity or commodity index. Essentially, a commodity swap is equivalent to a strip of forwarding contracts on a commodity.
Some of the commonly traded commodity swaps are metals and energy swaps. Furthermore, there are swap contracts on many other types of commodities.
Exotic Swap Structures
In addition to plain vanilla and other simple swaps, there are many complex swaps traded in OTC markets. Some of these complex product structures are listed below:
Accreting swap. A swap in which the notional principal increases over time.
Annuity swap. A swap involving an initial payment or receipt, then an exchange of equal coupons during the life of the swap.
Asset swap. A swap in which the fixed payment stream is generated by an asset, such as a bond that is held by one of the contract parties.
Amortizing swap. An interest rate swap in which the principal amount decreases over time.
Discount swap. A swap with payments made on a discounted basis in advance.
Forward swap. A swap that takes effect from a future date.
Overnight index swap (OIS). A simple interest rate swap, fixed-for-floating, in which the floating rate is tied to an overnight rate (Interbank Overnight Cash reference rate), compounded over a specified term.
Rollercoaster swap. A swap where the notional principal fluctuates (both increasing and decreasing) over the contract term as agreed.
Zero coupon swap. A swap where the fixed coupon is discounted (accumulated) and is to be paid at the beginning (maturity).
Index amortizing swap. The notional principal, or term of the swap, varies according to some randomly changing interest rate indexes.
Index differential swap, or just “diff” swap. An interest rate swap with cash flows based on two floating rates in different countries, but are derived from the notional of only one of the currencies. For example, pay €-based LIBOR, and receive US$-based LIBOR, on a notional of US$20 million and all payments are in US$.
Note An off-market swap is a simple interest rate swap in which the fixed rate may be away from the market. Typically, it contains the initial payment to offset the difference.
A credit derivative is a financial contract between two parties to exchange the credit risk of the specific issuer (reference entity). In other words, a contract in which one party provides the protection to the other party from a credit event of a specific underlying (reference obligation).
There are two sides to this contract—a protection buyer and a protection seller. The protection buyer pays a premium to the protection seller and, in return, the protection buyer will receive the protection amount in case of a credit event. Typically, a reference obligation is debt, such as a bond, issued by the reference entity.
Contract terms such as credit events, reference obligation, protection amount, and other details are predefined. The contract is between only two parties and does not directly involve the underlying issuer (reference entity) itself.
Basically, a credit event is an event that adversely affects the value of the reference obligation. Credit events are defined by ISDA. They include bankruptcy (or insolvency), failure to pay, debt restructuring, obligation default, credit rating downgrade below a specified level, obligation acceleration, and repudiation (moratorium).
A credit derivatives contract is similar to an insurance contract on an obligation such as a corporation or sovereign entity’s debt. The credit derivatives market is a critical part of the global financial market.
Credit derivatives are widely used products to assume or reduce credit exposure, typically on bonds or loans of a sovereign or corporate entity. In addition, credit derivatives are used to directly trade credit risk.
Recent regulations enforcing the clearing of some of the credit derivatives (credit default swaps [CDS] and credit default indices [CDX]) are strengthening these markets by bringing increased transparency, standardization, and security.
The following terms are the key terms associated with credit contracts:
Protection buyer (going short risk or sell risk). The protection buyer is a buyer of the credit contract (for instance, CDS). Buying protection has a similar credit risk position of selling a bond or shorting a loan.
Protection seller (going long risk or buy risk). The protection seller is a seller of the credit contract. The seller collects the periodic fee. Selling protection has a similar credit risk position as owning a bond or loan.
Reference entity (issuer). The underlying entity on which one is buying or selling protection, such as corporations, sovereigns, and municipalities.
Reference obligation (credit). The bond or loan that is being protected and issued by a reference entity. Typically, a senior unsecured bond is the reference obligation. Other obligations include municipal indexes, asset-backed indexes, leveraged loan indexes, commercial real-estate indexes, and other portfolios of bonds or loans.
Term, tenor, or maturity. Duration of the contract. Contracts are available with various maturities such as one year, three years, five years, ten years, and more.
Contract notional or principal amount. The amount on which credit risk is being transferred. It is also known as a risk notional or protection amount.
Spread or premium. The annual coupon or premium paid for providing the protection, quoted in basis points. Typically, payments are paid quarterly or semi-annually. The spread is also called the fixed rate, coupon, or price.
Contract legs. There are two legs—fee leg and contingent leg. The premium payment side of the contract is known as a fee leg and the protection payment side is known as a contingent leg.
Credit events. Events that trigger payouts, such as bankruptcy, failure to pay, obligation default or acceleration, and debt payment moratorium.
Applications of Credit Derivatives
The following are primary uses and benefits of credit derivatives:
Credit Risk Management. Credit derivatives provide an efficient way to manage the credit risk because credit contract cost represents just the cost of credit risk. Thus, credit risk is separated from other types of risk such as market risk.
Trade Credit Risk. Credit derivatives allow users to trade the credit risk either to eliminate the credit risk (hedge exposure) or to assume credit risk (negative credit view—speculation).
Flexibility. Credit derivatives allow users to customize contracts to suit their risk profiles (different maturities and others), and to customize the choice of credit products to address exposure from different components of the capital structure, such as a senior secured bond, senior unsecured bonds, and syndicated secured loans.
Product Availability. The credit market provides a large set of products such as single names, baskets, and tranches. Thus, investors can choose products to suit their risk profile.
Efficiency. The credit derivatives market is relatively large and quickly reacts to news and market events, resulting in efficient credit prices.
Tax Efficiency. The use of credit products allows users to avoid triggering taxation and accounting implications that may arise from the sale of underlying assets.
Efficient Markets. CDS and CDX instruments are standardized and widely traded, thus providing transparency, operational efficiency, liquidity, and reduced costs.
Capital Leverage. Credit contracts do not require contract notional investment and, thus, free up capital that can be used for other business activities.
There are many different types of credit products traded in credit markets.
The following list shows some of the common contracts:
Credit default swaps (CDS). These are standard credit default swaps with reference obligations as corporate bonds and mostly senior unsecured bonds, loans, or sovereign debt.
Single name CDS. Protection on a single reference entity.
Credit basket (multi-name CDS). Protection on a basket or portfolio of reference entities.
Credit index (CDX) (multi-name CDS). Standardized CDS providing protection on a basket of entities.
Loan CDS (LCDS). A standard CDS contract but with a syndicated secured loan as a reference obligation.
Preferred CDS. A CDS contract with a preferred stock as a reference obligation.
Digital default swap. A standard CDS but in the case of a credit event, payment is 100% of notional or what is known at the time of contract inception.
Tranche CDS. A tranche CDS provides protection from a particular amount of loss on a portfolio of reference entities.
Forward CDS. A forward CDS is a CDS contract where protection starts at some future date (“forward starting”). For example, a 5y/5y forward is a 5-year CDS contract starting in five years.
Credit options. These are options on CDS, CDX, and tranches. A credit option is an option to buy or sell CDS, CDX, or a tranche on a specified reference entity at a fixed spread on a future date.
A call option provides investors with the right to buy risk (receive spread), while put options provide investors with the right to sell risk (pay spread) at the strike spread.
First-to-default baskets (FTD). A FTD basket is a basket of credit swaps for which the protection buyer pays the fixed coupon throughout the life of the contract.
On a credit event in one of the basket names, the swap terminates and the protection buyer delivers the notional amount of the FTD basket in bonds or loans of the defaulted entity to the protection seller. The protection seller then pays the buyer the notional amount of the trade in cash.
The most actively traded credit indices are the following:
CDX North America Investment Grade
CDX North America High Volatility
CDX High Yield
CDX Emerging Market
iTraxx High Volatility
iTraxx Europe Senior Financials
iTraxx Europe Subordinated Financials
Markit also publishes list of reference entities and reference obligation identifiers.
The foreign exchange market is a fast-paced segment of financial markets. The foreign exchange market is global and a most liquid and transparent market. Most participants in this market are large financial institutions, corporations, central banks, and hedge funds.
The terms FX, forex, foreign exchange, and currency are synonymous, and they all refer to the foreign exchange market. When the term forex market is used, it typically refers to the spot market. This section doesn’t include spot mar-kets because they are not part of a derivatives market.
FX products are divided into three major categories: FX spot, FX forwards, and FX futures. The FX spot market trades all spot transactions, the FX forwards market (OTC) trades forwards, and the swaps and FX futures market trades listed products.
As in the case of other derivatives, the FX market also trades most classes of derivatives including currency futures, currency forwards, currency options, options on currency futures, and currency swaps.
FX-related terms include the following:
Currency code. Currencies are identified by the three-letter ISO convention such as USD, GBP, and EUR.
Exchange rate. This is the price or value of a currency expressed in terms of the units of another currency.
Direct quote. The domestic currency quoted for one unit of a foreign currency. For example, in the United States, 0.91 USD = 1 CAD (Canadian dollar).
Indirect quote. The foreign currency quoted for one unit of domestic currency. It is equal to 1/Direct quote. For example, in the United States, 1.10 CAD =1 USD. It is also known as a price quotation.
Base currency. Currency in which the price is quoted. For example, if the dollar-yen rate is 108, it is 108 yen for one dollar.
Spot price, current exchange rate, or outright rate. The exchange rate of the currency at the time of the trade for immediate delivery. Most FX transactions settle in two days (T+2) after the trade date.
Forward rate. The exchange rate on some future date. Forward rates are typically calculated in relation to the spot rate. This is known as the outright rate or NDF rate (NDF = nondeliverable forward).
Quotation. Most currencies are quoted either in US dollars or euros. Typical market quote conventions are either in American or European terms.
American terms. A number of US dollars per one unit of another currency. A US dollar is the numerator. For example, USD/GBP means units of dollars per British pound (arithmetic convention). However, according to market convention, it is written as “GBP/USD” and is called Sterling-Cable.
European terms. The number of units of foreign currency per dollar. The foreign currency is a numerator. For example, JPY/USD means the unit of Japanese yen per dollar.
Cross-currency rate or cross-rate. One currency in terms of another and neither of the currencies is the US dollar—for example, the euro-yen (EUR/JPY).
Forward point. The difference between the spot and forward rate of a certain maturity, also known as the swap point. Most FX derivative contract prices are quoted in points.
Straight date. Standard dates that contracts mature on are known as the straight dates. Odd-dated contracts are basically ones that do not mature on standard dates.
Value date. The date on which two parties actually exchange the two currencies.
FX Derivative Instruments
FX transactions and the exchange of one currency to another are known as outright transactions. If the exchange takes place immediately, then they are known as spot transactions.
If it takes place in the future, then they are known as forwards or outright forwards. If two parties agree to exchange and re-exchange one currency for another, then they are known as FX swaps.
While spot transactions are not derivatives, forwards and swaps are derivative contracts. The following list briefly explains various types of FX derivative instruments:
Outright forward. A contract to exchange two currencies on a future date at a rate initially agreed upon. A future date is more than two days, as a spot settles in two days. There are two types of forwards— deliverables and non deliverable forwards (NDF) or forward contracts for differences (FCD).
In a derivable forward, upon maturity, currencies are exchanged. In an NDF, upon maturity, only the difference between the prevailing spot and the contract rate is settled. In practice, the outright term refers to a forward contract.
The forward contract for differences (FCD). An outright contract in which only the difference between the contracted forward outright rate and the prevailing spot rate is settled at maturity.
FX future. Standardized forward contracts traded on exchanges.
Currency option. An option contract sold for a premium that gives the buyer a right, but not an obligation, to buy (in case of a call option) or sell (put option) a specific quantity of a currency at a specified price at a specified later date.
FX swap or currency swap. A contract to buy certain amounts of base currency at an agreed rate while simultaneously reselling the same amount of base currency at a later date to the same counterpart at an agreed rate, or vice versa. Essentially, an FX swap is a combination of a spot deal and a reverse outright deal.
It is either buy/sell (B/S)—that is, buy spot now and sell forward on a future date—or a sell/buy (S/B)—that is, sell spot now and buy forward on future date. The first value date of a swap is known as a near date; the second value date is known as a far date.
Cross-currency swap. An interest rate swap contract to exchange streams of interest payments and principal on loans denominated in two different currencies for a specified period of time. The amounts exchanged are equal in value based on a predetermined exchange rate. It is not the same as an FX swap because it involves multiple cash flow exchanges.
Currency option. A contract that gives the right to buy or sell a currency with another currency at a specified exchange rate during a specified period. This category includes many exotic currency options such as average rate options and barrier options.
Currency swaption. An option contract to enter into a currency swap contract.
Applications of FX Derivatives
There are three major uses of FX derivatives:
Arbitrage. In arbitrage, an investor can create a profit by using simultaneous trades that result in the guaranteed (riskfree) profit from imbalances in market prices. Arbitrage opportunities are short-lived and limited participants profit from them.
Hedge. FX derivatives are useful for global firms to hedge the risk involved in foreign currency. A corporation can protect a business against adverse movements in foreign exchange rates and plan future cash flows and budgeting.
In addition, for a corporation operating in foreign countries, swaps can lower funding costs and provide locked-in exchange rates for longer terms.
Speculation. Speculators can take a position (long or short) to realize a profit from their market view.
Interest Rate Derivatives
Interest rate derivative (IRD) contracts are those whose underlying value is affected by or associated with interest rates such as bonds and other interest dependent instruments.
Interest rate derivative contracts are available either in a single currency or in two different currencies. Multi-currency derivatives are also known as cross-currency derivatives.
Interest rate derivatives are traded in all classes. The following list shows different types of contracts:
Interest rate futures. A futures contract on a debt instrument such as a treasury bill, corporate bond, or an interest rate. Interest rate futures on short-term instruments have an underlying security that matures in one year or less, whereas long-term instruments have maturities exceeding one year.
Forward rate agreement (FRA). A contract in which the rate to be paid or received on a specific obligation of certain maturity, beginning at some time in the future, is determined at the contract’s inception.
Interest rate option. A contract that gives the right to pay or receive a specific interest rate on a pre-determined principal for a set period of time. These contracts are traded on exchanges as well as in OTC markets. Listed contracts are mostly on interest rate futures. OTC contracts range from simple contracts to exotics such as caps, caplets, floors, floorlets, and collars.
Interest rate swap. A contract to exchange future cash flow streams of interest payments on a specified principal amount for a fixed period of time. There are many types of interest rate swaps.
Interest rate cap. An OTC option contract in which one party agrees to pay the other when the reference rate exceeds a predetermined level (strike rate).
Interest rate floor. An OTC option contract in which one party agrees to pay the other when the reference rate falls below a predetermined level (strike rate).
Interest rate collar. An OTC option contract with both the cap and floor options embedded.
Interest rate swaption. An OTC option to enter into an interest rate swap contract at a future date, purchasing the right to pay or receive a predetermined rate.
Equity derivatives are derivative contracts that are based on stock, a stock index, or a basket of stocks. Equity derivatives are useful for risks and return management of a portfolio that is directly or indirectly linked to equity products.
Equity derivative products trade in listed as well as in OTC markets. The major equity derivative product classes are futures, forwards, options, and swaps.
Applications of Equity Derivatives
Equity derivatives are typically used by portfolio managers. The following list shows uses of equity derivatives:
Risk management. Modifies the risk characteristics of a portfolio.
Return management. Enhances the return of a portfolio.
Cost management. Reduces the costs associated with portfolio management.
Regulatory management. Achieves efficiency in the presence of legal, tax, or regulatory obstacles.
The following list shows various equity derivatives in listed and OTC markets.
Listed Equity Derivatives
Single stock options. Options contracts on a single common stock.
Options on equity indices (such as S&P 500, S&P MidCap, Russel 200 Index, Nikkei 225, NASDAQ 100, and an NYSE Composite Index.)
Options on equity futures contracts.
FLEX (Flexible exchange options). Customizable options with an exchange guarantee—Equity FLEX Options, and Index FLEX Options.
LEAPS (Long-term Equity Anticipation Securities). Offers options with longer maturities ranging from one year to 39 months. Available on stocks and some stock indexes.
Single stock futures. Futures on a single stock.
Equity index futures. Futures on equity indices.
OTC Equity Derivatives
Stock option. Options contracts on a single stock.
Option on a basket of stocks. An option on a portfolio of stocks.
Option on a stock index. An option contract on a stock index.
Warrant. A contract with a right to buy underlying (stock) at a certain price until a predetermined, customized date.
Equity forwards. A forwards contract to purchase a stock, stock portfolio, or stock index on a future date at a predetermined price.
Equity swap. A swap contract in which one or both cash flow streams are linked to the performance of equity or an equity index such as S&P 500. The other stream is based on a fixed or floating interest rate.
Commodity derivative contracts are the oldest of derivatives. In commodity derivatives, underlying assets are commodities such as metals (precious and non-precious), energy, and agricultural commodities.
Energy products include crude oil, natural gas, heating oil, gasoline, propane, and electricity. Agricultural commodities include grains and tropical commodities.
Both listed and OTC markets trade a large volume of commodity derivatives. Commodity market participants range from commercial producers to local energy distribution companies to banks. Commodity derivatives are traded in all classes—futures, options, forwards, and swaps.
Synthetic products are typically a mixture of multiple instruments combined to create an effect and value as another asset. It is not an instrument itself, but a position.
Synthetically created assets are treated as a single asset for risk-based capital or regulatory capital. A regulatory capital represents the minimum required liquid reserves to be held by an institution. The requirement is enforced by regulatory rules such as Basel.
This is a common strategy used by firms to add certain positions (assets) to their portfolio without actually owning that asset. They virtually create the effect and value as same as owning that asset. In most cases, derivative contracts are used to build various investment strategies.
For instance, purchasing a call option and selling a put option on one stock creates the same effect as actually owning that stock. Two more examples of this are explained below.
Swap as Asset
Swaps can be used to create the effect of owning a certain asset. For example, simple, fixed-to-floating interest rate swaps are identical to issuing a fixed rate bond and using the proceeds to purchase a floating rate bond.
Synthetic Asset Using IRS
Assume that firms own bonds with a coupon that may be fixed, floating, or a combination of the two. It can use an interest rate swap to convert the bond’s cash flow from fixed to floating, and vice versa.
The bond can also be denominated in a foreign currency, instead of in US dollars. A cross-currency swap is used to convert the bond’s cash flow to fixed or floating as well as to exchanging the foreign currency for US dollars.
This is one of the asset liability management (ALM) strategies that end clients adopt in order to alter the characteristics of assets or liabilities.
A firm owning AAA rated cash bonds can combine CDS and replicate a corporate bond. Insurance firms use a replication strategy known as a Replication (Synthetic Asset) Transaction (RSAT).
Funded vs. Unfunded
Contracts that involve the investment of notional principal are known as funded contracts. On the contrary, contracts with no notional principal investments are known as unfunded.
Most derivative contracts do not need the notional to be exchanged between counterparties. For instance, in a vanilla IRS with a $100 million notional, counterparties never exchange notional. Instead, they only exchange the interest amount on this notional.
Options vs. Futures
The premium paid is the cost of a buying option or the cost of eliminating or modifying the risk. In the case of futures, all cash flows are either gains or losses.
Profit or loss from a futures contract is unlimited. The option buyer has a limited loss and an unlimited profit potential. The option writer has limited profit (premium) and unlimited loss potential.
Hence, the options can be used to hedge asymmetric risk (unlimited exposure), whereas futures can be used to hedge symmetric risk (limited exposure). If the value of the derivatives position is not proportionate to the change in the value of underlying, then exposure from that position is known as asymmetric.
A futures payoff is symmetrical (as underlying price changes, gain/loss changes dollar-for-dollar), whereas an options payout is skewed (first covers the premium cost and then profit).
Futures vs. Forwards
Futures and forwards are conceptually similar, but they differ in certain aspects. These differences include the following:
Futures contract holders can realize gains and losses on a daily basis, while a forwards transaction requires settlement upon maturity.
Futures contracts are standardized, while forwards are customized in order to meet the special needs of the parties involved.
Futures contracts have virtually no counterparty risk (credit risk) because they are settled through an established clearinghouse, while forwards do have counterparty risk because they are settled between the counterparties directly (there is no clearinghouse).
Futures that are being exchange-traded are subject to regulations, whereas forwards being OTC contracts are loosely regulated.
Swap vs. Forward
The difference between a forward contract and a swap is that a swap involves a series of payments in the future, whereas a forward has a single future payment. A swap is fundamentally similar to a series of forwarding contracts with different maturities. However, both are used to either limit or assume the exposure to market rate movements.
Option vs. Insurance
Insurance policies require the actual loss to occur for the payoff, whereas an option contract does not require any loss to occur. Rather, it is linked to the parameter, such as the price of the stock.
To earn the payoff, the option owner doesn’t have to own the underlying asset or become impacted by the change in the value of that asset.
However, for theoretical purposes, insurance is treated as a put option on an asset that we already own.
The use of derivative instruments results in various transactions. While some transactions involve the settlement of underlying or cash, others do not involve any settlement. The treatment of these transactions is critical for the purpose of taxation and internal and external reporting.
The accounting treatment is prescribed by local and international accounting regulatory agencies such as the US-based Financial Accounting Standards Board (FASB) and the Europe-based International Accounting Standards Board (IASB).
Accounting standards treat transactions based on multiple factors such as hedging purpose, settled or unsettled, time of settlement, and the type of product. These rules include definitions such as how derivative positions are valued and whether a specific transaction is a balance sheet or off-balance sheet item.
What Is Not a Derivative
Before this blog ends, it is important to understand the distinction between derivatives and nonderivatives. Some financial instruments resemble derivatives, but they are not derivatives. Some of those instruments include the following:
Insurance. Insurance is not a financial derivative. Insurance contracts do not have market prices, and we cannot evaluate them in terms of price. They simply provide financial protection against the consequences of the occurrence of a specified event.
Contingencies. Contingencies such as guarantees and letters of credit are not financial derivatives. These are simply predefined conditions that are to be met for a financial transaction to take place.
Hybrid products. Standard financial instruments with embedded options features such as convertible options are not derivative contracts. The price of these instruments may be different due to an embedded feature; however, it still only refers to a primary instrument.