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Differences Between Exchange-Traded Derivatives And Introduction to Derivatives Copyright © 2018 Oliver Publishing All rights are reserved, including the right of reproduction in whole, or in part, without the express written permission of Oliver Publishing Inc. ISBN: 978-1-894749-64-0 Published by: Oliver Publishing Inc. 151 Bloor Street West, Suite 800 Toronto, Ontario M5S 1S4 Tel: (416) 922-9604 Fax: (416) 922-5126 Toll Free: 1-800-238-0377 Email: [email protected] www.oliverslearning.com Printed and bound in Canada TABLE OF CONTENTS OVERVIEW 4 Definition 4 Options 5 ForwardsandFutures 5 DifferencesBetweenExchange-TradedDerivativesAndOTCDerivatives 6 TypesofUnderlyingInterests 7 UsesforDerivatives 8 RiskandCostReduction 9 RisksandTradingIssues 10 FUTURES 12 TypesofForwards 12 OrganizedFuturesExchanges 13 BuyingandSellingaFuturesContract 14 ReadingaFuturesQuotationPage 15 ExchangesandClearingHouses 16 FuturesPricing 17 Arbitrage 18 Hedging 19 Speculation 21 FundamentalAnalysis 22 TechnicalAnalysis 23 EXCHANGE-TRADED OPTIONS 24 Option-BasedContracts 24 WhyBuyanOption? 26 Whybuyacall? 27 Whybuyaput? 27 ReadingQuotations 29 OptionsPricing 30 IntrinsicValue 30 TimeValue 30 VolatilityoftheUnderlyingInterest 31 EssentialOptionStrategies 32 BullishOptionStrategies 32 BearishOptionStrategies 34 SWAPS 36 SwapDealer’sFunction 36 TypesofSwaps 36 RISK, ACCOUNTING AND TAXATION ISSUES 40 TypesofRisk 40 MeasuringRisk 41 InternalControlandMonitoringtoReduceRisk 42 LimitsonRisk-Taking 43 Accounting,Disclosure,Taxation 43 Taxation 44 Definition Derivatives are financial products that are unique, in that they are derived from and based on another financial product. These products include: • stocks; • bonds; • foreign currencies or exchange rates; • indexes such as stock-markets, prices, rates, or credit indexes; • commodities, such as lumber; or even 1 • events like a change in the weather, interest rates, or credit ratings. CommonFeatures OVERVIEW For every buyer of a derivative, there is a seller on the other side of the contract. These are called the counterparties. The purchase or sale of a derivative involves a contractual agreement between these buyers and sellers to either buy or sell the underlying interest, at a specific price, either within a specific time period or at a specific future date. Derivatives have a market price, and this price fluctuates, depending on the market price of the underlying interest. The derivative contract is terminated on theexpiry date. With some derivative contracts, a performance bond, called margin, is required when the derivative contract between the buyer and seller is established. This is meant to guarantee that the contract will be honoured. With other derivatives, the buyer makes an immediate payment to the seller when the contract is established. This is called the premium. The premium is a payment for the right to either buy or sell the underlying interest (depending on the type of derivative), at a pre-agreed price, beforethe expiry date. The effect of leverage (either positive or negative) must be considered when buying or selling derivatives. Since large dollar amounts of the underlying interest may be bought (or sold, depending on the type of derivative) using relatively small amounts of money, the effect of leverage can result in significant capital gains or losses. A ratio of 40:1 is not uncommon, compared to 3:1 for other investment products. While the owner of the derivative can determine whether or how much leverage they want to use, very aggressive use of leverage must be monitored and controlled. Chapter 1: Overview Because there is always a buyer or a seller on either side of the contract, any profit that one side of the contract makes is exactly offset by the identical loss to the other side. This is called a zero-sumgame. Options The buyer of an option has bought the right—but not the obligation—to either purchase or sell (depending on which type of option was bought) the underlying interest to which the option applies. The risk to the buyer is limited to the amount of the premium. Options can either be traded on exchanges or over the counter (OTC). The seller has sold the right and is obliged to either purchase or sell (depending on which type of option was sold) the underlying interest to which the option applies, if the buyer exercises their right. Thus, the writer carries the burden of risk, in exchange for which they are paid a premium. The seller is also called the optionwriter. There are two types of options: calls and puts. Both calls and puts can be bought and sold. Acall option is a right or an obligation to buy the underlying asset, while a putoptionis a right or an obligation to sell the underlying asset. RightsandObligationsofCallandPutBuyersandSellers CALL PUT Buyer Right to Buy Right to Sell Seller Obligation to Sell Obligation to Buy The premium is the cost of the option, paid by the buyer to the seller to compensate the seller for their risk. It is set by supply and demand for the option, which in turn is calculated by the market price of the underlying interest and the exercise price of the option. The exerciseprice is the price at which the underlying interest may be bought (for a call) or sold (for a put), if the buyer exercises their right. The expiry date is the date the option expires. If the option is not exercised on or before the expiry date, the option expires worthless. Therefore, the seller gets to keep the premium. Purchasing an option is rather like purchasing insurance, and may be used as a planning strategy to manage risk by guaranteeing the future value of an asset. ForwardsandFutures A forward contract obliges the buyer to buy and the seller to sell a specific quantity of an underlying interest, at an agreed-upon price, at a specific time in the future, which is called the delivery date. An exchange-traded forward is called a future. The downside of a forward is that it obliges both parties to complete the transaction—unless they agree to cancel it. DifferencesBetweenOptionsandForwards Options are rights that are purchased by paying a premium. The buyer has the right to exercise but no obligations. The seller has the right to keep the premium paid but is obligated to either deliver the underlying asset or accept delivery of the underlying asset. With forwards, both sides have obligations, and have little or no initial cost. The buyer of a forward does not have to pay a premium to the seller when the forward contract is established. 6 Chapter 1: Overview Call options have value if the market price of the underlying interest is above the exercise price, and put options have value if the market price is below the exercise price. However, the value of the option does not typically change dollar for dollar with the change in the market price of the underlying interest as it is made up of intrinsic value as well as time value. On the other hand, forwards have value that corresponds with the change in the market price of the underlying interest. DifferencesBetweenExchange-TradedDerivativesAndOTCDerivatives Exchange-TradedDerivatives The organized exchanges provide standardization and liquidity, and some would say more fairness and transparency, that is not found in the over-the-counter (OTC) market. Default risk is not a major concern as a clearing house (such as the Canadian Derivatives Clearing Corporation known as CDCC) guarantees the obligations of both sides of the contract, and the contract itself. Over-the-CounterDerivatives There are two types of forward-based (OTC) derivatives that tradeforward agreements and swapagreements. The most popular forward agreements are based on foreign exchanges (foreign-exchange agreements) or interest rates (forward-rate agreements). A major feature of OTC derivatives, making them more complex, is that every aspect of the contract can be customized with special features by the buyer or the seller (e.g., a swap agreement). The most common swap is theinterest-rateswap, in which two investors swap two different interest rates with each other (e.g., a fixed rate for a floating-rate loan payment). A swap agreement differs from a regular forward contract in two ways: • An underlying interest is not delivered. Instead, the buyer and seller exchange the difference between their respective interests. As a result, only one of the investors actually makes the (net) payment. • The swapcontract is effectively a series of forward contracts that are packaged together. There is not one delivery and one payment, as there would be with a forward contract, but rather a series of exchanges of cash flows at future times, with the dates specified in the contract. A “knock-out”feature is often included with an OTC option. With this feature, the option expires if the underlying interest falls to or below the exercise price prior to expiry. Other special OTC features are caps,floors,barriers, andcompoundoptions. A relatively new type of OTC derivative is the contractfordifferences(CFD). Limited to Canadian accredited investors, CFDs track the fair value of an underlying interest (e.g., stocks, indexes, commodities, treasuries). Settlement is made in cash. CFDs have no fixed expiry date or contract size. Contrasts Flexibility: The terms, conditions, underlying interests, expiry, contract size, and other features may all be customized for an OTC derivative. Exchange-traded derivatives do not have this flexibility. Underlying interests, contract size, expiry, and other features are standardized by the exchange. Privacy:Only the buyer and seller to the OTC derivatives contract have knowledge about the contract. All aspects of all exchange-traded derivatives are a matter of public record. 7 Chapter 1: Overview Liquidity:The downsides of customization and privacy are that OTC derivatives are not easy to sell to a third party. Selling a derivative or offsetting a position (taking the opposite of an established position) in an exchange is easy. Risk: Because of the private nature of OTC derivatives, default and credit risk can be a concern. This is not a consideration for exchange-traded derivatives as the exchanges guarantee and the clearing houses verify all transactions.
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