Differences Between Exchange-Traded Derivatives And

Introduction to Derivatives

ISBN: 978-1-894749-64-0

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Printed and bound in Canada TABLE OF CONTENTS

OVERVIEW 4 Definition 4 Options 5 Forwards and Futures 5 Differences Between Exchange-Traded Derivatives And OTC Derivatives 6 Types of Underlying Interests 7 Uses for Derivatives 8 Risk and Cost Reduction 9 Risks and Trading Issues 10

FUTURES 12 Types of Forwards 12 Organized Futures Exchanges 13 Buying and Selling a Futures Contract 14 Reading a Futures Quotation Page 15 Exchanges and Clearing Houses 16 Futures Pricing 17 Arbitrage 18 Hedging 19 Speculation 21 Fundamental Analysis 22 Technical Analysis 23

EXCHANGE-TRADED OPTIONS 24 Option-Based Contracts 24 Why Buy an Option? 26 Why buy a call? 27 Why buy a put? 27 Reading Quotations 29 Options Pricing 30 Intrinsic Value 30 Time Value 30 Volatility of the Underlying Interest 31 Essential Option Strategies 32 Bullish Option Strategies 32 Bearish Option Strategies 34

SWAPS 36 Swap Dealer’s Function 36 Types of Swaps 36

RISK, ACCOUNTING AND TAXATION ISSUES 40 Types of Risk 40 Measuring Risk 41 Internal Control and Monitoring to Reduce Risk 42 Limits on Risk-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.

Common Features 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 the expiry 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, before the 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-sum game.

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 option writer. 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 put option is a right or an obligation to sell the underlying asset. Rights and Obligations of Call and Put Buyers and Sellers 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 exercise price 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.

Forwards and Futures

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.

Differences Between Options and Forwards 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.

Differences Between Exchange-Traded Derivatives And OTC Derivatives

Exchange-Traded Derivatives 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-Counter Derivatives There are two types of forward-based (OTC) derivatives that tradeforward agreements and swap agreements. 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 the interest-rate swap, 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 swap contract 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, and compound options. A relatively new type of OTC derivative is the contract for differences (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 allbe 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. Clearing houses guarantee the financial obligation of the contract through a system of performance bonds, called margin, which must be posted by those entering into the contract. Accounting: Whereas OTC derivatives are settled on the expiry date, exchange-traded derivatives are accounted for on a daily basis, called marking to market, and margin accounts are adjusted accordingly, giving the net value of the transaction. Regulation: OTC-traded contracts are private and unregulated. Since exchange-traded contracts are public, they are regulated. Regulation has negative and positive aspects. On the one hand, lack of regulation permits far greater creativity and innovation in the OTC market. On the other hand, regulation in the organized exchanges guarantees fairness, transparency, and an efficient secondary market. Delivery: OTC derivatives usually result in delivery at expiry. The underlying interest of an exchange-traded derivative is rarely delivered in actuality. Commission: OTC commissions are typically hidden in the price whereas any commission on an exchange-traded derivative is disclosed.

Types of Underlying Interests

The two major types of underlying interests for derivatives are commodities and financial assets. Producers, merchandisers, and processors of commodities use commodities derivatives to guarantee future prices, either for consumption or for investment purposes. In Canada, financial derivatives trade on the Montréal Exchange (MX). Commodity futures used to trade on the Winnipeg Commodities Exchange now trade on ICE in the US. The largest derivatives market in the US is the CME Group, which owns and operates The Chicago Mercantile Exchange (CME), the Chicago Board of Trade (CBOT), and the New York Mercantile Exchange and Commodity Exchange (COMEX). The other major player is the Chicago Board Options Exchange (CBOE) which is owned by the Cboe Global Markets. An OTC derivative can be created on any underlying asset if the two parties agree. Types of Commodities Type Examples Exchanges Agricultural products Grains and oilseeds (wheat, corn, Chicago Board of Trade (CBOT) soybeans, canola) ICE Futures (formerly Winnipeg Commodity Exchange)

Livestock and meat (pork bellies, Chicago Mercantile Exchange hogs, live cattle, feeder cattle) (CME) Forest, fibre, and food contracts Coffee, Sugar, and Cocoa Exchange (lumber, cotton, orange juice, Chicago Mercantile Exchange sugar, cocoa, coffee) (CME) New York Cotton Exchange

8 Chapter 1: Overview Types of Commodities Type Examples Exchanges Precious and Industrial Metals Gold, silver, platinum, copper, New York Mercantile Exchange aluminium, lead, nickel (NYMEX) London Metal Exchange Energy Products Crude oil, heating oil, gasoline, New York Mercantile Exchange natural gas, propane International Petroleum Exchange

Types of Financial Derivatives Type Examples Exchanges Equity Individual stocks, ETFs Chicago Board Options Exchange (CBOE) Philadelphia Stock Exchange International Securities Exchange Bourse de Montréal Interest-rate Instruments Treasury bills, Eurodollars, Treasury Chicago Mercantile Exchange notes, bonds (U.S.), bankers’ (CME) acceptances, Government of Chicago Board of Trade (CBOT) Canada bonds (Can), London Bourse de Montréal Interbank Offered Rate (LIBOR), Eurex Treasury bonds (OTC) Euronext.liffe Foreign Currencies U.S. dollar, British pound, Japanese Chicago Mercantile Exchange yen, Swiss franc, euro (CME) Bitcoin International Monetary Market Philadelphia Stock Exchange Montréal Exchange

Stock Indexes S&P 500, S&P/TSX 60 volatility Montréal Exchange indexes CBOE Other Credit, weather, and emissions ICE derivatives

Uses for Derivatives

Derivatives are used by companies and financial institutions to: • Reduce risk; • Reduce costs; and • Facilitate market entry and exit. Other investors use derivatives for: • Yield enhancement; • Speculation; and • Arbitrage. Creators of ETFs use swaps in the creation of synthetic, leveraged, and inverse ETFs.

9 Chapter 1: Overview Risk and Cost Reduction

Risk Reduction or Hedging Derivatives are used by financial institutions, manufacturers, mining and natural-resource companies, farmers, retailers, and governments to: • Manage risk due to volatility in exchange rates, interest rates and commodity prices; • Reduce costs; • Enter and exit markets; • Improve yields; • Speculate; and • Engage in arbitrage. Mitigating cash-flow volatility as part of a risk-reduction plan, also called hedging, is the most common use of derivatives. Because derivatives can be bought or sold immediately, derivatives can be used to manage and adjust for specific risks on an ongoing basis. The logic of hedging is that, by taking a position using a derivative at a substantially lower cost than owning an asset outright, the trader can mitigate the risk of either holding or planning to hold the asset by taking a position opposite to the primary position. Although it may seem counterintuitive, the decision not to hedge can turn a producer into a speculator because of the uncertainty of future prices. Hedging rarely eliminates all risk associated with an investment. For example, the correlation between the quantity and quality of the hedge may not perfectly match the quantity or quality of the primary position. The risk added to a hedge by imperfectly correlated positions is called basis risk. Another consideration is that the complete elimination of all risks may be prohibitively expensive andthus reduce or eliminate profit as well. The decision to buy a forward, an option, an OTC or an exchange-traded product is complex. It involves such considerations as the hedger’s take on the future, their specialized needs, or the likelihood they may wish to withdraw from the contract in the future due to changing circumstances.

Cost Reduction Hedgers can use derivatives to reduce the cost of new or existing debt by utilizing the principle of comparative advantage. This is accomplished by means of interest rate or currency swaps in which the buyer and the seller exchange financial interests, each of which is of value to the other.

Market Entry and Exit Commissions, bid-ask spreads, and other administrative costs can be very expensive, especially if the trader is trading in and out of markets often or trading large volumes, both of which can cause the market price to rise or fall dramatically. Derivatives can enable a trader to control a block of assets far in excess of the actual cash outlay.

Yield Enhancement Derivatives can be used, on a speculative basis, to enhance the returns earned on a portfolio by sellingan interest in the investment assets one already owns. If correctly and carefully executed, the premium earned on the options can enhance the portfolio’s yield by “locking in” the portfolio’s current value without actually 10 Chapter 1: Overview sacrificing any value.

Speculation In general, speculation using derivatives is inconsistent with the goal of risk management because it increases rather than reduces risk. Speculators trade on the future direction of commodities, currencies, stocks, bonds, and other securities, as well as derivatives. By trying to predict the direction of the market, they hope to profit from someone with the opposite belief. Due to the principle of the zero-sum game, in the long term such strategies tend to be self- defeating. Although derivatives can facilitate speculation, the leverage involved also vastly increases the risk (and, of course, the potential reward). This is especially true of forwards, which, as contractual obligations, cannot be allowed to simply expire, as is the case with options.

Arbitrage Advanced dealers and traders use derivatives for arbitrage. An arbitrage opportunity arises when the derivative is traded at different prices in two or more separate markets. The arbitrageur buys a derivative at the lower price in one market and almost immediately sells it at the higher price in the other market, thereby locking in the profit with nearly no risk. The actual risk in arbitrage is a function of the amount of time that passes between the buy and the sell, during which time the price may change.

Creation of ETFs Synthetic, leveraged and inverse ETFs are created using derivatives such as swaps rather than purchasing the assets the ETFs are tracking. These ETFs are less transparent and have increased counterparty risk in comparison to other ETFs. Swaps increase tracking errors as well as the costs of ETFs passed on to the investor. The use of swaps also increases the flexibility for the ETF creator.

Risks and Trading Issues

The main risk of derivatives is not inherent in the use of derivatives themselves but in the ease with which a trader can intentionally or unintentionally use leverage, which is potentially far greater than with other investments. This risk is magnified when derivatives are used for speculation rather than risk management. Because derivative investing is a zero-sum game, it is not realistic to expect that one can consistently “beat the market.” The use of derivatives must be incorporated into a comprehensive risk-management program, with explicit objectives and effective limits on risk, acceptable types of derivatives and maximum permitted positions. These restrictions must apply to the entire derivative portfolio and to each individual trader. Trading decisions must be subject to monitoring and control by overseers who are not involved in trading and who do not benefit from trading activities either directly or indirectly. The monitoring and reporting system should be explicit, accurate, objective and efficient.

Users and Uses Globally, open interest in exchange-traded futures and options were estimated to be USD 33,669 billion in December 2017. OTC derivations, as of 2016 were estimated to be USD 552,925 billion for financial derivatives, USD 1,770 billion 11 Chapter 1: Overview for commodity contracts and USD 11,977 billion for credit derivatives. Most companies use derivatives for risk management rather than speculation. The following table summarizes the correlation between company types and types of derivatives used: Global Correlation of Type of Company to Type of Derivative (all correlations positive) Company Type Derivative Type Commodity price hedgers No preference Firms with higher leverage Interest-rate derivatives Firms with higher proportions of foreign assets, Foreign-exchange derivatives sales, and income Utilities Interest-rate derivatives Utilities, oil, mining, steel, chemicals Commodity-price derivatives

Use of derivatives by companies tends to be greater in countries with larger local-currency derivative markets, such as the US.

Additional Resources Visit the International Accounting Standards Board https://www.ifrs.org/

12 A forward is a contract or agreement made between a buyer and a seller that requires the buyer to take delivery of the underlying interest and pay for it and the seller to deliver the underlying interest and take the pre-agreed payment for it. All forwards have a buyer and a seller, an expiry date, and a formula explaining how the payment is to be made. These features are negotiated when the two parties enter into the contract. As mentioned earlier, forwards can trade on an exchange. They are then known as futures. Prepayment or a premium is not required when the 2 contract or agreement is made. At the time of the contract or agreement, a performance bond called margin is required for exchange-traded futures but not typically for the OTC forward markets. Thus, forwards can be more FUTURES highly leveraged than futures. Types of Forwards

Exchange-Traded • Futures Contracts ◦◦ Financial Futures (e.g., interest rate, currency, equity futures) ◦◦ Commodity Futures (e.g., gold, soybeans, crude oil)

Over-the-Counter (OTC) • Forward Agreements ◦◦ Forward-Rate Agreements (FRAs) (based on interest rates) ◦◦ Foreign-Exchange Agreements (based on currencies) ◦◦ Foreign-Commodity Agreements

Swaps • Interest rates • Foreign-exchange • Credit-related • Commodity-based • Equity-based Trading in forwards and futures is considered to be a zero- sum game, as the buyer’s gain is the seller’s loss and vice versa. The amount of gain or loss varies continuously with the fair value of the underlying interest. Chapter 2: Forwards and Futures Characteristics A forward agreement is a private, customized, legally binding contract between a buyer and a seller to buy and sell an underlying interest at a specific price on an expiry date. The price at which the buyer agrees to buy and the seller agrees to sell is the exercise price. All aspects of this agreement can be negotiated. There is no standardization. The buyer of the contract is said to be “long” as they believe that the price will rise, whereas the seller is called “short” as they believe that the price will fall (or are hedging against that risk). Since the exercise price and the market price are the same when the forward contract is transacted, the fair value of the forward at inception is zero. Thus, no fees apply. The payout is simply the intrinsic value at expiry. Buyer: Payout = Market Price − Exercise Price Seller: Payout = Exercise Price − Market Price In actuality, forward agreements are generally transacted by a third-party dealer (e.g., an investment bank), which acts as agent between buyer and seller, selling and buying the forward agreements to and from the buyer and seller in two separate transactions.

Five Differences between a Forward Agreement and a Futures Contract Contract size: Because futures contracts trade on an exchange, they are standardized. This means that the size of a contract may not exactly correspond to the needs of a buyer. For example, silver contracts trade in standard contracts of 5,000 troy ounces. Standard contract sizes are reported in the financial press, as well as by exchanges. Delivery date: Also due to standardization, the delivery date set by the exchange may not exactly match the buyer’s personal needs. Using forwards eliminates this issue as the two parties can agree on a date that works for both of them. Mark to market: The mark-to-market accounting system, explained below, means that the net difference between the buyer’s and the seller’s interest is settled daily, whereas OTC contracts are settled when the contract expires. The final net payout is the same, but the timing of the cash flows differs. • Offsetting transaction: If a buyer or a seller wants to reverse (offset) their position, the exchanges have better liquidity compared with OTC transactions, meaning that either one can acquire an opposite or offsetting position easily. It can be quite difficult to find a counterparty when you are trying to offset anOTC forward. • Guarantee: All transactions within an exchange are guaranteed by the exchange or the clearing house, which means that futures contracts are essentially risk free. This is not true of the OTC market.

Organized Futures Exchanges

Futures markets carefully regulate the trading activities that they facilitate. Futures contracts must be approved and listed for trading by the appropriate regulatory authority. In Canada this is the provincial securities commission. In the United States it is the Commodity Futures Trading Commission (CFTC). To calm markets, the exchanges set limits on the amount by which the price can rise or fall during a single daily trading session. If the price falls by an amount equal to the daily trading limit, the contract is said to be “limit down.” If it rises by an equal amount, it is said to be “limit up.”

14 Chapter 2: Forwards and Futures

What Exchanges Regulate and Standardize Contract size (quantity) Maximum daily price limits Deadline days Maximum price fluctuations Delivery locations (delivery place) Price increments Delivery months Quality (grade) Delivery standards Settlement Delivery time Terms and conditions Margin requirements Tradeable months Marking to market Trading hours Maturity Underlying interest(s) Although in theory trading may continue at these limits, in practice trading usually comes to a halt. This puts traders who are “out of the money” in a very precarious situation, especially if the limits last for several days. Most exchanges use one of the following approaches to lessen this risk: • limits are increased by 150% to improve liquidity; • limits are removed entirely for futures contracts trading in their delivery month; • some exchanges have abolished limits altogether.

Buying and Selling a Futures Contract

In fact, most futures contracts are terminated before the expiry date through an offsetting trade. This is done by the “long” independently selling the contract and the “short” independently buying back the contract. The payout is the difference between the offsetting transaction and the original entry price. As long as the contract is offset before the first delivery day that is near the end of the month before the delivery month, there is no need for the investor to think about delivery. For example, if the long position receives a notice on October 24, he is expected to deliver between November 1 and November 30. As long as he closes out his long position before November 1, he will not be obligated to deliver. Contracts that have not been offset prior to this first delivery date are subject to physical delivery (with the exception of stock-index futures, which are cash delivered). If there is delivery: • the seller controls the delivery process: time, location, and grade; • the delivery process begins with the first delivery day. “Shorts” notify the clearing corporation of their intention to deliver, and “longs” are notified by the clearing corporation that they must take delivery. Exchanges notify the buyers and sellers that their first delivery day is approaching. Then they can close out their respective positions and, if they want to maintain the position, roll over into a new contract further into the future. Investors are encouraged to close out before delivery. One method of doing this is to increase margin requirements on and after the first delivery day.

Cash Settlement Some futures contracts are cash settled. These are called cash-settled futures contracts. A stock-index futures contract is an example of a cash-settled contract. The buyer or seller with the negative payout compensates the investor with the positive payout in cash.

15 Chapter 2: Forwards and Futures Margin and Marking to Market Margins on futures transactions differ from stock margins in that stock margins represent loans by a broker, whereas futures margins are good-faith deposits or performance bonds. Both the long and the short must maintain margin. Minimum margin requirements are set by the exchange or the clearing house. Original margin is the margin required by the original terms of the futures transaction. Maintenance margin is the minimum amount that must be maintained in the account as long as the futures position exists. This amount is lower than the original margin. Futures use a marking to market system. This system calculates the daily profit or loss for the position. This profit or loss is added to the account. If the position has lost money that day, the money is deducted from the margin in the account. If the client’s margin in the account goes below the minimum maintenance margin amount, the client must put more money into the account. If the position has increased in value, this amount is added to the already existing margin amount.

Futures Trading and Leverage In the context of futures trading, leverage may be defined as the ratio of the capital required to control an underlying interest relative to the fair value of the underlying interest. In the world of equities, a security can be bought with margin ranging from 30% to 80% (3:1 to 1.25:1). However, in the world of futures trading, where margin requirements vary from 3% to 10% (33:1 to 10:1), the risk to the investor is far greater if the fair value of the underlying interest moves in the wrong direction.

Reading a Futures Quotation Page

A futures quotation page of the type found in a daily newspaper or exchange website would typically include the following information: Name of asset Delivery month of the contract Current trading session • Open: opening price expressed in U.S. dollars • High • Low • Last • Most recent settlement price: the average of the prices of trades made towards the end of the session, specified by the exchange’s Pit Committee • Point change: the difference between the current and previous day’s settlement price • Estimated volume Previous trading session • Settle • Volume • Open interest: number of outstanding contracts Futures traders evaluate the technical strength or weakness of a market by analyzing the open interest (pending orders) and volume figures, as well as price trends.

16 Chapter 2: Forwards and Futures Size of the Contract and Underlying Interest Value The fair value of the underlying interest per contract is calculated by multiplying the contract size by the price. Contract sizes are usually published in the financial press.

Additional Resources Find futures quotations online: http://www.barchart.com

Exchanges and Clearing Houses

Exchanges An order to buy or sell a futures contract is first communicated to the trading floor of the futures exchange where that contract is listed, and then to the area of the floor where that specific contract is traded, called the “pit.” The buying and selling is done through an “open-outcry auction process” (i.e., verbal and hand signals are used). Computerized auction market systems are growing in popularity, despite some initial resistance. Canada, for example, has completely electronic trading floors. In order to trade on the exchange, the member firm (or brokerage firm) must be registered. There are two types of registered floor traders: locals primarily trade for their own accounts and floor brokers fill orders for customers.

Exchange Functions

Open Auction Forum The essential function of an exchange is to provide the communications infrastructure, physical or electronic, for buying and selling futures contracts through an auction system, as well as a publication, monitoring, and enforcement system that guarantees fair and competitive markets.

Contract Development An exchange’s new-products committee is responsible for evaluating the economic viability of proposals for offering new types of futures contracts and submitting them to the regulatory authorities for approval, as well as for redesigning or delisting existing products.

Clearing House Functions The clearing house is established by the exchange to handle financial settlements. It may be a department of the exchange or an independent company. The following table shows the names of the clearing houses associated with three major Canadian exchanges: Canadian Futures Exchanges and Associated Clearing Houses Exchange Clearing House Bourse de Montréal Canadian Derivatives Clearing Corporation Natural Gas Exchange NGX ICE Futures ICE Clear , Inc.

17 Chapter 2: Forwards and Futures Guaranteeing Performance The clearing house guarantees the financial obligations for both sides of every transaction and thus maximizes the efficiency and integrity of the exchange by acting as seller to every buyer and as buyer to every seller. This is called the principle of substitution. Clearing houses are able to guarantee buyers’ and sellers’ financial transactions by deriving financing from three main sources: • margin requirements; • guarantee deposits; • fees for services.

Clearing The clearing house matches the trades that are submitted by the member firms, either on behalf of their clients or for their own accounts. The clearing house verifies the accuracy of all transactions, ensures that there is a buyer for every seller and a seller for every buyer, verifies that the original margin is received, and then correlates all positions so that they balance.

Handling Deliveries The clearing house takes the role of ensuring that all deliveries are completed without problems; for example, when the clearing house receives notification of an intention to make delivery, it in turn notifies the member firms with long positions, usually on a first-in, first-out basis (i.e., the member firms with the oldest long positions are notified first; this practice is referred to as FIFO). The clearing house is not required to take on the obligation of delivery if one side does not satisfy the conditions of delivery.

Additional Resources Visit the Canadian Derivatives Clearing Corporation: http://www.cdcc.ca/index_pc.php Visit the Natural Gas Exchange: http://www.ngx.com/

Futures Pricing

Overview Whereas expectations concerning the future value of a commodity do figure highly in determining futures prices in some markets, in others (e.g., gold) the main basis of futures prices is a concept called cost of carry.

Cash Market / Futures Market The cash market is a market in which assets are traded for immediate delivery with payment in cash. The cash market is not an exchange but rather a loose network of buyers and sellers who keep in touch with each other by telephone and electronically. The price at which cash trades take place is called the market price, and this varies according to the grade and location of the commodity. Since this is an OTC market, the buyers and sellers take upon themselves the risk of each other’s default.

18 Chapter 2: Forwards and Futures Since the futures market represents an obligation to buy and/or sell an underlying interest, the futures price will be similar to the current market price of the underlying interest. The essential difference between the two markets is timing. Cash markets are immediate; futures markets are deferred.

Cost of Carry The cost of carry is the opportunity cost of carrying (i.e., holding) an underlying interest (e.g., storage, financing, and insurance costs for a period of time). In a normal market, the fair value of a futures contract is equal to the market price plus the cost of carry for the term of the contract. If a mispricing were to occur, it would be quickly corrected by arbitrage (defined below). Thus, in a normal market the futures price rises with time, since the cost of carry also rises. This is due to the increase in the period of time during which the underlying interest is held.

Basis The basis is the difference between the market price (i.e., the fair value at which the underlying interest is trading in the futures market) and the futures price.

Normal Market In a normal market, the futures price is higher than the market price and the basis widens as prices rise, or narrows as prices fall. A normal market occurs when supplies of a commodity are plentiful. An inverted market occurs when the futures price is lower than the market price and the basis widens as prices fall, or narrows as prices rise, contrary to a normal market. An inverted market occurs when supplies of a commodity are scarce.

Arbitrage

Arbitrage (simultaneously buying an asset in one market and selling it in another with the intention of making a profit from the price difference) is the mechanism by which the market aligns futures prices with market prices plus carrying costs for the term of the contract, called the “time to expiry.” If futures prices deviate from market prices plus carrying costs to a degree sufficient to justify the transaction costs (e.g., commissions, bid- ask spreads, etc.) of the arbitrage itself, the arbitrageurs will move in to either buy or sell, thereby bringing the futures price back into line with the fair value. For futures contracts to trade close to fair value, arbitrage must be cheap and easily executed.

Cash-and-Carry Arbitrage Cash-and-carry arbitrage occurs when a future is overpriced relative to the underlying interest. The arbitrageur sells the futures and buys the underlying interest. At expiry, they deliver the relatively underpriced asset and keep the difference as their profit. Arbitrage is a form of speculation that is nearly risk free. Arbitrage opportunities are infrequent and short-lived, leading to George Soros’s famous quip that arbitrageurs do not live very long. Arbitrage is a highly specialized institutional technique that is not readily accessible to ordinary investors.

Reverse Cash-and-Carry Arbitrage Reverse cash-and-carry arbitrage occurs when a future is underpriced relative to the underlying interest. The arbitrageur buys the future and borrows, then sells, the underlying interest. At expiry, the relatively underpriced asset is delivered and the difference is kept as profit. The reverse cash-and-carry arbitrage involves the additional expense of leasing the borrowed underlying interest and the opportunity cost of providing collateral on the one hand, while earning interest on the borrowed asset and avoiding the cost of storage and insurance on the other.

19 Chapter 2: Forwards and Futures Because reverse cash-and-carry arbitrage is more expensive than direct cash-and-carry arbitrage, there is a downward pressure on futures prices that results in futures prices being more readily underpriced than overpriced.

Four Conditions of Arbitrage Four conditions facilitate arbitrage: • the ability to short sell; • plentiful supply of the underlying interest; • storability; • stable supply and demand. Financial futures meet all of the conditions for making arbitrage easy to implement. Ironically, as a result, financial futures (e.g., equities and currencies) tend to trade close to cost of carry. Grains, oil seeds, and crude oil, because they are seasonal, do not lend themselves to easy arbitrage, and thus their prices tend to deviate from a strict cost-of-carry basis. With these types of commodities, the expectations of the market become a crucial factor in pricing. The additional cost of owning a physical asset that is in short supply is called theconvenience yield. The addition of the convenience yield to the cost of carry can result in volatile prices and inverted markets.

“Backwardation” An inverted futures market occurs when the price for the futures contract falls significantly below the market price. This typically occurs when there is a shortage in the underlying interest in the cash market that bids the market price up to the point where the market price is greater than the futures price. As supply shrinks, the demand moves to the nearest delivery date, pushing up these futures prices over futures prices for later delivery dates. This occurs if the buyers believe that the shortage will be short-lived. If supply is short in November, for example, this will push up futures prices in December, which causes futures prices in January to increase as well. Inversions can occur during periods of normal supply (as opposed to periods of shortage), for example, in anticipation of a new grain harvest. This means that the market puts a short-term premium on the market price of the commodity, believing that the supply will be relieved with the next harvest (i.e., the supply becomes limited during the winter and early spring, but will be replenished during the summer harvest). If an asset cannot be borrowed, reverse cash-and-carry arbitrage is not possible and, therefore, the degree to which futures prices can trade below the fair value is theoretically without limit.

Convergence The technical term for the narrowing of the basis as it approaches expiry in a normal market is called convergence. Convergence reflects the gradual decline of the cost of carry.

Hedging

Types Futures markets enable participants to either reduce (or eliminate) or take on risk. Reducing or eliminating risk is called hedging, assuming risk is called speculation.

20 Chapter 2: Forwards and Futures Two types of risk are: the risk of owning an asset and the risk of expecting to own an asset in the future.

Short Hedge A short hedge sells an interest that the hedger owns or expects to own in the future, thus locking in the selling price of the asset in the future. Hedges are generally offset towards the end of the contract to avoid delivery. In most cases, futures hedges are used as a risk-management strategy to control prices, not as a means of delivery. A corn farmer is worried that when it is time to deliver his crop, the price of corn will have fallen. He sells a corn future in October at US$375. At expiry, in December, corn is trading at US$350. He has made a profit of $25 calculated as $375 - $350 on the futures he sold. Although he will only be able to sell his corn at $350, the profit from the futures has increased his income by $25 and locked in the price of his corn at $375.

Long Hedge A long hedge buys an interest that the hedger expects to buy in the future, thus locking in the purchase price of the asset in the future. A national bakery is concerned about the price of wheat due to a drought in the west. The drought could drive up the price of the wheat due to short supply. The CFO decides to buy wheat futures. He pays US$560 per contract. When the futures contract expires the price of wheat is $655, a difference of $95. His contract was marked to market each day. As the price increased so did the value of his contract. He can choose to sell his contract (what typically happens) and buy the wheat on the open market or accept delivery of the wheat. Either way, the price for his company is $560 profit from the futures, calculated as $650 - $95. When futures prices and market prices narrow to the point that they are identical when the contract expires, this is called a perfect hedge. A perfect hedge occurs if two preconditions are met: • Maturity match: the hedger’s holding period must be equal to the time to expiry of the contract; • Asset match: the asset that the hedger holds must be identical to the underlying interest of the contract. If the foregoing conditions are not met, a perfect hedge is still possible, but less likely. An imperfect hedge exposes the hedger to basis risk, which is the risk of an unexpected change in the difference between the market price and the futures price (i.e., the basis). In the example above, the bakery might have needed to buy wheat in January but the futures they bought do not expire until February. Or the type of wheat they prefer to make their bread is not the type of wheat the futures contract is based on. One way of effecting a perfect hedge, even if the expiry and/or the asset do not match, is by offsetting the futures contract prior to its expiry and before the basis deviates from the hedger’s expectation. For example, if the hedger feels that prices for oil futures will increase to $70, the hedger will close out the position just as the prices are reaching $70, before the prices go above $70.

Imperfect Hedges An imperfect hedge is defined as a hedge in which the basis changes in a way that is inconsistent with the hedger’s expectations. An imperfect hedge makes sense only if the basis risk (i.e., the probability of an unexpected change in the basis), is less than the market risk (i.e., the risk of being unhedged). An unexpected change in the basis can be caused by changes in the supply-demand equilibrium, which can result in a temporary deviation from the market price.

21 Chapter 2: Forwards and Futures A cross-hedge may be used when a futures contract based on the underlying interest is not available. A cross- hedge is based on an asset that is correlated to but not identical with the underlying interest. A cross-hedge also introduces basis risk into the hedge.

Optimal Hedge Ratio Where considerations of an expiry or asset mismatch make expectations uncertain, and thus increase the basis risk, the optimal hedge ratio can be used to calculate the best number of contracts to buy to adjust for the historical or expected price relationship between the futures contract and the underlying interest. If the market price is expected to rise relative to the futures price, the number of contracts should be increased. If futures prices are expected to be more volatile than the market price, the number of contracts should be decreased. The optimal hedge ratio is a function of the standard deviation of the market price, the standard deviation of the futures price, and the coefficient of correlation between the asset to be hedged and the underlying interest. Optimal Hedge Ratio = Correlation Coefficient × (Standard Deviation of Market Price ÷ Standard Deviation of Futures Price) The number of contracts required is multiplied by the optimal hedge ratio to arrive at an adjusted figure. For example, a national flour producer prefers a certain type of wheat for its flour that it sells to bakeries for bread products. However, there are no futures trading on this type of wheat. So, it will implement an imperfect hedge by buying Chicago Wheat Futures. To create the hedge, the CFO of the company will use the correlation coefficient between the two types of wheat, and the standard deviation of the market prices of the required wheat as well as standard deviation of the futures prices. Using the following information: Correlation Coefficient = 0.9071 Standard Deviation of Market Price = 0.0275 Standard Deviation of Futures Price = 0.0358 The CFO calculates a hedge ratio of: .9071 x (0.0275/0.0358) = 0.6968 The national flour producer should hedge by taking a position in Chicago Wheat futures that corresponds to 69.68% of its exposure. The wheat future has a contract unit of 5,000 bushels. The flour producer needs 2,000,000 bushels. They need to buy 400 x .6968 = 278.72 or 279 contracts.

Statistical Recap: Standard deviation (σ) is the degree to which a value deviates from the mean of the distribution. Correlation coefficient is the degree to which two variables are correlated.

Speculation

What Attracts Speculators? Unlike hedgers, who seek to avoid risk, speculators are risk-seekers. They assume the risk that hedgers are trying to avoid, thereby increasing market liquidity. Speculation is the process of seeking to derive a profit by assuming risk. Four main conditions facilitate speculation in the futures markets: • Easy entry and exit: Assuming a position in a futures market is simple, quick, and easy. Trading can be

22 Chapter 2: Forwards and Futures accomplished online through a discount broker or on the telephone. Low margins facilitate trading. • Variety of opportunities: Futures markets give access to assets and trading strategies (e.g., spreads) that small investors would not be able to trade otherwise. Mini-contracts (i.e., fractions as low as one-tenth of a regular contract) are affordable and liquid. • Leverage: Leverage as low as 3% enables a speculator to control a large block of assets with little money down. • Emotion: Speculative trading in the futures markets challenges the speculator to understand the market better than the trader on the other side of the transaction. For many speculators this is a source of satisfaction.

Types of Speculator • Locals (“scalpers”): work on the trading floor; have a short time horizon for maintaining positions (e.g., minutes); look for small price differentials within short periods of time; trade frequently; make (or lose) small amounts per trade; depend on volume to make a living. • Day traders: take positions for no longer than one trading session; liquidate positions by the end of the day; look for small price moves, but larger than the locals; are risk averse; avoid taking positions on or around days when major economic reports are expected. • Position traders: utilize time horizon of weeks or months; profit from longer-term price trends; tend to be well financed and able to withstand short-term price fluctuations. • Spreaders: identify situations where the price relationship between two related underlying interests has deviated from the norm (typically, one asset is underpriced and the other is overpriced); buy the underpriced contract and at the same time sell the overpriced contract, then wait until the price relationship reverts to the norm. There are four types of spreads: • Intramarket spreads (called calendar or time spreads) involve buying and selling futures contracts on the same underlying interest but with different expiry dates. • Intercommodity spreads take two different-but-related futures contracts that may or may not trade on the same exchange; involve buying the underpriced and selling the overpriced and waiting for the price relationship to revert to the norm, then liquidating both contracts (e.g., buying treasury notes and selling treasury bonds is called notes over bonds (NOB)). • Intermarket spreads involve buying and selling futures contracts on the same underlying interest but executing them on different exchanges. • Commodity product spread involves buying and selling a futures contract in a commodity (e.g., soybeans) and a by-product of the commodity (e.g., soybean meal). Managed Futures Investor: uses futures to diversify equity and bond portfolios. There are three types: • Managed accounts: for an investor who wants some exposure to the futures markets and is willing to give trading authority to a trading advisor. • Managed futures fund: a mutual fund that invests in the futures markets. There are several types of managed futures (mutual) funds, depending on the investor’s objectives. • Commodity pools: funds that are available only to sophisticated investors; typically have a high minimum investment and are sold as a limited partnership.

23 Chapter 2: Forwards and Futures Fundamental Analysis

Favoured by position traders, fundamentalists seek to forecast long-term price movements during or at the end of a specific time period by analyzing the factors of an asset’s supply and demand, and projecting the equilibrium price. • Rising demand relative to supply means higher prices. • Rising supply relative to demand means lower prices. • Stable supply and demand mean stable prices. The factors governing an asset’s supply and demand include existing inventory (“carryover”), acreage size, yield, weather patterns, imports, on the asset side; size of livestock herds, crop developments in foreign countries, foreign economic and political developments, and foreign exchange, on the demand side. Information on farm production can be obtained from private and government sources, such as the United States Department of Agriculture and Statistics Canada.

Limitations In the context of futures trading, fundamental analysis has three main limitations: Precision: Fundamental analysis is much less precise than debt and equity analysis. In particular, it may recognize a trend but be unable to forecast a specific price or a specific time period, thus limiting the utility of the information. Complexity: There are so many different relevant factors that it is difficult to account for them all, and even if they are all accounted for, new factors may enter into the picture that completely upset the previous scenario. Market efficiency: Markets may have already incorporated the results of the analysis into the market price before the fundamentalist can act, thus effectively discounting the predictive power of the analysis.

Technical Analysis

Technical analysis is premised on the axiom that all information is already incorporated (“discounted”) in the current market price, and that therefore fundamental analysis does not add any value to the trading decision. All that is needed is to examine the behaviour of the market itself. A corollary axiom of technical analysis is that markets move in predictable and repetitive trends, and cycles are not random or momentary. The three primary sources of information available to a technician (or technical analyst) are price, open interest, and volume. Technicians use chart and statistical analyses to evaluate the dynamics of the market. Chart analysis plots daily, weekly, and monthly price movements to identify predictive patterns and trends and thereby determine price entry and exit points.

Additional Resources Read more on technical analysis: http://en.wikipedia.org/wiki/Technical_analysis

24 Option-Based Contracts

The buyer of an option derivative has the right (option) to buy or sell an underlying interest at a pre-agreed price within a specific time period, ending with the date of expiry. A call option gives the buyer the right to buy the underlying interest. A put option gives the buyer the right to sell the underlying interest. The option seller receives a premium for the option, in consideration for which they are obligated to buy or sell 3 the underlying interest if the buyer chooses to exercise their rights. The seller of a call must sell the underlying interest to the EXCHANGE- buyer if the buyer decides to exercise the right to buy. The seller of a put must buy the underlying interest from the buyer if the buyer decides to exercise their right to TRADED sell. Options are used to: mitigate the risk of ownership, actual or expected; to speculate; to enter or exit a market; to OPTIONS improve yield; or to practise arbitrage.

Types of Options The most popular option has equity as its underlying interest. Other non-equity options are based on bonds, foreign currencies, stock indexes, commodities and futures contracts. Options trade OTC or on an exchange.

Options and Forwards: Similarities Underlying interest: The fair value of both options and forwards is based on an underlying interest. Contractual: Both options and forwards are binding agreements between a buyer and a seller, in which each buyer or seller’s rights and obligations are explicitly delineated. Limited time: Both options and forwards are limited in the time during which they are binding. Leverage: Both options and forwards facilitate the use of leverage. Zero-sum game: The gain of the buyer or seller is exactly offset by the other’s loss. Chapter 3: Exchange-Traded Options Options and Forwards: Differences Binding character: Options are rights; forwards are obligations. Therefore, the option buyer’s risk is limited to the premium. Exercise price: Options have an exercise price in the contract that specifies the price at which an option has value when it expires. For a call option, the exercise price is a “floor” (i.e., the exercise price is the minimum price at which the call has value). For a put option, the exercise price is a “ceiling” (i.e., the exercise price is the maximum price at which the put has value). Premium: Option sellers are paid a premium for the sale of the option. The amount of the premium is a function of the option’s intrinsic value and its time value. Intrinsic value is the difference between the market price of the underlying interest and the exercise price. A forward has no premium.

Terms and Definitions American style: Options that can be exercised continuously right up to the expiry date. Assignment: Refers to the obligation of an option seller to buy or sell when the option is exercised. At the money: If the market price and the exercise price of an option are the same, the option is said to be at the money. Call: Gives the buyer the right to buy the underlying interest. Closing transaction: The transaction by which an option is offset prior to expiry, effectively liquidating or cancelling the position. European style: Options that can only be exercised on the expiry date. Exercise: Refers to the right of an option buyer to choose to buy or sell the underlying asset by exercising the options. In other words, buyers exercise, sellers are assigned. Exercise price: The price at which the underlying interest may be bought or sold, specified in the agreement. Expiry date: The date on which an option agreement ceases to be binding upon the parties. It is the Saturday after the third Friday in the expiry month. In the money: If it is in the buyer’s best interest to sell an option, the option is said to be in the money. A call option is in the money if the market price of the underlying interest is lower than the exercise price. A put option is in the money if the market price of the underlying interest is higher than the exercise price. Intrinsic value: The in-the-money part of a call or put option, equal to the difference between market price and exercise price. Opening transaction: The initial purchase or writing of an option. Out of the money: If it is not in the buyer’s best interest to sell an option, the option is said to be out of the money. A call option is out of the money if the market price of the underlying interest is higher than the exercise price. A put option is out of the money if the market price of the underlying interest is lower than the exercise price. Premium: The price charged by the option seller to the buyer for the right to buy or sell the underlying interest. Put: The right to sell the underlying interest. Right: Option buyers have rights but option sellers have the obligation. Time value: The value of the premium minus the intrinsic value. When the time value is positive, an option is said to have time value. Trading unit: The standardized number of shares underlying the option. Stock options are based on a board lot of 100 shares.

26 Chapter 3: Exchange-Traded Options Underlying interest: The underlying asset to which the option gives an entitlement or an obligation to buy or sell.

In-the money, at-the-money, out-of-the-money, time value, intrinsic value

Example 1: Faheed is considering buying call options in Ted’s Communication., Class B (TCI). TCI is currently trading at $66. The following table indicates the three call options he is considering: Company Expiry Exercise Premium In or out of the Intrinsic Value Time Value Month Price money TCI Apr 60 $7.00 In the money $6 ($66 – $60) $1.00 ($7 – $6) TCI Apr 66 $3.00 At the money $0 ($60 – $60) $3.00 ($3 – $0) TCI Apr 70 $1.25 Out of the money $0 ($66 – $70) $1.25 ($1.25 – $0) The Apr 60 call is in-the-money because the buyer could exercise the call and pay $60 per share for TCI, when it is currently trading at $66. The Apr 70 call is out-of-the-money because if the buyer exercised it, he would have to pay $70 a share for TCI, when TCI was currently trading at $66. He would not want to buy it as its buying price is higher than its original trading price. Two main factors will affect his buying decision: • How much money can he invest? Knowing that the Apr 60 call is more expensive than the Apr 70 call. • By how much does he think the price of TCI can increase by next April? If he were to buy the out-of-the- money call, the price would have to go up by at least $4 before it can be in the money. If he were to buy the at-the-money call, the price would only have to climb a little before being in the money. The Apr 60 call, is already in the money but it is the most expensive. However, TCI could actually fall in price and this call would still remain in the money.

Example 2: Felipe wants to buy a put option on a company he owns shares in called DNC-Javelin Group (DNC). DNC is currently trading at $48. Felipe is concerned that the price of DNC will drop. The following table indicates the three put options he is considering: Company Expiry Exercise Premium In or out of the Intrinsic Value Time Value Month Price money DNC Mar 50 $3.85 In the money $2 ($50 – $48) $ 1.85 ($3.85 – $2.00) DNC Mar 48 $2.75 At the money $0 ($48 – $48) $2.75 ($2.75 – $0) DNC Mar 46 $1.95 Out of the money $0 ($46 – $48) $1.95 ($1.95 – $0)

Note that, with puts, the option that is in-the-money has a higher exercise price than the current market price. If Felipe were to buy this option he could sell his shares of DNC for $50 a share, at a time when they are only worth $48 a share on the open market. In this case the out-of-the-money put is the one with the exercise price below the market price. If the buyer were to exercise, he would only be paid $46 per share for DNC, which is currently trading at a higher price, $48 per share. Therefore, it would not be the right option for him.

Why Buy an Option?

The option buyer buys options for one of two reasons: to assume risk (speculation) or to avoid or manage risk (hedging). 27 Chapter 3: Exchange-Traded Options The goal of buying a call option is that the market price of the underlying interest will increase above the exercise price by more than the value of the premium. The goal of buying a put option is that the market price of the underlying interest will decrease below the exercise price by more than the value of the premium. The two advantages of buying options instead of buying the underlying interest are leverage and limited risk.

Why buy a call?

Samir has $2,000 to invest. He is interested in Air Northern (AN) which is currently trading at $25. He thinks that the share price will increase over the next three months. He chooses to buy 10 AN Jan 25 calls with a premium of $2.00. His cost is therefore equal to $2,000 calculated as $2.00 × 100 × 10 calls. In January, AN is trading at $30. His calls will be worth at least their intrinsic value of $5.00, calculated as: Intrinsic value = share price – exercise price $30 - $25 = $5.00 When selling the calls, his profit will be $3,000, calculated as: $5 - $2 = $3 $3 × 100 × 10 = $3,000 If he had just bought the shares instead, he would only have been able to buy 80 shares ($2,000 ÷ $25). The price would still have gone up to $30 and he could have sold his 80 shares for $2,400, giving him a profit of $400. Buying calls gives him a return of 150% ($3,000 ÷ $2,000), while buying the shares gives him a return of only 20% ($400 ÷ $2,000). Thus, by buying calls, Samir maximized his leverage (explained below) to realize a more significant percentage return based on his investment.

Why buy a put?

Jing owns 1,000 shares of Brick Platinum (ABC), currently trading at $16. After reading a newspaper article, she is afraid that the price of ABC will decline. She decides to buy 10 ABC Dec 15 puts paying a premium of $1.50. Her cost is $1,500. At the beginning of December, ABC is trading at $12. Therefore, her put options will be trading at a minimum of $3.00. She has two options: she can sell her puts and use the profit to offset her loss from the ABC shares or she can exercise her puts by delivering her $1,000 shares and be paid $15,000 ($1,000 × 15).

Leverage The use of leverage is based on three assumptions: • the stock price will change in the expected direction; • the price change will occur within a specific time period; • the expected change in value will be greater than the cost of the premium. A critical difference between buying an option and buying a stock is that, whereas the value oftheoption terminates at expiry, a stock does not expire. This fact introduces a risk into buying an option that does not exist when buying the underlying interest itself.

Limited Risk The risk of an option buyer is limited to the price paid for the option (i.e., the premium). If the option loses value, it expires worthless, unlike the underlying interest, which is more expensive to buy than an option, due to limited leverage.

28 Chapter 3: Exchange-Traded Options With both options and stocks, the risk of buying is limited to the amount of the original investment. In the case of an option, this is the premium paid; in the case of a stock, it is the purchase price of a stock, since the stock cannot lose more than all of its value. The risk of selling short is far greater if one purchases the stock directly than if one purchases an option, because the stock can, in theory, rise indefinitely, whereas an option can never do worse than expire worthless. For this reason, selling a stock directly is by far riskier than selling an option. Risk Characteristics of Call and Put Buyers Call Buyer Put Buyer Maximum Risk Premium × 100 Premium × 100 Maximum Reward Unlimited (Exercise Price – Premium) × 100 Break-even Stock Price at Expiry Exercise Price + Premium Exercise Price – Premium

Why Sell an Option? The option seller sells options for the same reasons as the option buyer, but with the opposite expectations. The goal of selling a call or put option is that the option will expire worthless and the writer gets to keep the premium. This is one way to earn extra income.

Example 1: Maddie owns 1,000 shares in Arzi Inc. (ARZ) currently trading at $18.50. She does not want to sell her shares but would like to earn income. She sells 10 ARZ Apr 20 calls at a premium of $0.90, receiving a total of $900 ($0.90 × 100 × 10). If ARZ does not go above $20 before expiry, she will not be assigned and therefore she will keep the premium and can keep selling more calls. If ARZ goes above $20, she will still keep the premium but must deliver her 1,000 shares of Arzi Inc. and be paid $20 per share for them. What if Maddie did not own the shares? She can still write the 10 April 20 calls. However, if the price goes up to $25, for example, then she will be assigned and will have to deliver 1,000 shares of Arzi Inc. However, as she does not own them, she must go to market and buy them at the current market price of $25 per share. She is obligated to deliver these shares but will only be paid the exercise price of $20 per share. She has lost $5 per share, or $5,000 in total.

Example 2: Isabella is bearish on the telecommunications industry. She firmly believes that the price of Vzone Inc. (VZE) will decline in the near future. It is currently trading at $51. She sells 10 Oct 49 puts at $3.50, receiving a premium of $3,500. If VZE drops below $49, she will not be assigned and can keep the premium. She can continue to write puts. However, if she is wrong, and VZE increases in price to for instance, $70 per share, she will be assigned. At that point, she will have to pay $70 per share ($70,000 – 10 puts × 100 × $70) and accept delivery of the shares. Risk Characteristics of Call and Put Buyers Call Seller Put Seller Maximum Risk Unlimited (Exercise Price – Premium) × 100 Maximum Reward Premium × 100 Premium × 100 Break-even Stock Price at Expiry Exercise Price + Premium Exercise Price – Premium

Selling Uncovered Options Is Dangerous! When an option seller sells options on an underlying interest that they do not own, this is calledselling uncovered options. If the market turns against the uncovered option seller, huge losses can result due to the effects of leverage,

29 Chapter 3: Exchange-Traded Options since the uncovered option seller must purchase the underlying interest at the current market price to satisfy their obligations. Uncovered option sellers are also subject to a demand for significantly greater margin deposits as collateral for the potential losses.

Additional Benefits of Stock Options • Reducing the risk of owning and selling stocks. • Producing extra revenue on an underlying interest. • Guaranteeing a future stock price. • Adding diversification to a portfolio. • Advantages of Exchange-Traded Versus Over-the-Counter Options Third-party guarantee: Exchange-traded options are traded through the Canadian Derivatives Clearing Corporation (CDCC) and the Option Clearing Corporation (OCC) in the United States, both of which guarantee each transaction through a system of margin in which members with short option positions must provide collateral daily. Liquidity: The third-party guarantee and standard contracts make it very easy to offset (close by taking an offsetting position) exchange-traded options if needed. Disclosure and surveillance: Exchanges have strict trading, disclosure, and monitoring procedures that keep markets efficient and honest. Price transparency: Open price, volume, and open-interest statistics are continuously broadcast through a system of quote vendors and the public media.

Reading Quotations

The typical online intraday quotation will include the following items: • stock name; • historical volatility (annualized standard deviation of percentage changes of stock closing prices over the previous 30 trading days); • current market price of the underlying asset; • change in market price from previous day’s close; • bid (underlying interest); • ask (underlying interest); • option description including underlying asset, exercise price and expiry • bid (option); • ask (option, also called the offer price); • last price; • implied volatility (based on the mid-market price); • open interest (pending orders) at close of previous day. • current total options traded;

30 Chapter 3: Exchange-Traded Options Additional resources Visit the Canadian Derivatives Clearing Corporation: http://www.cdcc.ca/accueil_en.php Visit the Options Clearing Corporation: http://www.optionsclearing.com/

Options Pricing

Factors Affecting Option Prices As previously stated, the option will trade at least at its intrinsic value. If the option is trading at more than its intrinsic value, then the option has time value as well. Major influences that affect time value are: • time to expiry (“time remaining factor”); • volatility of the underlying interest; • net cost of carry, composed of the risk-free interest rate and the yield of the underlying interest (i.e. dividend yield for equity options and bond yield for bond options). Does the underlying asset pay a dividend during the life of the option? Other intangible influences include market sentiment and liquidity. The Black–Scholes Option Pricing Formula, incorporating the foregoing variables, was developed in 1973 by Professors Fischer Black and Myron Scholes to model option pricing. It is the most widely used options pricing model today.

Intrinsic Value

Difference Between Market Price and Exercise Price Intrinsic value is the difference between the market price of the underlying interest and the exercise price of the option. The fair value of an option on its expiry date will be equal to its intrinsic value. Note that the in-the-money options in the examples earlier in the chapter, whether put or call, are always more expensive than the out-of-the-money options, with the at-the-money option in the middle.

American Versus European Style American-style options (i.e., which trade continuously) will always trade at or above their intrinsic value, usually the latter, due to arbitrage. European-style options (i.e., which can only be exercised at expiry) can trade below their intrinsic value. This is especially true of puts, which are more expensive to arbitrage due to the cost of carry of the time to expiry.

Time Value

Time value arises primarily from the value of the time to expiry and is a function of volatility (i.e., the uncertainty as to the future market price of the underlying interest). If the market price of the underlying interest changes in a direction that favours the option buyer so will the fair value of the option increase.

31 Chapter 3: Exchange-Traded Options The limited risk of the option (i.e., the fact that, since the purchase of an option does not oblige the buyer to exercise the option, therefore the risk is limited to the premium paid for the option) also confers a value on the option for which the buyer is willing to pay a premium over and above the intrinsic value. Time value is greatest when the market price of the underlying interest and the exercise price are identical. As the difference between the market price of the underlying asset and the exercise widen, in either direction, the time value of the option decreases.

Time to Expiry The longer the time to expiry, the greater the probability that the market price of the underlying interest will change in a direction that benefits the option buyer and therefore the larger the number of opportunities to exercise the option. The relationship between time value and time to expiry is not linear. Rather, as the time to expiry shortens, the time value decays gradually and then accelerates as the expiry date approaches. Observe the quotes below, retrieved at the end of September. Each have an intrinsic value of $0 as the exercise prices are above the current market price. So, their entire premium is time value. However, as time to expiry grows closer, the time value declines. The October call has less time value than the December call. Company Expiry Exercise Price Premium Time Value SUNUP (SP) Month $47.65 SP call Oct 48 $0.68 $0.68 SP call Dec 48 $1.74 $1.74 SP call Mar 48 $2.47 $2.47

Volatility of the Underlying Interest

Volatility increases the probability that the market price of the underlying interest will change in a direction that benefits the option buyer. Therefore, increasing volatility adds time value to the option. This behaviour is unlike the stock market, where positive and negative volatility cancel each other out. Since the option buyer’s risk is more limited than the stock buyer’s risk, increasing volatility produces a net benefit for the option buyer that is not experienced by the stock buyer. Thus, whereas increasing volatility increases risk for the stock buyer, for the options buyer volatility can actually increase the fair value of the option. Volatility is either historical or expected. As the name implies, historical volatility is the volatility of an underlying interest, based on its past performance. Since historical performance cannot completely account for current conditions, traders use expected volatility as the basis for making trading decisions.

Implied Volatility Indexes The market will have an opinion as to the expected volatility of an option class. This opinion is reflected in the premium of the option. It is calculated by means of an option pricing model such as the Black-Scholes and is called implied volatility.

32 Chapter 3: Exchange-Traded Options Examples of Volatility Indexes Abbreviation Exchange Underlying Interest MVX Montréal Exchange At-the-money options on iShares CDN S&P/TSX 60 Fund (XIV) RVX Russell 2000 VIX CBOE S&P 500 Index, at-the-money 30-day options VXD Dow Jones Industrial Average VXN Nasdaq 100

Cost of Carry The net cost of carry is equal to the difference between the borrowing rate (i.e., the cost of financing the purchase of the underlying interest) and any income received from owning it.

Risk-Free Rate of Return The risk-free rate of return is the pure cost of money (i.e., the borrowing rate on a risk-free investment, usually equated with the rate of return of Canada T-bills). There is a direct relationship between the risk-free rate of return and the rate of return of a call option (all else being equal). In theory, a rising risk-free rate of return should put downward pressure on the premium of a put and make selling the actual security more attractive. In reality, however, margin requirements tend to counteract this effect, and a rising risk-free rate of return has little impact on the put premium.

Additional Resources Black-Scholes http://en.wikipedia.org/wiki/Black%E2%80%93Scholes

Essential Option Strategies

All successful option strategies assume that you have the ability to choose a stock, an expiry month and an exercise price that will maximize the strategy chosen. The specific strategy chosen will be a function of your risk preference and market forecast which includes price and timing expectations.

Bullish Option Strategies

Bullish option strategies are based on the expectation that the fair value of the underlying interest will rise. The specific type of option strategy is a function of your degree of bullishness, ranging from neutral to outright.

Long Call—Outright Bullish Description: Buy call options on an underlying interest. Choosing the Right Strategy: Choose this strategy if you believe that the market price of the underlying interest will rise or you want to guarantee a future price. Choosing the Expiry Month: If you believe that the market price of the underlying interest will recover in the near future, buy a near-term call. If you are uncertain about the timing, buy a longer-term call.

33 Chapter 3: Exchange-Traded Options Choosing the Exercise Price: If you are very bullish, buy out-of-the-money calls. If you are less bullish, buy in- the-money calls. In the Money and Out of the Money Calls and Puts Call Put Current market price of underlying Current market price of underlying In the Money interest is above exercise price of interest is below exercise price of option option Exercise price of option is higher Exercise price of option is lower Out of the Money than current market price of than current market price of underlying interest underlying interest

Example: Sidra believes that ABC Inc. is going to increase in price over the next few months. It is currently trading at $40. She buys 10 ABC March 45 calls, currently out-of-the-money, with a premium of $0.55. If she is correct, and ABC increases in price to $50, she can sell the calls for a minimum premium of $5.00 (their intrinsic value).

Protective Put (Married Put, Synthetic Call)—Outright Bullish, Near-Term Concerns Description: Purchase a put while owning the underlying interest. Choosing the Right Strategy: Choose this strategy to lock in current profits while allowing for future price appreciation. Choosing the Exercise Price: Choose an exercise price a bit less than the current market price of the underlying interest.

Example: Mahmoud owns 1000 shares of DEF Inc., which is currently trading at $56. He buys 10 DEF Dec 55 Puts. If the price goes up, then the options will expire worthless. However, if the price of DEF declines to $50, he can then exercise his options and sell his shares for $55. He has protected his investment from falling below $55.

Covered Call (Covered Write)—Moderately Bullish Description: Purchase the underlying interest and write equivalent calls against it. Choosing the Right Strategy: Choose this strategy if you believe that the market price of the underlying interest has only a limited likelihood of rising or if you want limited downside protection from owning the underlying interest. Choosing the Exercise Price: The more bullish you are, the more out of the money the exercise price should be.

Example: Adita owns 1000 shares of FRB, currently trading at $25. She believes that the price of FRB will increase. She sells 10 Jan 30 calls. If the price increases, but stays below $30, the options will expire worthless and she gets to keep the premium.

Short Put—Neutral to Bullish Description: Sell a put (i.e., sell the right to sell the underlying interest). Choosing the Right Strategy: Choose this strategy if you believe that the market price of the underlying interest will remain above the exercise price of the option, to earn extra income or to buy the underlying interest for less than the current market price.

34 Chapter 3: Exchange-Traded Options Choosing the Exercise Price: N/A

Short Put Buying Strategies Objective Market Forecast Neutral Bullish Earn extra income Out-of-the-money put At or in-the-money put Buy the stock current market price − premium = price at which you are willing to buy underlying interest

Example: Anatoly sells 5 JKL Apr 30 puts. If the price of JKL remains above $30, the options expire worthless and he gets to keep the premium.

Bearish Option Strategies

Bearish option strategies are based on the expectation that the market value of the underlying interest will fall. The specific type of option strategy is a function of your degree of bearishness, ranging from neutral to outright.

Long Put—Outright Bearish Description: Buy put options on an underlying interest. Choosing the Expiry Month: If you expect the market price of the underlying interest to fall before an approaching expiry date, buy a near-term put. Otherwise, buy a long-term put. Choosing the Exercise Price: If you are very bearish, buy cheaper out-of-the-money puts (i.e., the exercise price is lower than the current market value of the underlying interest).

Example: Sara believes that LOY Inc is going to decline in price once the first quarter results are released. It is currently trading at $45. She buys 10 LOY Apr 40 puts. If she is correct, and the price falls below $40 to $38, the option premium will increase by at least $2, as they are now in-the-money. She can sell the put options and make a profit.

Covered Put Sale—Moderately Bearish Description: Sell the underlying interest and write an equivalent put against it. Choosing the Right Strategy: Choose this strategy if you believe there is only limited likelihood that the market price of the underlying interest will fall or if you want some limited upside price protection from shorting the stock. Choosing the Exercise Price: The more bearish you are, the more out-of-the-money the exercise price should be.

Example: Sean feels the market for RFF is going to fall. It is currently trading at $62. He sells short 1000 shares of RFF, but is a little uncertain about whether he is right or not. So he sells 10 RFF Jan 60 puts. If he is right and the price falls, his puts will be exercised and he will have to pay $60 per share for RFF. But his short position will be covered. If he is wrong and the price of RFF goes up, his puts will expire worthless and he can use the premium to offset his losses caused by covering the short sale of the shares.

35 Chapter 3: Exchange-Traded Options Short Call—Neutral to Bearish Description: Sell a call (i.e., sell the right to buy). Choosing the Right Strategy: Choose this strategy if you believe that the market price of the underlying interest will remain at or under the exercise price and you want extra income. Choosing the Exercise Price: If your market forecast is neutral, choose an out-of-the-money call. If your bent is bearish, sell at-the-money or in-the-money calls.

Example: Sam believes the market is going sideways, that is, it will not go up or down significantly for the next few months. He sells 5 ABC Apr 40 calls, when ABC is trading at $38. If he is correct, the call options will expire worthless and he can keep selling calls to make money.

Additional Resources Read an explanation of risk graphs (a.k.a. risk-and-reward profiles, profit diagrams, or payout diagrams): http://www.investopedia.com/articles/optioninvestor/05/012605.asp

36 Swaps are used by financial, industrial, and insurance companies; banks; global organizations; and governments for: mitigating capital costs, exploiting economies of scale, risk management, arbitrage, market entry and creating synthetic instruments. A swap is a cash-settled forward agreement (i.e., trades OTC) characterized by a series of specific exercise dates. Swaps include currency swaps, credit-default swaps, and—the most common—interest-rate swaps, discussed in detail below (also equity and commodity swaps, which are not discussed here). 4 Swap Dealer’s Function The swap dealer facilitates the process of customizing and implementing swaps by acting as buyer to the seller SWAPS and seller to the buyer for a consideration, typically by charging a bid-ask spread on the fixed periodic payments. Dealers also warehouse swaps and hedge the risk, while seeking a suitable buyer or seller to match to an existing swap. As with a clearing house, the transactions on either side of each individual deal that the dealer transacts do not have to cancel out directly. Rather, it is the net of all outstanding swaps, called the “swap book,” that should cancel out, leaving a profit. If they do not do so, the dealers themselves will enter into the market to obtain the necessary offsetting swap or swaps.

Types of Swaps

Currency Swaps In the case of currency swaps, the cash flows are designated in various currencies. The interest rates exchanged may consist of any combination of fixed or floating rates. Unlike other interest-rate swaps, with currency swaps the principal is frequently exchanged when the swap is created, then returned when it expires.

Credit-Default Swaps Credit-default swaps are the fastest-growing type of swap. Credit derivatives are based on an underlying credit asset or pool of credit assets (e.g., bonds, mortgages), and are a form of credit risk management. Chapter 4: Swaps A credit-default swap is a type of credit derivative in which a premium is exchanged for insurance against the risk of a default on a fixed-income security.

Interest-Rate Swaps Interest-rate swaps are the most common type of swaps. The interest-rate swap specifies a series of dates on which cash flows are exchanged.

Plain Vanilla The most basic and common type of interest-rate swap is called a plain vanilla swap. With a plain vanilla swap, the buyer and the seller agree to exchange the net difference between a fixed-rate and a floating-rate interest rate based on the same notional principal. This has the effect of converting the buyer’s and the seller’s respective interest rates into an interest rate of the opposite type.

Example: Let’s assume two parties want to arrange an interest rate swap. They determine that the cash flows will be based on a notional principal of $150 million. Party A wants to pay a 6% fixed rate and Party B wants to pay a floating rate. Payments must be made semi-annually for 5 years. After 6 months, the first payment is exchanged. Party A must pay Party B $4,500,000 (6% ÷ 2 × $150 million). The current floating rate is 5.5%. Party B must pay Party A $4,125,000 (5.5% ÷ 2 × $150 million). Six months later, the floating rate is 6.2%. Party A still pays Party B $4,500,000 but Party B now owes Party A $4,650,000 (6.2% ÷ 2 × $150 million). Why would the two parties do this arrangement? Party A may have a floating rate loan for $150 million and would like to stabilize their cash flows. So, this arrangement allows Party A to pay a set, stable amount each time but receive the necessary cash from Party B’s floating rate payment. They use this money to pay the interest on their loan. Party B, on the other hand, may have a fixed rate loan. They use the stable cash flows from Party A to pay the interest on their loan.

Rate Conversions Interest rates quoted by banks in London, England, are the benchmark for setting the floating interest rate for interest-rate swaps, especially the London Interbank Offered Rate (LIBOR). LIBOR is the average interest rate charged on interbank loans of Eurocurrency deposits.1 LIBOR is quoted for one-, three-, and six-month and annual deposits. The most common interest-rate swaps are the six-month LIBOR and U.S. T-note rate. Since six-month LIBOR and the U.S. T-note rate are based on 360- and 365-day years respectively, both compounded semi-annually, the annual effective rates may differ, although the nominal rates may be identical. Thus, the two rates must be reduced to a common denominator, such as a per annum basis compounded semi- annually.

Structure Another reason for participating in an interest-rate swap, besides market expectation, is if a company has a comparative advantage (e.g., due to a superior credit rating) in one interest-rate market compared with another. Comparative advantage is relative to absolute rate-advantage differentials. Swaps can also be entered into for speculative purposes.

1 Other interbank interest-rate indexes are the PIBOR (Paris) and SIBOR (Singapore). 38 Chapter 4: Swaps Pricing Not considering default risk, an interest-rate swap, in which the buyer or seller pays a floating rate of interest based on LIBOR and takes back a fixed rate of interest, is the same as buying a bond paying the same fixed-rate interest rate as in the swap and selling a bond with a floating interest rate based on LIBOR. The maturities of the two bonds are the same as the swap. Since a swap can be considered to be the same as a long position and a short position in two bonds, pricing a swap is the same as pricing the long and short positions in two bonds. The value of a swap, therefore, may be calculated using the following formula: Value of Swap = Value of Long Bond – Value of Short Bond Pricing a swap means selecting the interest rate of the fixed-coupon bond, such that the value of the fixed- coupon bond and the value of the floating-rate bond are the same. The swap at inception, therefore, is worth zero.

Indication Pricing Schedule Swap dealers typically use an “indication pricing schedule” to price their services; this is a schedule of their rates. This means that they do not price on the basis of a fixed, up-front fee, but rather price on a spread over a T-bill yield (i.e., number of basis points above the yield). The spread is based on the term structure of interest rates at the time (higher spreads for longer maturities) and creditworthiness of the end user.

Credit Risk Credit risk is the likelihood that either the dealer or the buyer or the seller of a swap agreement may default. The risk of default only applies to the buyer or seller with the positive position. One way of hedging OTC credit risk is for the buyer or the seller to enter into a credit derivative contract in which the payout is equal to the positive value of the swap. Actual defaults are limited by the difficulty of qualifying to enter into a swap. The following means are also used to limit risk: • limiting expiry to less than ten years; • requiring credit enhancements, such as collateral (e.g., securities, real estate, line of credit); • triggering events (e.g., change in credit rating), whereby collateral must be posted or increased in response to a negative credit event; • bilateral netting, whereby all swap agreements with the same buyer or seller are combined. The legal status of bilateral netting—in the event of bankruptcy, for example—is uncertain.

Terminaton OTC swaps are very difficult to liquidate prior to expiry; however, an interest-rate swap can be terminated by: • taking an opposite (offsetting) swap agreement; • finding someone else to take the position; • paying off the other buyer or seller; • exercising a previously purchased option that allows the buyer to terminate.

39 Chapter 4: Swaps Why Interest-Rate Swaps Are Used • Comparative advantage; • Flexibility; • Low cost (standardization).

Other Types Of Swaps Arrears swap: interest payment date is the date on which the floating rate is calculated. Basis swap: interest payments for both parties are floating, but with different basis for buyer and seller. Amortizing swap: notional principal drops to zero (e.g., mortgage-backed securities). Accreting swap: notional principal increases. Quanto swap: interest-rate payments are based on different currencies. Index swap: payments are based on an index.

Additional Resources Read the Wikipedia article on the London Interbank Offered Rate: http://en.wikipedia.org/wiki/LIBOR

40 Types of Risk

Market Risk A major reason for the existence of derivatives is to reduce market risk (i.e., the risk of a loss of value due to fluctuations in market volatility). Market risk can be properly assessed only by looking at the market exposure of an entire company. If a system of risk management and control based on hedging is perfect, market risk disappears, and thus becomes irrelevant. However, few actual hedges are perfect. In particular, 5 hedges involving highly volatile investments can produce unpredictable results because of basis risk. Managing market risk differs for forwards and options. Since futures, forwards, and swaps are continuously RISK, related to the fair value of the underlying interest, any negative change in the fair value of the underlying interest ACCOUNTING is easily offset by acquiring a contrary position using another forward-type derivative. AND Because of their non-linear relationship to the fair value of the underlying interest, managing market risk for options is more complex. Delta measures the sensitivity of the price TAXATION of the option to the fair value of the underlying interest. Thus, managing market risk in the case of options involves ISSUES constantly adjusting a hedge to changes in the delta. Credit Risk Credit risk is the risk that the seller of a derivative will default, either through bankruptcy or insolvency. Credit risk is assessed by daily marking to market of all derivatives held. Credit risk can be controlled by properly researching a seller’s credit rating and diversification (by seller, industry, and country), by using exchange-traded derivatives, and by the use of credit derivatives (e.g., credit-default swaps).

Settlement Risk Settlement risk is a particular type of credit risk in which the final exchange at expiry of an OTC derivative is not consummated by the buyer or seller due to time-zone differences. Because certain types of derivatives involve larger sums, the settlement risk of a forward, where a single lump-sum payment is required at expiry, is greater than the settlement risk of a currency swap, in which the principals are exchanged at inception and expiry. The settlement risk of a currency swap is greater than the Chapter 5: Risk, Accounting and Taxation Issues settlement risk of an interest-rate swap, in which the principal amount is never exchanged. Since settlement risk is directly proportional to the amount of the exchange at expiry, settlement risk can be reduced by a strategy called bilateral netting, in which only the difference between the obligations of buyer and seller is actually exchanged, as with interest-rate swaps. Since the amount of cash is reduced to the minimum, the settlement risk is significantly reduced.

Liquidity Risk Derivative positions that change are often subject to liquidity risk. Although OTC derivatives have the greatest liquidity risk, exchange-traded derivatives are also subject to liquidity risk. In general, only derivatives with expiry dates that are close together trade actively enough to make liquidity risk of little concern. Liquidity and the bid-ask spread are inversely correlated. Larger spreads correspond to greater liquidity risk, whereas smaller spreads correspond to higher liquidity.

Legal Risk Legal risk is the risk that a contract is legally unenforceable. Legal risk increases as derivatives markets become increasingly globalized and innovative. On the other hand, legal risk may be expected to diminish as securities laws become increasingly internationalized and sophisticated.

Operational Risk Operational risk is the risk of loss arising from administrative errors, misjudgements, lack of attention, or actual incompetence, including the areas of risk management, internal controls, accounting, record-keeping, mark-to- market evaluation, recording or settling transactions, the computer system, etc.

Systemic Risk Systemic risk is the risk of a failure of the whole derivatives support system in response to a failure or a major disruption (e.g., bankruptcy) of a part, including a major company, a market segment, or the settlement system.

Reputation Risk Reputation risk is the risk to a company’s professional credibility if it acts dishonestly or in bad faith in derivatives dealings.

Measuring Risk

Steps to Measuring Risk 1. Correlate derivatives with types of potential risk. 2. Measure risks that can be quantified (e.g., market, credit, liquidity). 3. Evaluate risks that cannot be quantified (e.g., legal, systemic, operational). 4. Update current market value of all derivative positions daily (mark to market).

Value-at-Risk Method Value-at-Risk (VaR) method represents a company’s total risk exposure from a portfolio of assets, expressed as three variables:

42 Chapter 5: Risk, Accounting and Taxation Issues • total risk exposure, expressed in dollars; • time frame, expressed in days; • confidence level, expressed as a percentage (the inverse of confidence is risk). VaR is calculated based on historical market performance or Monte Carlo simulation (i.e., random variation within stated limits). VaR is based on three axioms: asset returns are normally distributed (a normal distribution is also called a bell curve); computationally intensive; and not additive (i.e., interactive).

Stress-Testing Method Stress testing is a type of scenario analysis in which the performance of a portfolio is evaluated under a variety of improbable, but possible, circumstances. The popularity of stress testing is increasing.

Internal Control and Monitoring to Reduce Risk

Derivatives are used in a corporate risk-management program to expedite cash-flow stability and liquidity. These goals are secured by establishing a system of checks and balances to ensure that derivatives are used for risk control and not for speculation within an efficient and effective administrative structure. A risk management committee of board members and senior managers oversees the following responsibilities: • developing and implementing risk-management policies and procedures for assessing and measuring risk; • limiting risk exposures; • trading and clearing authorities; • internal reporting and communications; • systems support; • mark-to-market evaluation; • training and educating personnel.

Oversight An efficient oversight policy demands that the board and senior managers understand the derivative products used in the risk-management program, the risk parameters of their risk-management strategies and scenarios, and understand that all risk-management decisions are under their authority and subject to their approval. Risk management includes identifying, measuring, reporting, controlling, and monitoring risk and defining what risks are acceptable and what risks are not acceptable.

Relevant Questions to Ask: ◦◦ What risks are inherent in our current or potential derivatives activities? ◦◦ What are acceptable risks? ◦◦ What are unacceptable risks? ◦◦ What is the acceptable cost of our risk-management choices ◦◦ What type of derivatives will we use? ◦◦ Who will be given authority to trade what types of contract? ◦◦ What is the credit exposure to counterparties?

43 Chapter 5: Risk, Accounting and Taxation Issues Limits on Risk-Taking

Limiting risk includes: • identifying each potential market risk and setting an acceptable risk level for each type; • transferring or transforming certain risks to a buyer or seller or another type of derivative; • limiting the nature and extent of derivatives-related activities by managers; • limiting exposure to individual counterparties; • defining the minimum acceptable credit rating of counterparties; • avoiding, or at least limiting, the use of new or exotic derivatives; and • requiring managerial approval for the use of new derivatives.

Separation of Duties The separation of duties avoids any potential conflict of interest that might arise where a single individual, or a small group with similar interests, is given complete control and authority over the risk-management process. Derivatives traders should not be able to process, record, verify, value, or approve their own trading activities. The front office should handle transactions and the back office should process, record, verify, and make payments on those transactions, with mutual functional independence.

Segregation of Compensation Compensation should not include perks that encourage risk-taking behaviour, such as enhancing yieldson speculative trades. Front-office and back-office personnel should be separately compensated. Those who monitor and control the traders should not benefit, directly or indirectly, from any profits generated by traders.

Internal Reporting and Communication Changes in market conditions should be communicated to everyone openly with complete transparency.

Continuing Education All personnel should be qualified and experienced in handling derivatives and should be required to keep pace with new developments by means of continuing education and training courses and programs.

Additional Resources Learn more about VaR: http://en.wikipedia.org/wiki/VaR

Accounting, Disclosure, Taxation

Accounting The main problem in derivatives accounting is deciding when cash flows are accounted for and how they are treated. The right accounting methodology for a derivative is mostly based on its intended use and what typeof transaction it is.

44 Chapter 5: Risk, Accounting and Taxation Issues Accounting methodologies differ according to whether the transaction is entered into for hedging or speculation. Hedges are accounted for using hedge accounting; speculation is accounted for using a mark-to-market accounting methodology.

Hedge Accounting Cash flows relating to a hedge are accounted for when the asset or liability being hedged is accounted for. If the asset or liability being hedged is accounted for in terms of its historical cost, any cash flows related to the hedge are accounted for when earnings on the asset or liability are accounted for. However, if the asset or liability being hedged is accounted for in terms of its market value, then any cash flows resulting from the hedge are accounted for as a part of the asset or liability’s mark-to-market evaluation. Cash flows of hedges of future obligations or expected transactions are accounted for as a part of the hedged transaction when it happens.

Mark-to-Market Accounting Generally accepted accounting principles (GAAP) require that any cash flow resulting from hedges entered into for the purpose of speculation must be accounted for immediately as income. Hence the term “mark-to-market accounting,” in which cash flows resulting from such hedges are accounted for daily. For the purpose of GAAP, any hedge that is not entered into for the purpose of reducing risk is considered speculation. This creates a problem with OTC transactions, since these are not traded on an exchange and their fair value is difficult to estimate. Exotic derivatives are also difficult to evaluate.

New Standards The Canadian Institute of Chartered Accountants Accounting Standards Board (AcSB) and the International Accounting Standards Committee (IASC) have completed a financial-instruments project in which the following issues are addressed: • classification of financial instruments (debt, equity) and cash flows (interest, dividends, gains, losses); • disclosure of type, extent, and terms and conditions of financial instruments; • balance-sheet reporting of offsetting financial assets and liabilities; • standards for disclosure of exposure to credit risk and credit concentrations; • disclosure of fair market values of derivatives.

Financial Reporting and Disclosure Historically, derivatives have not been included on the balance sheet until significant cash flows, positive or negative, emerge, because derivatives have zero value at inception and only develop value over time. The relatively new AcSB guidelines require that all financial instruments, including derivatives, appear on the balance sheet at fair market value or, if fair value cannot be established, at cost or amortized cost.

Taxation

The two main questions regarding the taxation of derivatives relate to the year in which the associated cash flows should be reported for tax purposes and whether the cash flows are income or capital gains or losses. The answers to these questions depend on whether the derivative is a hedge, what type of underlying exposure is being hedged and the type of derivative. A hedge for tax purposes must be identified as such by the taxpayer and must fall into one of three types: fair-

45 Chapter 5: Risk, Accounting and Taxation Issues value hedge, cash-flow hedge, or hedge of a net investment in a self-sustaining foreign operation. The underlying item or exposure that is being hedged must be identified, together with a reasonable expectation that the hedge will continue to be effective as such. If the taxpayer seeks to come out of the transaction with a profit, then the derivative is classified as a speculation for tax purposes.

Tax Treatment of Derivatives Used for Speculation Speculative derivatives transactions are taxed as straight income upon receipt, and thus their tax treatment is relatively simple. At the end of the tax year, any outstanding derivatives transactions are marked to market based on their fair market value and taxed as ordinary income.

Tax Treatment of Derivatives Used for Hedging Cash flows relating to a hedge are taxed when the underlying interest being hedged is taxed. A cash flow on a hedge is classified as income or as capital gains, depending on how a similar cash flow on the underlying interest would be classified. The foregoing applies primarily to end-users of derivatives that are not financial corporations. Since brokers and dealers derive their living from trading, all their cash flows are taxed as income. End-users, including speculators and hedgers, who are not exposed to significant market risk (e.g., foreign- currency risk, interest-rate risk, etc.), may make an election that their derivatives transactions shall be taxed as income or as capital gains. This election, once made, is irrevocable.

Additional Resources Visit the Accounting Standards Board: http://www.acsbcanada.org/index.cfm/ci_id/185/la_id/1.htm