CHAPTER 10: DERIVATIVES Topic One: What Is a Derivative? 1. Overview. A. Derivatives are investments that derive value from an underlying asset or security (e.g., stock, currency, stock market, index, or a real asset, such as gold). B. Derivatives can be used to reduce the risk of an underlying asset’s future position, to speculate on the value of the underlying asset, or to hedge an underlying asset. C. The two categories of derivatives are options and forwards. (1) Options: A contract between a buyer and a seller: (a) The buyer has the right (but not the obligation) in the future to buy or sell an agreed-upon amount of an underlying asset at an agreed-upon price. (b) If the buyer wishes to exercise his or her right, the seller must complete the transaction. (c) An owner of a call option has the right to buy the underlying asset. (d) An owner of a put option has the right to sell the underlying asset. (2) Forwards: Also contracts between a buyer and a seller. The buyer and seller are obligated to complete a transaction in the future for an agreed- upon amount of an underlying asset at an agreed-upon price. 2. Features Common to All Derivatives. A. Derivative agreements are contracts that set out the rights and obligations of the buyer and the seller. B. Both parties to the contract must fulfill their contractual obligations or exercise their rights by the expiration date, after which the contract is automatically terminated. C. Each derivative contract includes a price or formula to determine the price of the asset to be bought or sold on the expiration date or before. D. No up-front payment is required for forwards. To provide the seller with a sense of confidence that the terms of the contract will be fulfilled, the buyer can put up a performance bond or a good-faith deposit. E. An options buyer makes a payment, called a premium, to the seller when the contract is drawn up. The buyer may then buy or sell the underlying asset at a preset price, on or before the contract expires. F. Derivatives are a zero-sum game: every dollar lost by one party represents a dollar gained by the other. 3. Derivative Markets. A. Derivatives trade on over-the-counter (OTC) markets and exchanges. (1) Over-the-Counter (OTC) Derivatives (a) The OTC derivatives market is made up mainly of financial institutions (e.g., banks) trading with each other and with large corporate clients. (b) Transactions are made by dealers/brokers directly over the phone and computers, 24 hours per day, including weekends and holidays. (c) OTC derivatives can be more complex than exchange derivatives, as they are often custom-made to meet the needs of the client. (2) Exchange-traded Derivatives (a) A derivative exchange provides trading facilities via a trading floor or an electronic trading system. (b) Regulations for trading are made and enforced by the exchange. (c) This market was created due to standardization, credit risk, and liquidity issues present in the OTC market. Comparison of OTC vs. Exchange-traded Derivatives OTC Exchange-traded Standardization and No standard contracts — Standardized contracts—no flexibility contracts customized to customization client need Privacy Completely private trades Trades are publicly known Liquidity and Contracts not liquid Contracts easily liquidated by offsetting taking offsetting market position Default risk High Low due to clearing houses that guarantee contractual financial obligations Regulation Unregulated Regulated by their exchanges and government agencies Topic Two: Types of Underlying Assets (For Exchange-traded Derivatives) 1. Commodities. A. Commodities are consumable: grains and seeds, livestock, lumber, fibre, food (e.g., orange juice, sugar), precious and industrial metals, and energy products (e.g., oil, natural gas). B. Commodity futures and options are used: (1) By commodity producers, merchandisers, and processors, to protect against fluctuating commodity prices. (2) By speculators, to profit from fluctuating commodity prices. C. Commodity prices depend on supply and demand, agricultural production, weather, government policy, international trade, demographics, economics, and politics. D. Most commodity derivatives are traded on exchanges. 2. Financials. A. Financial derivatives have financial assets underlying them. B. Volatile interest and exchange rates, deregulation and competition among financial institutions, globalization, technological advances, and advancements in financial engineering have all played a role in the recent growth of financial (and other) derivatives. C. Equity and Equity Indexes. (1) Equity options (i.e., individual stock options): (a) The principal type of equity derivative. They trade on organized exchanges in the major trading nations (e.g., the Montreal Exchange). (2) Equity index derivatives: (a) Based on equity indexes. (b) Settled by cash delivery instead of delivery of the underlying stocks, thus eliminating the cost and complications of trading a quantity of stocks in the index. (c) Used by investors for hedging stock positions, adjusting portfolios, arbitraging comparable stock-combination contracts, and speculating on market direction. (d) In Canada, one index on which these derivatives are based is the S&P/TSX 60 Index. (e) Options on exchange-traded funds (e.g., iUnits S&P/TSX 60) are a recent type of listing; they require settlement by delivery of the underlying ETFs. (3) Interest-rate derivatives (exchange-traded): (a) Interest-rate derivatives traded on an exchange are based on securities that are sensitive to interest-rate changes, not based on interest rates directly. (b) Underlying assets for these derivatives in Canada are GOC bonds and bankers’ acceptances, with futures options available on three-month bankers’ acceptances. (c) In Canada, interest-rate futures trade on the Montreal Exchange. (d) In the United States, underlying assets for these derivatives include Eurodollars, and treasury notes and bonds. (4) Interest-rate derivatives (OTC-traded): (a) OTC-traded interest-rate derivatives are based on floating interest rates. (b) OTC contracts settle in cash. (5) Currency derivatives: (a) Common underlying assets for these include the U.S. dollar, the Japanese yen, the British pound, the Euro, and the Swiss franc. (b) On organized exchanges, currency futures and options are commonly traded. On OTC markets, currency forwards and currency swaps are common. (c) Currency derivatives are not listed on any Canadian exchanges. Topic Three: Why Investors Use Derivatives 1. Individual Investors. A. Individual investors mainly trade exchange-traded derivatives through a special account with a brokerage firm that must be registered to handle these accounts. (1) Options are more actively traded than futures. B. These investors use derivatives to speculate and manage risk. C. Investors must understand the risks of derivatives before investing, and should speculate only if they can handle the potentially large losses involved. D. Investment advisors and representatives must have the following courses completed to become licensed before dealing with individual derivatives investors: (1) The CSI’s Derivatives Fundamentals Course (DFC), and (2) The Options Licensing Course (OLC or the Futures Licensing Course (FLC). E. Individuals who purchase hedge funds and mutual funds that use derivatives are indirectly participating in derivatives. 2. Institutional Investors. A. Institutional investors that use derivatives include insurance companies, managers of mutual funds, hedge funds, pension funds, etc. (1) They also use derivatives to speculate and manage risk. (2) Many institutional investors use derivatives to alter their asset allocation. B. Unlike individual investors, they are able to trade OTC derivatives in addition to exchange-traded derivatives. (1) Costs associated with trading, including commissions, bid-ask spreads, and administrative fees can affect a decision to enter or leave a market. (2) Switching markets temporarily using derivatives may be more cost- effective than directly trading in the underlying assets. 3. Corporations and Businesses. A. Use derivatives to manage risks associated with interest rates, currency, and commodity prices. B. The companies that use derivatives often: (1) Use borrowed funds. (2) Have international interests. (3) Consume or produce large amounts of commodities. C. Corporations use hedging to manage risk while focusing on their primary business. (1) The purpose of hedging is to reduce the risk of losses from investments. Hedgers ―play both sides‖ by investing in derivatives that will benefit them in the opposite way as assets they are already invested in. (2) Hedging is useful for individuals or companies that rely on a certain asset as a part of their everyday business; by hedging with derivatives against the asset, they balance out the risk of loss. (3) In order to protect against price decreases, the hedger can take a short position in a forward contract or buy a put option on the asset. (a) For Example: A beef farmer has an interest in the price of beef increasing, but can offset the risk of it decreasing by buying derivatives that benefit from low beef prices. (4) In order to protect against price increases, the hedger can buy a forward contract or a call option on the asset. (a) For Example: A car- parts manufacturer benefits from low prices of metals, but can offset high metal prices by buying derivatives that pay off when metal prices are high. (5) Hedging can reduce—but does not eliminate—risk, so the company’s board of directors must be knowledgeable enough to decide when and how much to hedge. 4. Derivative Dealers. A. Derivative dealers are intermediary users of derivatives: they buy and sell derivatives, according to the demand of end users. (1) Individual investors, institutional investors, and corporations and business are end users of derivatives. B. On OTC markets, derivative dealers take the opposite side to positions entered into by end users. C. OTC derivative dealers in Canada include: (1) The ―big six‖ banks. (2) Canadian subsidiaries of large foreign banks. (3) Investment dealers. D. Exchange-traded derivative dealers in Canada include: (1) Banks.