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Derivatives 1: Derivatives explained
• An option is the securitised right (not the obligation) to buy (“call”) or sell (“put”) an underlying asset at a specifi c price and at a specifi c time in the future.
• In futures contracts, buyers and sellers commit themselves to buy or sell a specifi c amount of an underlying asset at a set price when it falls due.
• Clearing houses intervene between buyer and seller upon conclusion of the contract and provide both parties with a guarantee that the transaction will be executed.
• The spot price is the price of a fi nancial asset for immediate delivery, while the futures price is the expected price at a specifi c time in the future. This whitepaper is exclusively for use by Professional Clients and Financial Advisers in Continental Europe, Qualifi ed Investors in • Contango and backwardation describe pricing situations in the Switzerland and Professional Clients in Dubai, Jersey, Guernsey, Isle of commodities market. If the market is in contango, then the futures Man, Ireland and the UK. This price is higher than the spot price. Backwardation is the word used document is not for consumer use, please do not redistribute. when the futures price is lower than the spot price of an asset.
1 investmentcampus Derivatives 1: Derivatives explained A wide range of objectives can be pursued with derivatives – from hedging risk to implementing investment ideas. Derivatives are “derived” securities (in Latin: derivare = derive). Their valuation arises from the performance of an underlying asset, such as equities, bonds, commodities, currencies or interest rates. In contrast to “direct” investments, such as stocks, derivatives are “indirect” investments. The most important derivatives include options, futures and swaps. Investors who want to use derivatives are not the only ones who should understand the hidden meaning of terms such as options, futures, clearing house, spot and futures price, as well as contango and backwardation. It also makes sense for fund investors, since many funds work with these derivative instruments when implementing their investment strategy.
In many cases derivatives are used with the aim to reduce risks. Derivatives are also nothing new. Historically, the derivatives trade can be traced to the second millennium before Christ. Even back then, people tried to hedge against price fluctuations when trading agricultural products, for example.
Originally, hedging was the primary purpose for derivatives. It is still important today and a common reason for using them. However, derivatives are now also frequently used to implement investment ideas, for example, when an investor is convinced that the US dollar will strengthen against the euro or that oil prices will fall. The advantage of derivatives? The underlying asset itself must no longer be bought and sold, so capital investment is reduced.
With futures transactions, or deals related to the future, the basic distinction is made between the Options: Agreements conditional and the unconditional – meaning those that represent only a possibility and those that represent an obligation. Conditional futures transactions include options. These differ from futures on optional buying and and forwards, which involve an obligation to buy and sell, as well as pay, and are therefore selling in the future “unconditional.”
Figure 1: How options work
Arrangement Exercise of option
Put option
Option premium
Call option
Buyer Seller Buyer decides on Seller waits exercising option
Source: Invesco. Schematic representation for illustration purposes only.
Basic knowledge
Options With options, the investor concludes a contract to be able to buy (call) or sell (put) an underlying asset at a price agreed in advance (exercise price, also known as the strike price). The seller of the option must comply with this right upon the buyer’s request. In return, he receives an option premium from the buyer. Underlying assets (also known as “underlyings”) include equities, bonds, currencies or commodities. The right to buy or sell is only valid for a specific time period. If the option is not exercised within that period, it expires. A distinction is made between European options, which can be exercised only on the expiry date, and US options, which can be exercised on any trading day before expiry. Options are usually traded on futures and option exchanges and are defined in relation to contract size, exercise or strike price, and duration.
2 investmentcampus Derivatives 1: Derivatives explained Options have advantages and disadvantages. One advantage is that the required capital investment does not have to be produced in the first place, unlike an immediate direct investment in the underlying asset. There is also a leverage effect in relation to the underlying asset: Its gain results in the option’s disproportionate price increase. Last but not least, it is possible to speculate on rising and falling markets with options. However, there are also disadvantages: If the underlying asset does not perform in the desired (expected) direction, then heavy losses are possible, including a complete loss of the premium.
Futures contracts, on the other hand, involve the obligation – not just the possibility (option) – Futures: The obligation to buy or sell an underlying asset at a specific time in the future. For this reason, they fall into the category of “unconditional” futures transactions. They can hedge against risk, but they can to buy or sell also be used to take a view on specific price developments that may be expected.
As with options, the essential advantage of futures is also that the required capital investment does not have to be produced in the first place, unlike an immediate direct investment in the underlying asset. Likewise, the fact that you can take a view on falling and rising prices. However, one disadvantage is the contract sizes, which in practice are often very large, making an investment more difficult for private individuals. And there is the possibility of high losses, when prices of the underlying asset develop in a different direction than that expected.
Figure 2: Futures contracts
Long investor (=buy) Contract Short investor (=sell) if the risk is to be taken on if the risk is to be passed on
exchange of risks
Futures exchange
Clearing house
Source: Invesco. Schematic representation for illustration purposes only.
Basic knowledge
Futures Futures are standardised, exchange-traded contracts. A contracting party has the obligation to deliver (“short position”) a specific amount of an underlying asset – equities, for example – at a set price and at a specific time. The other contracting party is obligated to take delivery (“long position”). In contrast to options, the purchase and sale are therefore binding, hence the term “unconditional” futures transactions. A distinction is made between commodity futures – meaning futures contracts for goods – and financial futures, which are futures contracts related to equities, bonds, indices or currencies. The futures business emerged to hedge prices for agricultural products and commodities. Today, futures are used for hedging, efficient portfolio management as well as speculative or arbitrage purposes. They are traded on futures markets.
3 investmentcampus Derivatives 1: Derivatives explained The term “clearing house” often appears in connection with transactions in securities and derivative Clearing house instruments. This refers to a settlement agent for the processing and settlement of securities transactions. Processing through a clearing house has many advantages. For example, clearing companies can pool various orders, thereby reducing transaction costs. Clearing houses also carry out the risk controlling for the contracting partners.
Figure 3: How does a clearing house work?
Market participant Participant A Participant B
Sale Purchase
Central counterparty Clearing company
Settlement instructions
National and international Custodian 1 Custodian 2 Custodian 3 central custodians
Source: Invesco. Schematic representation for illustration purposes only.
Basic knowledge
Clearing house The task of a clearing house, also known as clearing company, is to assess the mutual claims and obligations, the delivery commitments as well as the settlement (meaning mutual compliance in spot and futures transactions) for dealings in securities and futures contracts. Upon completion of a contract, clearing houses intervene between the buyer and seller, guaranteeing compliance for both parties to the transaction – they therefore act as a central counterparty. They are also responsible for the settlement of transactions effected, administer margin deposits and calculate the netting values. In the so-called settlement, the traded security is then exchanged for its equivalent value in cash, thereby completing the transaction. The users, or members, of a clearing system must comply with specific requirements and provide collateral to receive authorisation. Clearing houses are normally business units of exchange operators.
Using derivatives to hedge or to implement investment ideas and strategies necessarily involves Spot and futures an understanding of prices and price formation in markets, also within a particular time frame. Current prices in spot markets and futures prices in the corresponding futures markets can differ prices significantly for a particular underlying asset. Therefore, futures relating to an underlying asset – for example, a commodity such as crude oil – and depending on the relevant term, have another price, which differs from the current spot price under normal circumstances. The prices are determined by the specific supply-and-demand conditions at the time, but also by expectations relating to future price developments.
Figure 4: Spot and futures prices for gold – an example
Spot price 15 Futures price December August 2018 2016
1,348.99 1,354.80 US-Dollar US-Dollar
On 15 August 2016, the spot price for an ounce of gold on the New York Commodities Exchange (Comex) was $1,348.99. That means, the ounce could be purchased on that day at that price. The futures price for the ounce for delivery in December 2018 was $1,354.80.
Source: Invesco. Schematic representation for illustration purposes only.
4 investmentcampus Derivatives 1: Derivatives explained Basic knowledge
Spot and futures prices Spot price (also cash price) is understood as the current price of a financial investment – a security, commodity or currency, for example – for immediate delivery. By contrast, futures price describes the expected price at a specific time in the future. Spot prices not only provide important information in their own right, but also serve as a basis to calculate futures, forwards and options. The terms spot price and futures price are used most often for commodities contracts, for oil or gold, for example. Normally, the futures price is higher than the spot price because of costs relating to storage, insurance and prevailing interest rates. However, there could also be the reverse market situation, for example, when an oversupply is expected for the future.
One thing is noticeable when considering prices, whether they are current or expected for the Contango and future: The futures price is usually higher than the current spot price – that is the norm. The so- called futures curve, which mirrors prices for all traded futures contracts of different durations, backwardation: Price usually points upwards as a result. However, it is sometimes the other way around – and there conditions in the can indeed be reasons for this. commodities market Figure 5a: Contango - the gold price US dollars per ounce
1,300
1,250 1,200 1,150 1,100 1,050 Jan Jun Oct Feb Jun Oct Jun Jun Jun Dec 10 10 10 11 11 11 12 13 14 14
Source: Invesco. Schematic representation for illustration purposes only.
Figure 5b: Backwardation - the sugar price
US dollars per pound 0.30
0.26
0.22
0.18
0.14 Feb Apr Jun Sep Feb Apr Jun Sep Feb Apr Jun Sep 10 10 10 10 11 11 11 11 12 12 12 12
Source: Invesco. Schematic representation for illustration purposes only.
Basic knowledge
Contango and backwardation The terms contango and backwardation describe price conditions in the commodities market. If the market is in contango, then the futures price – meaning the price for delivery in the future – is higher than the current price (spot price) for that commodity. A commodity to be delivered in the distant future would therefore be more expensive than if it were purchased and delivered immediately or in the near future. This applies as the norm because of costs relating to storage, insurance and prevailing interest rates. Backwardation describes the reverse situation: It is the term used when the futures price is lower than the spot price. A commodity to be delivered in the distant future would therefore be cheaper than if it were purchased and delivered immediately or in the near future. It can occur when market participants expect prices to fall or when there is an acute shortage of a particular commodity.
5 investmentcampus Derivatives 1: Derivatives explained Contango and backwardation are mostly relevant in connection with so-called rollover losses or gains. The reason: The underlying asset should actually be delivered upon expiry of a futures contract, but this is generally not required. Through a rollover, commodities investors can then go from an expiring contract into a futures contract with a longer duration. The old one is sold and a new one is purchased. In this way, losses or gains can occur, depending on whether the next futures contract is more expensive or cheaper than the one that is about to expire. This is referred to as a “rollover loss” or “rollover gain.” This topic is also relevant to fund investors because funds also have to cope with rollover losses.
Contact us Important information This whitepaper is exclusively for use by Professional Clients and Financial Advisers in Continental Europe, Qualified Investors in Switzerland and Professional Clients in Dubai, Jersey, Guernsey, Isle of Man, Ireland and the UK. This www.invesco.eu document is not for consumer use, please do not redistribute. All data is as at 31 December 2016 sourced from Invesco unless otherwise stated. Where Invesco has expressed views and opinions, these may change. The views expressed herein do not refer to any specific Invesco product. Opinions and forecasts are subject to change without notice. The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested. Past performance is not a guide to future returns. Forecasts are not reliable indicators of future performance. Investors considering alternatives should be aware of their unique characteristics and additional risks from the strategies they use. Whilst great care has been taken to ensure that the information contained herein is accurate, no responsibility can be accepted for any errors, mistakes or omissions or for any action taken in reliance thereon. The information presented herein contains general information only and does not take into account individual objectives, taxation position or financial needs. It is not an offer to buy, sell or hold financial instruments nor does it constitute investment advice or a recommendation of the suitability of any investment strategy for a particular investor. No part of this document may be copied, photocopied or duplicated in any form by any means or redistributed without Invesco´s prior written consent. Germany: Issued by Invesco Asset Management Deutschland GmbH, An der Welle 5, D-60322 Frankfurt am Main. Austria: Issued by Invesco Asset Management Österreich – Zweigniederlassung der Invesco Asset Management Deutschland GmbH, Rotenturmstrasse 16-18, A-1010 Vienna. Switzerland: Issued by Invesco Asset Management (Schweiz) AG, Talacker 34, CH-8001 Zürich. Dubai: Issued by Invesco Asset Management Limited, PO Box 506599, DIFC Precinct Building No 4, Level 3, Office 305, Dubai, United Arab Emirates. Regulated by the Dubai Financial Services Authority. Ireland: Issued by Invesco Global Asset Management DAC, Central Quay, Riverside IV, Sir John Rogerson’s Quay, Dublin 2, Ireland. Regulated in Ireland by the Central Bank of Ireland. Jersey and Guernsey: Issued by Invesco International Limited 2nd Floor, Orviss House, 17a Queen Street, St Helier, Jersey, JE2 4WD. Regulated by the Jersey Financial Services Commission. Isle of Man: Issued by Invesco Global Asset Management DAC, Central Quay, Riverside IV, Sir John Rogerson’s Quay, Dublin 2, Ireland. Regulated in Ireland by the Central Bank of Ireland. UK: Issued by Invesco Asset Management Limited, Perpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire RG9 1HH, UK. Authorised and regulated by the Financial Conduct Authority. CEUK200/2017
6 investmentcampus Derivatives 1: Derivatives explained