🏦Financial Institutions and Markets Unit 10 – Derivative Markets and Risk Management

Key Concepts and Definitions

• Derivatives financial instruments that derive their value from an underlying asset, reference rate, or index
• Underlying assets include commodities, stocks, bonds, currencies, interest rates, and market indices
• Derivative contracts specify the terms of the agreement between two parties, including the price, quantity, and settlement date
• Derivatives used for hedging (reducing risk), speculation (taking on risk for potential profits), and arbitrage (exploiting price discrepancies)
• Derivative markets facilitate price discovery, risk transfer, and enhanced liquidity
• Counterparty risk the potential for one party in a derivative contract to default on their obligations
• Margin requirements ensure that market participants have sufficient funds to cover potential losses
  • Initial margin deposited when entering a position
  • Variation margin additional funds required if the position moves against the holder

Types of Derivative Instruments

• Futures contracts standardized agreements to buy or sell an asset at a predetermined price on a future date
  • Traded on organized exchanges with standardized contract specifications
  • Require daily settlement of gains and losses (marked-to-market)
• Forward contracts customized agreements to buy or sell an asset at a predetermined price on a future date
  • Traded over-the-counter (OTC) between two parties
  • Settled only at the end of the contract period
• Options contracts that give the holder the right, but not the obligation, to buy (call option) or sell (put option) an asset at a predetermined price (strike price) on or before a specific date (expiration date)
  • American options exercisable at any time before expiration
  • European options exercisable only on the expiration date
• Swaps agreements to exchange cash flows based on the performance of an underlying asset or reference rate
  • Interest rate swaps exchange fixed and floating interest rate payments
  • Currency swaps exchange principal and interest payments in different currencies
• Exotic derivatives complex, customized instruments that often combine features of other derivatives (barrier options, lookback options, Asian options)

Mechanics of Futures and Forward Markets

• Futures markets operate through centralized exchanges (Chicago Mercantile Exchange, Intercontinental Exchange)
• Standardized contract specifications include the underlying asset, contract size, delivery date, and minimum price fluctuation (tick size)
• Clearing houses act as intermediaries between buyers and sellers, guaranteeing the performance of the contracts
  • Clearing houses require market participants to post margin to cover potential losses
  • Daily settlement of gains and losses (marked-to-market) ensures that margin accounts remain adequately funded
• Forward markets are decentralized and operate over-the-counter (OTC)
  • Customized contract terms negotiated directly between counterparties
  • No daily settlement of gains and losses; settled only at the end of the contract period
  • Higher counterparty risk due to lack of a clearing house
• Convergence of futures and spot prices as the delivery date approaches, known as the basis

Options Trading Strategies

• Long call buying a call option to profit from an expected increase in the price of the underlying asset
• Long put buying a put option to profit from an expected decrease in the price of the underlying asset
• Covered call writing (selling) a call option on an asset already owned to generate income and partially hedge against price declines
• Protective put buying a put option to hedge against potential losses on an existing long position in the underlying asset
• Bull spread simultaneously buying and selling call options with different strike prices to profit from a moderate increase in the price of the underlying asset
  • Limits potential profits and losses compared to a simple long call position
• Bear spread simultaneously buying and selling put options with different strike prices to profit from a moderate decrease in the price of the underlying asset
  • Limits potential profits and losses compared to a simple long put position
• Straddle simultaneously buying a call and a put option with the same strike price and expiration date to profit from significant price movements in either direction
• Strangle simultaneously buying a call and a put option with different strike prices and the same expiration date to profit from significant price movements in either direction

Swaps and Other Exotic Derivatives

• Interest rate swaps exchange fixed and floating interest rate payments to manage interest rate risk or speculate on interest rate movements
  • Plain vanilla swaps involve exchanging fixed for floating payments on a notional principal amount
  • Basis swaps exchange floating payments tied to different reference rates (LIBOR vs. EURIBOR)
• Currency swaps exchange principal and interest payments in different currencies to manage currency risk or access foreign capital markets
  • Allows borrowers to access funding in a desired currency without directly borrowing in that currency
• Credit default swaps (CDS) transfer the credit risk of a reference entity (bond issuer) from one party to another
  • CDS buyer makes periodic payments to the seller and receives a payoff if a credit event (default, bankruptcy) occurs
• Exotic derivatives highly customized instruments that often combine features of other derivatives
  • Barrier options become active or expire based on whether the underlying asset price reaches a predetermined level (barrier)
  • Lookback options allow the holder to buy or sell at the most favorable price observed during the life of the option
  • Asian options have a payoff based on the average price of the underlying asset over a specified period

Risk Management Applications

• Hedging using derivatives to reduce exposure to various types of risk (price, interest rate, currency, credit)
  • Airlines use futures and options to hedge against fluctuations in jet fuel prices
  • Companies use interest rate swaps to convert floating-rate debt to fixed-rate or vice versa
• Portfolio insurance using put options to limit potential losses on a stock portfolio
• Value-at-Risk (VaR) a statistical measure of the potential loss a portfolio could suffer over a given time horizon and confidence level
  • Derivatives used to manage and reduce VaR by offsetting risk exposures
• Credit risk management using credit default swaps (CDS) to transfer credit risk and manage counterparty exposure
• Enterprise risk management (ERM) a holistic approach to identifying, assessing, and managing risks across an organization
  • Derivatives play a role in ERM by providing tools to manage specific risk exposures

Pricing Models and Valuation Techniques

• Black-Scholes-Merton (BSM) model a widely used option pricing model that assumes the underlying asset follows a log-normal distribution and there are no arbitrage opportunities
  • Inputs include the current price of the underlying asset, strike price, time to expiration, risk-free interest rate, and implied volatility
• Binomial option pricing model a discrete-time model that assumes the underlying asset price can move up or down by a certain amount at each time step
  • Builds a binomial tree of potential price paths and calculates the option value by working backward from expiration
• Monte Carlo simulation a technique that generates multiple random price paths for the underlying asset to estimate the option value
  • Useful for valuing complex derivatives with multiple sources of uncertainty or path dependence
• Implied volatility the volatility input that equates the BSM model price with the observed market price of an option
  • Provides a market-based estimate of expected future volatility
• Greeks sensitivity measures that quantify how option prices change with respect to various inputs (delta, gamma, vega, theta, rho)

Regulatory Framework and Market Challenges

• Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) introduced sweeping changes to the U.S. financial system, including new regulations for the OTC derivatives market
  • Requires most OTC derivatives to be cleared through central clearing houses and traded on exchanges or swap execution facilities (SEFs)
  • Imposes margin requirements and reporting obligations for non-cleared swaps
• European Market Infrastructure Regulation (EMIR) a European Union regulation that aims to increase transparency and reduce systemic risk in the OTC derivatives market
  • Requires central clearing for eligible OTC derivatives and reporting of all derivative contracts to trade repositories
• Basel III a global regulatory framework that introduces higher capital and liquidity requirements for banks, including specific provisions for derivatives exposures
• Counterparty credit risk a major concern in OTC derivatives markets, as the default of one party can lead to losses for the other party
  • Mitigated through netting agreements, collateralization, and central clearing
• Liquidity risk the potential inability to exit a derivatives position at a fair price due to lack of market depth or disruptions
  • Exacerbated during times of market stress or crisis
• Operational risk the risk of losses arising from inadequate or failed internal processes, people, and systems, or from external events
  • Complex derivatives can strain back-office systems and processes, leading to errors or delays in confirmation, settlement, and risk management