Financial Derivatives, Basic Concepts, Forwards, Futures, Options and Swaps

1. Financial Derivatives
Welcome to:
LEARNING UNIT 1 | BASIC CONCEPTS
‘Forwards, Futures, Options and Swaps’

2. What are Derivatives?
 A derivative is a financial instrument whose price is derived from the
price/value of another asset, known as the Underlying Asset.
 Most common Derivatives are Forwards, Futures, Options & Swaps.
 Most common Asset Classes are FX, Interest Rates, Fixed Income then
Equities and Commodities would follow.
 Derivatives are traded on Exchanges and/or Over-the-Counter (OTC).
 Swaps are the most traded derivative for both Interest Rate Swaps and
Cross Currency Swaps.
For instance, the value of a Gold Futures Contract is derived from
the value of the underlying asset reflected by the Gold Spot Price.

3. Investor Profiles
HEDGER
A hedger is someone who faces risk associated with price movement
and who uses derivatives to manage the level of portfolio risk.
SPECULATOR
Uses futures and options contracts to get extra leverage in bettingon
price direction of an asset in pursuit of profits.
ARBITRAGEUR
Take advantage of gaps between the prices of one asset quoting in
several markets. Discrepancies arise from different time zones, base
currencies and regulations of those specific markets.

4.  The contract between the two parties is privately negotiated.
 Non-standard products are traded in the so-called OTC derivatives
markets. The most common being Forwards and Swaps.
 OTC main players are Investment Banks and SwapDealers and include
Financial (hedge funds, commercial banks, etc. ) and Non Financial
Institutions like governments, municipalities or corporations.
 Main advantages of OTC compared with regulated exchanges are that
contract specifications are tailor made and reduced costs.
OTC vs. Exchange Traded Derivatives
Over the counter (OTC) or off-exchange trading is to trade financial
instruments such as stocks, bonds, commodities or derivatives directly
between two parties without going through an exchange or other
intermediary.
I. OTC Markets

5. A derivatives exchange is a market for investors that trade standardized
contracts originally predefined by the exchange.
The exchange acts as an intermediary in all related transactions. It takes an
initial margin from both counterparties minimizing counterparty risk (It also
charges an exchange fee).
OTC vs. Exchange Traded Derivatives
USA hosts the world's
largest derivative exchanges
as CME, CBOT, NYMEX, etc.
II. Exchange Traded Derivatives

6. OTC (Over the counter ) trading
Exchange Traded Derivatives
 Future Contracts
 Forward Contracts
 Options
 Swaps
Most common Derivative Products

7.  Enhance liquidity of the underlying asset
 Lower transaction costs
 Improve the price discovery process
 Upgrade portfolio management capabilities
 Allow risk management thru hedging & leverage
 Provide signals of market movements
 Facilitate financial markets integration
Derivatives, advantages for Markets…
…from an academic approach

8. A forward is a non-standardized contract between two parties to buy or
sell an asset at a specified future time at a price agreed today.
It is a customized and tailor made contract in the sense the terms of the
contract are agreed by both counterparties.
Hence, it is an OTC derivative product as no exchange is involved.
What is a Forward?

9. Forward Contract Example
I agree to sell
500kgs Wheat at
40€/kg after 3
months.
Farmer
Bread
Maker
Then 3 months later…
Farmer
Bread
Maker
500 Kgs. of wheat
20,000 €
At the starting point,

10. Credit Risk – Does the other party have the means to pay?
Operational Risk – Will the other party make delivery? Will the other
party accept delivery?
Liquidity Risk – In case either party wants to opt out of the contract, how
easy is to find another counterparty?
Classical Risks in Forward Contracts

11. Long Position
Short Position
Spot Price
Delivery|Fwd Price
Maturity Date
Investor ‘is more of a buyer in an asset (x)’.
Asset (x) in net terms is short in a portfolio.
Price of the underlying asset in the spot market.
Price of the asset at the delivery date.
It’s the date when a future expires and dies.
Forward Specifications

12. A Future is a STANDARDIZED “Forward” contract.
It’s traded in an ORGANIZED EXCHANGE.
Standardizations involve:
 Quantity of underlying asset
 Quality of underlying (mostly in commodities futures)
 Delivery dates and type of settlement (cash|delivery)
 Price quotes, ticks and symbols are predefined
What are Futures?

13. Situation A
Went Long at $10
Sold @ $10
Bought @
$14
S $14
Profit
$2
Loss $4 Profit
Situation B Situation C
Went Short at $12
L $12
Futures Contract Example

14.  INTEREST RATES (Below 2YR) Ex: 3month EURIBOR, 3mEURODOLLAR
 FIXED INCOME (Above 2YR) Ex: US 10YR Note, Bund, BTP, JGB
 FOREIGN EXCHANGE Ex: Eur/dol, eur/gbp, dol/yen
 EQUITY (Stock|Equity Index Futs) Ex: SP500, Dow, Nasdaq, Dax, IBEX
 COMMODITIES Ex: Gold, Crude Oil, Wheat, Copper
Asset Classes & Futures Contracts

15. Differences between…
…Forwards vs. Futures
No
No
No
No
No
No
No
No
Yes
Yes
Yes
Yes
Yes
Yes
Mostly
Yes
 Trade on organized exchanges
 Use standardized contract terms
 Use associate clearinghouses to
guarantee contract fulfillment
 Require margin payments and daily
settlements
 Markets are transparent
 Marked to market daily
 Closed prior to delivery
 Profits or losses realized daily

16. Contract size -> The amount of the underlying asset that has to be
delivered per (one) contract. Ex, a BMW future represents 100 lots of its
underlying asset which is BMW shares.
Expiry date -> Defines the date that ends the life period of a futures
contract. For european equity derivatives it’s common to be set the 3rd
Friday of each quarter.
Maturity -> Usually refers to the month in which the expiry of the future
will take place. Ex, Eurostoxx50 future shows quarterly maturities (or
expiries) in months Mar, Jun, Sep & Dec.
Futures Specifications

17. Generally, futures positions are not held until the expiry date and are closed
out earlier in order to avoid:
 Diminished liquidity as the expiry date comes nearer.
 Delivery obligation when the 1st notice date is reached.
Usual way for investors to do so is by ROLLING OVER their positions,
WHAT
HOW
WHEN
CASH Settlement
Most common, daily
settlement
DELIVERY Settlement
Mostly for commodities and
governments debt
vs.
Closing & Settlement of Futures
Keep bets on market direction without any delivery issues.
Closing up the position in the present expiry and (re)opening it up in
the next one. In this way the bet is protracted.
Before the expiry and/or the 1st notice date is reached.

18.  A margin is an amount of money that must be deposited with the clearing
house as a requirement to execute futures contracts.
 Both sides of the trade, buyer and seller, have to make this deposit in their
their respective margin accounts.
 Big picture, marging accounts help to reduce OTC markets overall
counterparty risk.
 In case a counterparty defaults there is already money put aside, thus,
the aggregated margin accounts, to honor the contracts.
Margin Concepts

19.  Initial Margin -> It’s an OTC concept, refers to the Deposit that an
investor must make when trading futures contracts. Usually amounts 10%
of the contract nominal size.
 Maintenance Margin -> As time goes by, the margin can reach its
‘minimum maintenance level’. Then the investor is required (by its CCP or
Counterparty) to bring the margin back to its IM level. On average
happens when margin drops below 75% of the IM.
 Margin call -> When the margin account falls below the maintenance
level, a ‘Margin Call’ is made to fill the gap.
 Variation Margin -> Additional margins can be required to bring an
account up to the required level under special market conditions.
Margins, more in detail (I)

20. Marking to Market is the practice of periodically adjusting the money
deposited in the margin account,
ORIGIN From increased regulation and public scrutiny after Lehman
Crash in 2008 this practice Mtm is extending from solely
exchange traded derivatives into OTC accountancy.
HOW
GOALMinimize counterparty default risk.
Margins, more in detail (II)
 By adding|subtracting funds based on changes in the market
price. Thus, reflecting daily the investor’s gain|loss.
 This leads to changes in margin accounts on a daily basis.

21. Contracts that give the holder the option…
The word “option” means that the holder has the RIGHT but not the obligati
to buy (or sell) the underlying asset.
An example of language flow in the trading of options:
The option to buy (or sell)a specified
quantity of the underlying asset,
At a particular price,
On (or before) a specified time period,
“Please quote me the DEC19 3500 PUT EUROSTOXX50 Tks.”
What are Options?
WHA
T
HOW
WHE
N

22. CALL
Option that gives the buyer the RIGHT (but not the obligation) TO
BUY a given quantity of the underlying asset, at a given price on (or
before) a particular date by paying a premium.
PUT
Option give the buyer the RIGHT (but not the obligation)
TO SELL a given quantity of the underlying asset, at a given price
on (or before) a particular date by paying a premium.
Option Types

23. EUROPEAN Can be exercised ONLY on the maturity date of
the option. Also known as the expiry date.
AMERICAN Can be exercised ANY TIME either before or on the
expiry date, thus, at any time during its life time.
Chart showing the execution possibilities of:
OPTION LIFE TIME
An AMERICAN OPTION
An EUROPEAN OPTION =
Option Styles

24. Right to buy 100 BMW shares,
at a price of 300 € per share,
after 3 months
Strike Price
BMW spot price = 250 €
Option Premium = 2,500 €
BMW spot price is 400 €,
Then the option IS EXERCISED
And the hundred shares are bought
PROFIT =40,000-30,000-2,500= 7,500
Expiry date
Calculation, this involves a
premium per share of 25 €
Scenario 1, a month later Scenario 2, a month later
BMW spot price is 200 €,
Then the option is NOT exercised
The premium paid is lost
LOSS = 2,500 € = Premium paid
Call Option, BMW example

25. Right to sell 100 IBM shares,
At a price of 35 $ per share,
after 3 months
Strike Price
IBM spot price = 40 $
Option Premium = 400 $
IBM spot price is 30 $,
Then the option IS EXERCISED
And the hundred shares are sold
PROFIT = 3,500-3,000-400 = 100 $
Expiry date
Calculation, this involves a
premium per share of 4 $
Scenario 1, a month later Scenario 2, a month later
IBM spot price is 50 $,
Then the option is NOT exercised
The premium paid is lost
LOSS = 400 $ = Premium paid
Put Option, IBM example

26. Underlying
Premium
Strike
Expiry date
Exercise date
Option holder
Option writer
Open interest
Options Specifications
Specific security or asset.
Price of the option.
Exercise price.
Date on which option expires.
Option is exercised (can be the expiry date).
One who buys options.
One who sells options.
Total number of a specific option contract that
have NOT yet been…
closed out|delivered|expired
…on a particular day.

27. Option Pay Off

28. Strike Price vs. Spot Price
Intrinsic Value of an option comes out comparing Strike|Spot price.
Therefore, for a given STRIKE and SPOT,
The value of an option position is quite different
when its Calls or Puts | Long or Short.
 It’s a concept that refers to the potential profit (or loss) derived from the
eventual exercise of a specific option position.
 In option pricing the reference price is the spot price of the underlying
asset.
Moneyness

29. We see now the TWO COMPONENTS involved in a PREMIUM,
namely TIME and INTRINSIC value.
Premium & Time to Expiry

30. Swaps are contractual agreements to exchange or swap a series of cash
flows.
These cash flows are most commonly the interest payments associated with
debt service:
 If the agreement is for one party to swap its fixed interest rate
payments for the floating interest rate payments of another, it is
termed an interest rate swap (IRS).
 If the agreement is to swap currencies of debt service obligation, it is
termed a currency swap (CCS).
 A single swap may combine elements of both IRSs and CCSs.
What are SWAPS? (I)

31. The swap itself is not a source of capital, but rather an alteration of the
cash flows associated with debt service payments.
What is often termed the plain vanilla swap is an agreement between
two parties to exchange fixed-rate for floating-rate financial obligations.
Swaps are the top traded single derivative product in the world.
What are SWAPS? (II)

32. I. A corporate borrower has an existing debt service obligation. Based on their
interest rate predictions they want to swap to another exposure (e.g. change
from paying fixed to paying floating).
II. Two borrowers can work together to get a lower combined borrowing
cost by utilizing their comparative borrow profiles,
 The Quality Spread Differential (QSD) represents the potential gains from the
swap that can be shared between the counterparties and the swap bank.
 There is no reason to presume that the gains will be shared equally.
 In the next slide we show an example where Company B is less credit-worthy
than Bank A, so they probably would have gotten less of the QSD, in order to
compensate the swap bank for the default risk.
Main reasons for using swaps

33.  A company agrees to pay a pre-determined fixed interest rate on a
notional principal for a fixed number of years.
 In return, receives interest at a floating rate on the same notional for
the same period of time.
 The Principal is NOT EXCHANGED. Hence, It’s called NOTIONAL
amount.
 IRS is the most traded of all swaps. Therefore, IRSs are the most
relevant financial derivative in the world.
What is an Interest Rate Swap?

34. LIBOR
+ ½%
10 3/8 %
LIBOR – 1/8%
LIBOR – ¼%
10 ½%
B saves ½ %
Bank
A
Swap
Bank
Company
B
A saves ½ %
The swap bank makes ¼ %
10%
Note that the total savings ½
+ ½ + ¼ = 1.25 % = QSD
COMPANY B BANK A DIFFERENTIAL
Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + 0.50% LIBOR 0.50%
QSD = 1.25%
IRS example,
Working together to get a
lower combined borrowing cost

35.  Since all swap rates are derived from the yield curve in each major
currency, the fixed-to-floating IRS existing in each currency allows firms
swap across currencies.
 The usual motivation for a currency swap is to replace cash flows
scheduled in an undesired currency with flows in a desired currency.
 The desired currency is probably the currency in which the firm’s future
operating revenues (inflows) will be generated.
 Firms often raise capital in currencies in which they do not possess
significant revenues for investments and/or logistics purposes.
What is a Currency Swap?

36. INITIALLY Company A which is US based wants to finance a
£10,000,000 expansion of a British plant. Alternatives,
BETTER SOLUTION for Company A would be to find a British MNC
with mirror financing needs and do a CCS.
 For this example, let’s assume this and also that both firms wish to
finance a project of the same size in each other’s country.
 Data, £10M and $16Mwith exchange rate $/£ = 1.60
I. To borrow $’s in the U.S. where they are well known and
exchange dollars for pounds. This results in exchange
rate risk.
II. To borrow £’s in the international bond market, but pay
a lot since they are not well known abroad.
CCS example (I)

37.  A is the more credit-worthy of the two.
 A pays 2% less to borrow in dollars than B.
 A pays 0.4% less to borrow in pounds than B.
 B has a comparative advantage in borrowing in £.
 B pays 2% more to borrow in dollars than A.
 B pays only 0.4% more to borrow in pounds than A.
Potential Savings or
Gains,
2.0 - 0.4 = 1.6%
CCS example (II)
If Swap Bank takes 0.4% and A&B split the rest:
“A” improves paying 11.6% - 0.6% = 11%
“B” improves paying 10% - 0.6% = 9.4%

38. Company
A
Swap
Bank
i$=8%
i$=8%
i£=11%
i£=12%
i$=9.4%
Company
B
i£=12%
A’s net position is to borrow at i£=11%
A saves i£=0.6%
B’s net position is to borrow at i$=9.4%
B saves i$=0.6%
The Swap Bank makes money too:
1.6% - (0.6 - 0.6) = 0.4%
The swap bank faces exchange rate
risk, but they could avoid it hedging
that amount.
CCS example (III)

39.  Derivative products are Forwards, Futures, Options and Swaps.
 Asset classes are FX, Interest Rates, Fixed Income, Equities and
Commodities.
 All above can be traded either taylor made at OTC markets or
standardized in Exchange derivative markets.
 Settlement can be done by cash or by delivery.
 Premium on option valuation involve two components which are
Time value and Intrinsic value.
 Swaps are widely used as they allow debtors to improve its payment
conditions.
SUMMARY and Q&A

40. Financial Derivatives
Fonetic Trading Unit
LEARNING UNIT 1 | BASIC CONCEPTS
‘Forwards, Futures, Options and Swaps’
End of presentation,
Thank you.