💠Complex Financial Structures Unit 8 – Derivatives and Hedging

What Are Derivatives?

• Financial instruments that derive their value from an underlying asset, reference rate, or index
• Contracts between two parties specifying conditions (amounts, dates, and resulting values) to be derived from the underlying asset
• Enable market participants to trade specific financial risks (interest rate risk, currency, equity, commodity price risk, etc.) to other entities more willing or better suited to take or manage these risks
• Facilitate the buying, selling, or transfer of risk independently of the underlying asset's ownership
• Serve important functions in financial markets including risk management, price discovery, and market efficiency
• Notional value represents the total value of a leveraged position's assets by considering the value of the underlying asset
  • Differs from market value as notional value accounts for the total position while market value is the price at which the derivative trades
• Include futures contracts, forward contracts, options, and swaps as primary types

Types of Derivatives

• Futures contracts obligate the buyer to purchase an asset (or the seller to sell an asset) at a predetermined future date and price
  • Standardized contracts traded on exchanges with specified underlying instrument, quantity, and delivery date
  • Require both parties to fulfill their obligations on the settlement date
• Forward contracts customize terms between two parties, traded over-the-counter (OTC)
  • Non-standardized, traded between financial institutions or between a financial institution and one of its clients
  • Specify contract size, underlying asset, settlement date, and delivery location based on the buyer and seller's needs
• Options provide the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a specified price (strike price) by a certain date (expiration)
  • Buyers pay a premium to purchase this right and sellers collect the premium for providing the option
  • American options can be exercised any time prior to expiration while European options can only be exercised at expiration
• Swaps involve two parties agreeing to exchange cash flows or liabilities from different financial instruments, most commonly interest rate swaps exchanging floating rate for fixed rate payments
  • Can also be used for exchanging currencies (currency swaps) or commodities
  • Allows parties to exploit comparative advantage and exchange interest rates or cash flows most appropriate for their asset/liability structures

Pricing and Valuation

• Pricing models determine a derivative's fair value based on the value of the underlying asset and other parameters
• Black-Scholes model prices European options using five key determinants: strike price, current stock price, time to expiration, risk-free rate, and volatility
  • Assumes stock prices follow a lognormal distribution and there are no dividends paid during the option's lifetime
• Binomial option pricing model uses a "discrete-time" model compared to Black-Scholes
  • Constructs a binomial tree with intrinsic values at each node to value American or European options
• Monte Carlo simulation calculates derivative prices by simulating underlying asset price paths given parameters like volatility and interest rates
  • Suited for path-dependent derivatives and can simulate various scenarios
• Greeks represent an option's sensitivity to factors like underlying asset price (delta), volatility (vega), time (theta), and interest rates (rho)
  • Used to manage risk by hedging specific factors that affect an option's price
• Value at risk (VaR) estimates the maximum potential loss over a period of time at a given confidence level
  • Historical simulation, variance-covariance method, and Monte Carlo simulation are used to calculate VaR

Risk Management with Derivatives

• Derivatives are used to manage and mitigate various financial risks including market risk, credit risk, and liquidity risk
• Market risk encompasses potential losses due to changes in market prices
  • Managed through hedging by taking offsetting positions in derivatives
  • Futures, options, and swaps can hedge commodity price risk, interest rate risk, and currency risk
• Credit risk involves potential losses resulting from a counterparty failing to fulfill its obligations
  • Credit derivatives like credit default swaps (CDS) transfer credit risk between parties
  • CDS provide protection against a credit event of a reference entity in exchange for periodic payments
• Liquidity risk arises from the inability to quickly buy or sell an asset at a fair price
  • Mitigated through derivatives by locking in prices or rates in advance
  • Futures contracts ensure the ability to buy or sell an asset at a predetermined price and date
• Operational risk stems from failures in internal processes, people, and systems
  • Managed through strict controls, procedures, and risk limits on derivative activities
• Model risk involves potential losses from using inaccurate or misused models to price and manage derivatives
  • Mitigated through model validation, backtesting, and stress testing

Hedging Strategies

• Hedging strategies use derivatives to reduce the risk of adverse price movements in an underlying asset
• A long hedge involves buying futures contracts to offset potential losses from price increases in the underlying asset
  • Example: an airline buying crude oil futures to hedge against rising fuel costs
• A short hedge involves selling futures contracts to lock in a price and offset losses from price decreases in the underlying asset
  • Example: a farmer selling wheat futures to guarantee a minimum price for their upcoming harvest
• Cross hedging uses a futures contract for a different asset that has a high correlation with the asset being hedged
  • Useful when a liquid futures market does not exist for the asset being hedged
  • Example: hedging jet fuel with heating oil futures since both are refined from crude oil
• Delta hedging dynamically adjusts the hedge as the underlying asset price changes
  • Involves maintaining a delta neutral position by continuously buying or selling the underlying asset
  • Used by options traders to hedge the risk associated with option price movements
• Hedge ratio determines the number of derivatives contracts needed to hedge a position in the underlying asset
  • Optimal hedge ratio minimizes the variance of the hedged position
  • Calculated using the correlation between the changes in the derivative and underlying asset prices

Market Players and Their Roles

• Hedgers use derivatives to reduce risk by taking an offsetting position in the derivative to balance any potential losses from their underlying exposure
  • Examples include commodity producers, financial institutions, and corporations
  • An airline might hedge jet fuel costs with crude oil futures to minimize the impact of rising fuel prices on profitability
• Speculators take positions in derivatives with the aim of profiting from anticipated price movements
  • They accept higher risk in exchange for potentially higher returns and provide liquidity to the market
  • Speculators can be individuals or institutions like hedge funds or proprietary trading desks
• Arbitrageurs exploit price discrepancies between related assets or markets to generate low-risk profits
  • They simultaneously buy and sell equivalent assets in different markets to profit from the price difference
  • Arbitrage helps maintain market efficiency and keeps prices in line across related markets
• Market makers provide liquidity by continuously quoting bid and ask prices and standing ready to buy or sell
  • They profit from the bid-ask spread and help facilitate orderly trading
  • Many derivatives exchanges use designated market makers to ensure liquidity
• Brokers act as intermediaries by executing trades on behalf of clients in exchange for a commission
  • They provide market access, advice, and facilitate clearing and settlement of trades
  • Brokers can be full-service offering personalized advice or discount focused on trade execution

Regulatory Framework

• Derivatives markets are regulated to ensure fair and orderly trading, prevent market manipulation, and protect market participants
• In the U.S., the Commodity Futures Trading Commission (CFTC) regulates futures, options on futures, and swaps markets
  • Oversees exchanges, clearing organizations, and market participants to maintain market integrity
  • Implements rules on position limits, margin requirements, and reporting to prevent excessive speculation and risk
• The Securities and Exchange Commission (SEC) regulates options on securities and security-based swaps
  • Focuses on disclosure, investor protection, and preventing fraud and manipulation
  • Requires registration of market participants and enforces rules on trading practices
• The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 introduced sweeping changes to U.S. derivatives regulation
  • Mandated central clearing for most standardized OTC derivatives to reduce counterparty risk
  • Increased transparency through trade reporting and execution requirements
  • Imposed capital and margin requirements on swap dealers and major swap participants
• The European Market Infrastructure Regulation (EMIR) and Markets in Financial Instruments Directive (MiFID) regulate derivatives in the European Union
  • EMIR focuses on reducing systemic risk, increasing transparency, and protecting against market abuse
  • MiFID aims to create a single, transparent market for financial services across the EU
• The Basel Committee on Banking Supervision sets global standards for bank regulation, including capital and risk management requirements for derivatives exposures

Real-World Applications

• Interest rate derivatives like swaps, futures, and options are used to manage interest rate risk
  • Corporations issue floating rate debt and use interest rate swaps to convert it to a fixed rate
  • Mortgage lenders use interest rate futures to hedge the risk of interest rates rising before loans are sold
• Currency derivatives are used to manage foreign exchange risk from international trade or investments
  • A U.S. company expecting a €100 million payment in three months can sell a €/$ forward contract to lock in the exchange rate
  • An exporter can buy put options on the currency they will receive to protect against depreciation
• Commodity derivatives are used by producers and consumers to hedge against price fluctuations
  • A gold mining company can sell gold futures to lock in a price for their future production
  • An airline can buy call options on crude oil to protect against rising fuel costs while maintaining the ability to benefit if prices fall
• Equity derivatives are used for risk management, speculation, and income generation
  • Put options are bought as a form of portfolio insurance to limit downside risk
  • Covered call strategies involve selling call options on stocks owned to generate additional income
• Credit derivatives are used to manage credit risk and gain exposure to credit markets
  • Banks use credit default swaps to hedge the credit risk of loans or bonds
  • Investors can buy CDS to speculate on a company's creditworthiness without owning its bonds
• Weather derivatives are used by companies to hedge against adverse weather conditions affecting their business
  • An amusement park can buy a weather derivative that pays out if the number of rainy days exceeds a certain threshold during peak season
  • A ski resort can use a weather derivative to protect against low snowfall totals impacting ticket sales and revenue