FACULTY OF COMMERCE

RISK MANAGEMENT AND INSURANCE

OPERATIONAL RISK MANAGEMENT GROUP ASSIGNMENT

NAMESSTUDENT NUMBERS

Bernadette Njekeya N0165080N

Charmaine Mupereri N0164831E

Tariro Chandiposha N0161192H

Tim Zengeya N0164893Y

Munashe Bope N0161154X

COURSE : Financial Markets Institutions and Regulations

COURSE CODE : CIN 4117

LECTURER : Mr T Zinyoro

QUESTION:

DERIVATIVES
A derivative security is a financial security whose payoff is linked to another, previously issued
security.

Derivative securities generally involve an agreement between two parties to exchange a standard
quantity of an asset or cash flow at a predetermined price and at a specified date in the future.

As the value of the underlying security to be exchanged changes, the value of the derivative
security changes.

Derivatives involve the buying and selling, or transference, of risk.

Under normal circumstances, trading in derivatives should not adversely affect the economic
system because it allows individuals who want to bear risk to take more risk, while allowing
individuals who want to avoid risk to transfer that risk elsewhere.

However, derivative securities’ traders can experience large losses if the price of the underlying
asset moves against them significantly. Indeed, at the very heart of the recent financial crisis
were losses associated with off-balance-sheet derivative securities created and held by FIs.

These losses resulted in the failure, acquisition, or bailout of some of the largest FIs (including
investment banks Lehman Brothers, Bear Stearns, and Merrill Lynch; savings institution
Washington Mutual; insurance company AIG; commercial bank Citigroup; finance company
Countrywide Financial; and government sponsored agencies Fannie Mae and Freddie Mac) and a
near meltdown of the world’s financial and economic systems. Losses from the falling value of
subprime mortgages and off-balance sheet securities backed by these mortgages reached over $1
trillion worldwide through 2009.

Using various empirics from the developing and developed world, derivatives have been
identifies to have various economic benefits to the economies.
∙ Financial derivatives can be used in risk management, hedging, arbitrage between markets, and
speculation.
∙ Derivatives assume economic gains from both risk shifting and efficient price discovery by
providing hedging and low-cost arbitrage opportunities, Jobst (2007).
∙ Derivatives catalyze entrepreneurial activity.
∙Determination of current and future prices,Prices in a structured derivative market not only
replicate the discernment of the market participants about the future but also lead the prices of
underlying to the professed future level. On the expiration of the derivative contract, the prices of
derivatives congregate with the prices of the underlying. Therefore, derivatives are essential tools
to determine both current and future prices.
∙ Risk allocation. The derivatives market reallocates risk from the people who prefer risk
aversion to the people who have an appetite for risk. Hence, derivatives allow the sharing or
redistribution of risk.
Derivative securities markets
Are the markets in which derivative securities trade? While derivative securities have been in
existence for centuries, the growth in derivative securities markets has occurred mainly since the
1970s. As major markets, therefore, the derivative securities markets are the newest of the
financial security markets.

While derivative securities have been in existence for centuries, the growth in derivative
securities markets has occurred mainly since the 1970s. As major markets, therefore, the
derivative securities markets are the newest of the financial security markets. The first of the
modern wave of derivatives to trade were foreign currency futures contracts. These contracts
were introduced by the International Monetary Market (IMM), in response to the introduction of
floating exchange rates between currencies of different countries.

The second wave of derivative security growth was with interest rate derivative securities.
Their growth was mainly in response to increases in the volatility of interest rates in the late
1970s and after.

Financial institutions such as banks and savings institutions had many rate-sensitive assets and
liabilities on their balance sheets. As interest rate volatility increased, the sensitivity of the net
worth (equity) of these institutions to interest rate shocks increased as well.
A third wave of derivative security innovations occurred in the 1990s and 2000s with credit
derivatives (e.g., credit forwards, credit risk options, and credit swaps). For example, a credit
forward is a forward agreement that hedges against an increase in default risk on a loan (a
decline in the credit quality of a borrower) after the loan rate is determined and the loan is issued.

Participants in derivatives market

Each type of individual will have an objective to participate in the derivative market. And they
are basically categorized by their trade motives and hence there are 3 broad categorize in the
trading market

● Hedgers

These are risk-averse traders in stock markets. They aim at derivative markets to secure their
investment portfolio against the market risk and price movements. They do this by assuming an
opposite position in the derivatives market. In this manner, they transfer the risk of loss to those
others who are ready to take it. In return for the hedging available, they need to pay a premium to
the risk taker.

If one holds 100 shares of XYZ Company which are currently priced at $ 120. The aim is to sell
these shares after three months. However, one doesn’t want to make losses due to a fall in market
price. At the same time, not losing opportunity to earn profits by selling them at a higher price in
future. In this situation, one can buy a put option by paying a nominal premium that will take
care of both the above requirements.  

● Speculators

These are risk-takers of the derivative market. They want to embrace risk in order to earn profits.
They have a completely opposite point of view as compared to the hedgers. This difference of
opinion helps them to make huge profits if the bets turn correct. In the above example, one buys
a put option to secure himself/herself from a fall in the stock prices. The counterparty i.e. the
speculator will bet that the stock price won’t fall. If the stock prices don’t fall, then one won’t
exercise the put option. Hence, the speculator keeps the premium and makes a profit.

● Arbitrageurs
These utilize the low-risk market imperfections to make profits. They simultaneously buy low-
priced securities in one market and sell them at higher price in another market. This can happen
only when the same security is quoted at different prices in different markets. Suppose an equity
share is quoted at $1000 in stock market and at $105 in the futures market. An arbitrageur would
buy the stock at $1000 in the stock market and sell it at $1050 in the futures market. In this
process he/she earns a low-risk profit of $50.

Types of Markets

The two major types of markets in which derivatives are traded are namely:

Exchange Traded Derivatives

Over the Counter (OTC) derivatives

Exchange traded derivatives (ETD) are traded through central exchange with publicly visible
prices.

Over the Counter (OTC) derivatives are traded between two parties (bilateral negotiation)
without going through an exchange or any other intermediaries. OTC is the term used to refer
stocks that trade via dealer network and not any centralized exchange. These are also known as
unlisted stocks where the securities are traded by broker-dealers through direct negotiations.

Dig 1.1

With different characteristics, the two types of markets complement each other in providing a
trading platform to suit different business needs. On one hand, exchange-traded derivative
markets have better price transparency as compared to OTC markets. Also, the counterparty risks
are smaller in exchange-traded markets with all trades on exchanges being settled daily with the
clearinghouse. On the other hand, the flexibility of OTC market means that they suit better for
trades that do not have high order flow or special requirements. In this context, OTC market
performs the role of an incubator for new financial products.
Spot contracts
A spot contract is an agreement between a buyer a seller at time 0, when the seller of the asset
agrees to deliver it immediately and the buyer agrees to pay for that asset immediately.
An agreement to transact involving the immediate exchange of assets and funds.
It can also be defines as a buy now, pay now deal for immediate delivery.

Spot transactions occur because the buyer of the asset believes its value will increase in the
immediate future (over the investor's holding period). If the value of the asset increases as
expected, the investor can sell the asset at its higher price for a profit.

Futures contracts
According to Wood (1995) forwards and futures refer to the same type of instrument, but
forwards normally refer to over-the-counter derivatives, while futures refer to exchange-traded
derivatives.

A future contract is a standardized contract that will not be performed until a specified date in the
future. Flanagan (2001)

A futures contract is an agreement between a buyer and a seller where the seller agrees to deliver
a specified quantity and grade of a particular asset at a predetermined time in futures at an agreed
upon price through a designated market under stringent financial safeguards. A futures contract,
in other words, is an agreement to buy or sell a particular asset between the two parties in a
specified future period at an agreed price through specified exchange.

A futures contract provides an opportunity to commit now to purchase or sell an underlying asset
at a specified price, with delivery and payment delayed until the settlement date.

There are two sides to every future contract, a long and a short. The long is the purchaser of the
contract, and profits as the underlying asset increases in value. The short is the seller of the
contract, and profits as the underlying asset decreases in value.
As the price of the underlying security changes from day to day, the price of the futures contract
also changes.
To encourage futures contract buyers and sellers to follow through with the transaction, a good
faith deposit, called initial margin, is required from both parties when a contract is initiated. The
buyer and seller of exchange-traded futures contracts recognize this daily gain or loss by
transferring cash to the margin account of the party reaping the benefit. This mark-to-market
practice keeps large unrealized losses from accumulating and reduces the probability of one of
the parties defaulting on the obligation. Futures contracts are settled daily, so if the price of, for
example, wheat increases, and the long investor will see an increase in margin cash, and if the
price decreases a corresponding decrease in cash. The change in margin is called the variation
margin. Margin is required to be above a set level, called maintenance margin. If margin drops
below this level, the investor will be forced into a margin call, to add cash to the account to
increase equity above the maintenance margin.

Solnik and McLeavey (2009) gave the following as types of futures contracts
Currencies
Investors may transact major currencies in small amounts for reasonable transaction costs.
Moreover, the market is very liquid this is an instrument to minimize the currency risk by taking
a contract on one currency to another currency at a specified date and at a specific price. It was
first introduced in 1972, at CBE (Chicago Board of Exchange).

Commodities
A large variety is traded throughout the world: perishable goods (e.g. soybeans, live cattle),
metals (e.g. copper, gold), and energy (e.g. oil).
For each commodity, the quality and quantity of the product traded are specified, as well as
location and terms of delivery

Interest rate futures:

e.g., Eurodollar and Treasury bond contracts.
Commercial banks and money managers use these futures to hedge their interest rate exposure,
to protect their portfolio of loans, investments or borrowing against adverse movements in
interest rates. To control the risk of interest rate fluctuation stock exchanges decided to introduce
Interest Rate Futures. It’s an instrument where two parties enter into an agreement to buy or sell
a debt instrument at a specified price and for a specified period. The underlying asset for Interest
Rate Futures is either Government Bonds or Treasury bond contracts.

Stock futures:
Futures are traded on stock indexes and on single stocks. Gain (loss) on a stock index future =
future price variation x Contract value multiple
To protect our investment from risk arising from a single stock investment, it is necessary to
construct a portfolio. But it’s not possible for an investor to invest in all top-performing
individual stocks. So, there is a need for an investing product which represents the whole stock
market and the need has been fulfilled by Stock Index A Stock Index Futures gives the
information about the price movements of the stock market, which is created by selecting a
group of stocks. It shows equity market benchmarks like the S&P Nifty Index, BSE Sensex
Index, Nifty Junior, etc. and

Przybilinski and Leonburger (2010) highlighted the common features of future contracts as
follows;
• Futures contracts are standardized contracts in terms of quantity, quality and
Amount.
• Margin money is required to be deposited by the buyer or sellers in the form
Of cash or securities.
• There is a diary of opening and closing of position,
known as marked to market. The price differences every day are settled through the exchange
clearing house.

Future markets
The most popular futures contracts are traded on organized exchanges and have standardized
contracts specifying how much of the security is to be bought or sold, when the transaction will
take place, what features the underlying security must have, and how delivery or transfer of the
security is to be handled.
If counterparty were to default on a futures contract, however, the exchange would assume the
defaulting party’s position and payment obligations. Thus, unless a systematic financial market
collapse threatens an exchange itself, futures are essentially default-risk free. In addition, the
default risk of a futures contract is less than that of a forward contract for at least four reasons:
(1) Daily marking to market of futures (so that there is no buildup of losses or gains),
(2) Margin requirements on futures that act as a security bond should a counterparty default,
(3) Price movement limits that spread extreme price fluctuations over time, and
(4) Default guarantees by the futures exchange it.

The futures market began to build universal popularity in the mid-19 th century as agricultural
production, business practices, and technology became more sophisticated. Market participation
demanded a reliable and efficient risk management mechanism. This led to the establishment of
the exchange model for agricultural commodities but quickly expanded to other asset classes
such as energy, precious metals, interest rates, equities, and foreign exchanges (Irwin, Sanders,
2010).Futures trading occurs on organized exchanges—for example, the Chicago Board of Trade
(CBOT) and the New York Mercantile Exchange (NYMEX), both of which are part of the CME
Group.
Futures markets serve two primary purposes. The first is price discovery. Futures markets
provide a central market place where buyers and sellers from all over the world can interact
to determine prices. The second purpose is to transfer price risk. Futures give buyers and sellers
of commodities the opportunity to establish prices for future delivery. This price risk transfer in a
process called hedging.Other examples of future exchanges include Chicago Mercantile
Exchange and Intercontinental Exchange.Futures contract performance is guaranteed by the
exchange through an institution known as the exchange clearinghouse, which tracks the value of
each trader’s position and ensures
that sufficient funds are available to cover each trader’s obligations. The exchange clearing-
house requires that traders (via the futures commission merchant or broker) deposit money
before a trade to ensure contract performance. This deposit is usually referred to as the initial
margin deposit. Each trader’s margin money is maintained in a separate margin account, which is
adjusted daily to reflect the gain or loss in contract value that occurred that day. This process is
sometimes referred to as “Marking-to-Market,” because the account is adjusted to reflect its
current market value based on that day’s closing or settlement price. Although the margin
requirements are small relative to the total value of the contract (typically less than 5 percent of
contract value), traders of futures contracts are relieved of the responsibility of worrying that the
trader on the other side of the contract will default on his or her financial obligations by the
mark-to-market margin system and by a series of checks and balances put in place by the
exchange to ensure that sufficient funds are available to cover each
account’s risk exposure.

Due to standardization, the contracts themselves began to be exchanged among participants of

the market. If the buyer decided he didn't want the commodity, for example, wheat, he could
easily sell or trade the contract to someone who did. Or, the farmer who didn't want to or
couldn’t deliver his wheat, he has the option to pass his obligation on to another farmer in the
form of a trade or exchange. The ease of exchange and trading in the market has made this
financial instrument indispensable to commodity producers, consumer, traders and investors
(Bakken et al 1961).
One reason futures markets are considered a good source of commodity price information is
because price changes are attributable to changes in the commodity’s price level, not changes in
contract terms.

Futures in Zimbabwe
According to an article published by The Independent on July 28 2006, it stated that Zimbabwe's
derivatives market was still in its infancy stage and products such as futures which require a
standardized exchange were not yet tradable.
Chikoko states that at this moment, Zimbabwe cannot operate a futures exchange like the South
African Futures Exchange (SAFEX) mainly because commodities market for both agricultural
and minerals are virtually non-existent. The agricultural sector has been on a free fall since the
year 2000 after the fast track implementation of land reform programme. The sector has failed to
recover to date to guarantee a steady supply of agricultural produce to the market, which makes
it difficult to have futures exchange in Zimbabwe.
Example
An airline company wanting to lock in jet fuel prices to avoid an unexpected increase could buy
a futures contract agreeing to buy a certain amount of fuel for a delivery in the future at a
specified price. A fuel distributor may sell a futures contract to ensure it has a steady market for
fuel and protect against an unexpected decline in prices. Both sides agree on specific terms such
as to buy (or sell) 1 million gallons of fuel, delivering it in 90 days, at a price of $3 per gallon.

In the above example both parties are hedgers, real companies that need to trade the underlying
commodity because it's the basis of their business. They use the futures market to manage their
exposure to the risk of price changes. However not everyone in the futures market wants to
exchange a product in the future. These people are speculators or investors, who seek to make
money off the price changes of the contract itself. If the price of jet fuel rises, the futures contract
itself becomes more valuable and the owner of the contract can sell the contract for more in the
futures market.

Futures can also be used for an arbitrager strategy, arbitragers are those who are dealing in two
markets; buy stocks from one market at lower price and sell it in another market at a higher
price. The difference between the buying price and the selling price will be the profits to the
arbitragers. Dealing in spot stock market and futures stock market provides the opportunity to the
arbitragers to earn profits with arbitrage strategies, like purchase stocks from spot market at
lower price and short futures contracts at higher prices.

Forwards Contract
A forward contract is a contractual agreement between a buyer and a seller at time 0 to exchange
a prespecified asset for cash at some later date at a price set at time 0. Market participants take a
position in forward contracts because the future (spot) price or interest rate on an asset is
uncertain. Rather than risk that the future spot price will move against them—that the asset will
become more expensive to buy in the future—forward traders pay a financial institution a fee to
arrange a forward contract. Such a contract lets the market participant hedge the risk that future
spot prices
Shapiro (2010) defines a forward contract on an asset is an agreement between the buyer and
seller to exchange cash for the asset at a predetermined price (the forward price) at a
predetermined date (the settlement date).
Forward contracts often involve underlying assets that are nonstandardized, because the terms of
each contract are negotiated individually between the buyer and the seller e.g.a contract between
Bank A to buy from Bank B, six months from now, $1 million in 30-year Treasury bonds with a
coupon rate of 6.25 percent). As a result, the buyer and seller involved in a forward contract must
locate and deal directly with each other in the over-the-counter market to set the terms of the
contract rather than transacting the sale in a centralized market (such as a futures market
exchange).

Forward market
Commercial banks and investment banks and broker-dealers are the major forward market
participants, acting as both principals and agents. These financial institutions make a profit on
the spread between the price at which they buy and sell the asset underlying the forward
contracts. The flexibility of forwards contributes to their attractiveness in the foreign exchange
market. A forward market is highly customized and each party has to deal with counter party
risk.

There are 4 types of fund forward contracts

-Closed outright forward
-Flexible forward
-Long-dated forward
-Non-deliverable forward

Forward contracts have been in use for thousands of years all over the world because these are
customized contracts and there is a possibility to postpone delivery and payment. Following are
the main features of forwards contracts:

Customized Contracts: Forward contracts are specially designed by the parties themselves as per
their requirements. There is no obligatory authority to specify the price, lot size and time period
of the contract

Settlement by Delivery on Expiration Date: Delivery of an asset on the expiration date is to be

made in forward contracts. But if the counter party does not require the delivery, both parties
may be mutually solving the problem.

Not Traded Through Exchanges: Forward contracts are not traded on the stock exchanges and
there is no obligatory authority over the forward contracts. They have characteristics similar to
those of exchange-traded futures and are referred to as over-the-counter (OTC) contracts.
Settlement of gains and losses on OTC contracts are not guaranteed by a central clearing
organization, so each side of the transition has counterparty risk exposure (Clarke et al
2013).Due to this if any counterpart does not execute contract the other party cannot file a suit
against it.

Example
If you plan to sell 500 bushels of wheat next year, you could sell your wheat for whatever the
price is when you harvest it or you could lock in a price now by selling a forward contract that
obligates you to sell 500 bushels of wheat to Kellogg after the harvest for a fixed priced. By
locking in a price now you eliminate the risk of falling prices however if prices rise you will only
be entitled to what was agreed to in the contract.
On the other hand if you are Kellog, you might want to purchase a forward contract to lock in
prices and control your costs. However you might end up overpaying if prices fall, or
underpaying if prices rise.

OPTIONS

Saunders and Cornett (2015a)defined an option as an agreement that gives the holder the right,
but not the obligation, to purchase or sell an underlyingasset at a prespecified cost for a
predetermined time span. There are two classes of options call options or put options.
Downey (2019) agreed with Saunders definition as he also defined options as a contract that give
the bearer the right but not the obligation to either buy (call option) or sell (put option) an
amount of some underlying asset at a predetermined price at or before the contract expires.

Hargrave (2019) went on to defineoptions as a contract is an agreement between two parties to

facilitate a potential transaction on the underlying security at a preset price, referred to as
the strike price, prior to the expiration date.

Options are incredible in light of the fact that they can upgrade a person’s portfolio. They do this
through added income,protection and even leverage. They can be used to hedge against a
declining stock market to limit downside losses. Options can be used to generate recurring
income. They often used for speculative purposes such as wagering on the direction of a stock.
People who buy options are called holders and those who sell options are called writer of
options.

Options as derivatives

Options belong to the larger group of securities known as derivatives. A derivative’s price is
dependent on or derived from the price of something else. Options are derivatives of financial
securities their value depends on the price of some other asset for example wine is a derivative of
grapes.

Call Options

Saunders and Cornett (2015b) went on to elaborate on call options stating that they give a holder
the privilege however not the commitment, to purchase the underlying security from the writer of
the option at a prespecified exercise cost or strike cost before a prespecified date. The buyer of a
call option must pay the writer an upfront fee known as a call premium. The purchaser possibly
stands to make a benefit should the stock's cost be greater than the strike price. The option is
alluded to as "in the money" when the cost of the stock is more prominent than the strike cost.
The purchaser can practice the option, purchasing stock at the strike cost and selling it quickly in
the market at the present market cost. If the cost of the stock is lower than the strike value the
option is alluded to as "out of the money", the purchaser of the call would not practice the option.
The option is alluded to as "at the money" when the stock cost is actually equivalent to the
exercise price.
Buying a Call Option

● As the stock's value rises, the call option purchaser has an enormous benefit potential.
The higher the stock’s costs at expiration, the bigger the benefit on the exercise of option.
● As the stock's value falls,the call option purchaser has a higher potential for misfortunes,
however they are constrained to the call option premium. In the event that the stock's cost
at lapse is beneath the exercise value the call purchaser is not committed to practice the
option. Consequently these purchaser's misfortunes are restricted to the measure of the
direct front premium instalment made to buy the call option.
● Hence, buying a call option is an appropriate position when the underlying asset’s price is
expected to rise.

Writing a Call Option

● The call option writer stands to receive a positive payoff increase if the stock prices fall.
At expiration if the stock price is less than the exercise price, the call option buyer will
not exercise the option. The call option writer’s profit has a maximum value equal to the
call premium charged up front to the buyer of the option.
● There is unlimited loss potential to the call writer, if the underlying stock price rises. On
condition that the underlying stock’s price is greater than the exercise price at expiration,
the call option buyer will exercise the option, forcing the option writer to buy the
underlying stock at its high market price and then sell it to the call option buyer at the
lower exercise price.
● Subsequently writing a call option is a proper position when the stock's cost is relied
upon to fall.

Call option example 1:

Assume that call options on AM Holdings, expiring in 3-months, with an exercise price of $70
are selling for $6 (premium). Suppose that AM trades at $85 at expiration.

● Value at expiration = stock price –exercise price

● = $85 -$70 = $16
● Profit = intrinsic value –premium
● = $15 –$6 = $9
Call option example 2:

Assume that the call option details on AM above are the same, except suppose AM trades at $75
at expiration.

● Value at expiration = $75 -$70 = $5

● Profit = $5 - $6. = -$1
● As long as the option is in the money, it will be optimal to exercise the call option,
because here the investor offsets some of the loss.

PUT OPTION

Saunders and Cornett (2015c) defined a put option as one that gives the buyer the right to sell an
underlying security at a prespecified price to the writer of the put option. A put premium is paid
to the writer by the buyer of the put option. The put option is "in the money" if the stock's cost is
less than the exercise price, the purchaser will purchase the stock in the stock market at a lower
cost and quickly sell it at the exercise cost by exercising the put option. On the off chance that
the cost of the stock is more than exercise value the put option is "out of the cash", the purchaser
of the option would not practice the choice. If the cost of the stock is actually equivalent to the
exercise premium when the option lapses the put option is exchanging "at the cash".

Buying a Put Option

● The lower the price of the stock at the lapse of the option,the higher the benefit to the put
option purchaser upon exercise.
● As the stocks cost rises,the likelihood that the purchaser of a put option has a negative
result increments. In the event that the stocks cost is more noteworthy than exercise price
at lapse, the put option purchaser will not practice the option. Subsequently, their most
extreme misfortune is constrained to the size of the in advance put premium paid to the
put option writer.
● In this way a put option is a fitting position when the price on the underlying asset is
expected to fall

Writing a Put Option

 ● There is an enhanced probability of making a profit for the option writer, when the
stock’sprice rises. The put option buyer will not exercise the option, if the underlying
stocks price is greater than the exercise price at expiration. The option writer’s maximum
profit, however, is constrained to equal the put premium.
● The put option writer is exposed to potentially large losses, if the stock prices fall. If the
price of the underlying stock price is below the exercise price, the put option buyer will
exercise the option forcing the option writer to buy the underlying stock from the option
buyer at the exercise price. The lower the stock’s price at expiration relative to the
exercise price, the greater the losses to the option writer.
● Hence writing a put option is a fitting position if the cost on the stock is relied upon to
rise, be that as it may, benefits are restricted and misfortunes are possibly huge.

Put option example

Assume a put option on AM, has an exercise price of $70 and a premium of $2. Suppose AM
trades $60 at expiration.

● Value at expiration = exercise price –stock price

● = $70 -$60 = $10
● Profit = intrinsic value –premium
● = $10 -$2 = $8

Saunders and Cornett (2015d) articulated that an option holder has 3 ways to liquidate his or her
position

1. In the event that conditions are never profitable for an exercise the option stays "out of
the money" the option holder can give the option a chance to lapse unexercised
2. The holder can take the contrary side of the exchange. Along these lines an option
purchaser can sell options on the underlying asset with a similar exercise cost and a
similar termination date.
3. The option holder can practice the option implementing the details of the option.

Types of Options
Sanders and Cornett (2015) identified two types of options American Options and European
Options. American Options give the option holder the right to buy or sell the underlying asset at
any time before and on the expiration date of the option. European Option gives the option
holder the right to buy or sell the underlying asset option only on the expiration date.

Downey (2019) further went on to describe American option noting that they carry higher
premium than other because of the right to exercise early which has some value. He also went on
to note another type of option the Exotic options, which are exotic because there might be a
variation on the different products all together with “optionality” embedded in them. For
example binary options have a simple payoff structure that is determined if the payout event
happens regardless of the degree. Other types of exotic options include knock-out; knock in,
barrier options, look back options, Asian options and Bermudan options.

OPTION VALUES

Saunders and Cornett (2015e) indicated the Black Scholes pricing model as the one mostly used
to price and value options. It examines 5 factors that affect the price of an option.

i. The spot price of the underlying asset

ii. The exercise price on the option
iii. The options exercise date
iv. Price volatility of the underlying asset
v. The risk free rate of interest

Downey (2019) defines intrinsic value as the value the buyer could extract from option if he or
she exercised it immediately. The time premium component is simply the difference between the
whole option premium and the intrinsic component. It is the value associated with the probability
that the intrinsic value could increase between the option’s purchase and the options expiration
date. The time value of an option is a function of the price volatility of the underlying asset and
the time until the option matures.

OPTION MARKETS

The Chicago Board of Options Exchange (CBOE) opened in 1973 as stated by Saunders and
Cornett (2015). It was the primary trade dedicated exclusively to the exchanging of options.
In 1982, financial futures options contracts (options on financial futures contracts, e.g.,
Treasury bond futures contracts) began exchanging. Options markets have developed quickly
since the mid-1980s. As with futures trading, many options also trade over the counter.The
exchanging method for options resembles that for future contracts. A financial expert
needing to take an option position calls their broker and presents a request to buy or sell
anexpressed number of calls or put option agreements with anexpressed pass date and
exercise cost. The broker controls this solicitation to its agent on the appropriate exchange
for execution. Most exchanging on the biggest trades, for example, the CBOE happens in
exchanging pits, where dealers for every delivery date on anoption agreement casually bunch
together. Like future contracts, option exchanging for the most part happens utilizing an
open-outcryauction strategy. Only option trade individuals are permitted to execute on the
floor of option trades. Exchanges from the public are set with a broker intermediary,
professional trader, or a market creator for the specific option being exchanged. Option
exchanges might be placed as market requests (instructing the floor representative to execute
at the best value accessible) or limit orders (teaching the floor broker to execute at a
predetermined cost). When a option cost is settled upon in an trading pit, the two parties
electronically send the details of the exchange to the option clearinghouse (the Options
Clearing Corporation), which separates trades into purchase and sell transactions and takes
the contrary side of every transaction turning into the seller for each option agreement
purchaser and the purchaser for each option agreement seller. The broker on the floor of the
option trade affirms the transaction with the investor’s broker.

Chikoko (2008) noted that when inflation soared beyond 100%, whilst the bank rate
remained at 52.7%. This resulted in massive flight of capital from the money market to the
stock market. Stockbrokers successfully traded share options on the back of the buoyant
market. Only call options were offered through over the counter markets. The main
participants in the call options market were individuals who used them for leveraged
speculation. The absence of the put option was mainly due to the high level of inflation. This
left the market with a higher upward potential compared to the downward potential hence the
unpopularity of put options on the market. The following institutions traded share options
over the counter: Kingdom Merchant Bank, Interfin Merchant Bank, Continental Securities,
Trust Banking Corporation and Barbican Bank. Though options are useful, share options in
 Zimbabwe proved to be speculative in nature, looking at the run in this particular period,
which was not backed by any fundamentals. Share options thus could have been said to have
fuelled inflation as funds were diverted from the productive to the unproductive sector. The
post 2004 period, trading in derivatives became illegal. The RBZ has been the sole trader in
derivatives through gold swap transactions with foreign countries though with no legal
grounds. In essence, there has been no legal, active derivative market in Zimbabwe since
2004.

STOCK OPTIONS

The stocks of a publicly traded company are the underlying asset for a stock option contract. An
option generally involves 100 shares of the underlying company’s stock.

STOCK INDEX OPTIONS

The underlying asset on a stock index option is the estimation of a major stock market index.
Aninvestor purchases a call (put) option on a stock index when the individual in question thinks
the value of the underlying stock market index will rise (fall) by the expiration date of the option.
On the off chance that the index does transcend (fall beneath) the exerciseprice on the option, the
call (put) option holder benefits by a sum equivalent to the intrinsic value when the option
expires. The contrast between a stock option and a stock indexoption is that at termination, the
stock index option holder cannot settle the option agreement with the real buy or sale of the
underlying stock index. At lapse, stock index options are settled in real money. Options on stock
indices enable investors to invest indirectly in a broadened portfolio that reproduces a significant
market index.

OPTIONS ON FUTURE CONTRACTS

Future contracts are the underlying asset on a futures option. The purchaser of a call (put) option
has an option to purchase (sell) the futures contract at or before expiration. The seller of a call
(put) option on a futures agreement makes the commitment to sell (purchase) the futures contract
on exercise by the option purchaser. If exercised, a call (put) option holder can purchase (sell)
the futures contracts at the exercise price. Options on futures can be more appealing to investors
than options on an underlying asset when it is cheaper or increasingly advantageous to convey
futures contracts on the asset instead of the real asset. Another favourable position is that price
information about futures contracts is commonly more promptly accessible.Options are currently
written on interest rate, currency, and stock index futures contracts.

CREDIT OPTIONS

Options also have a potential use in hedging the credit risk of a financial institution. Compared to
their use in hedging interest rate risk, options used to hedge credit risk are a relatively new
phenomenon. Two alternative credit option derivatives exist to hedge credit risk on a balance
sheet: credit spread call options and digital default options. A credit spread call option is a call
option whose payoff increases as the (default) risk premium or yield spread on a specified
benchmark bond of the borrower increases above some exercise spread. A financial institution
concerned that the risk on a loan to that borrower will increase can purchase a credit spread call
option to hedge its increased credit risk. A digital default option is an option that pays a stated
amount in the event of a loan default (the extreme case of increased credit risk). In the event of a
loan default, the option writer pays the financial institution the par value of the defaulted loans. If
the loans are paid off in accordance with the loan agreement, however, the default option expires
unexercised. As a result, the institution will suffer a maximum loss on the option equal to the
premium (cost) of buying the default option from the writer (seller)

SWAPS

A swap is an agreement between two parties to exchange specified periodic cash flows in the
future based on some underlying instrument or price.The are three types of swaps that is Interest
rate swaps, currency swaps and credit swaps.

Interest Rate swaps(the most common being vanilla swaps involves an exchange of fixed rate
payments for floating interest payments by counterparties. They allow swap parties to exchange
freely one stream of future interest payments for another based on predetermined notional
principal amount.

In a swap contract, a swap buyer agrees to make a number of fixed interest payment based on a
principal amount contractual amount on periodic settlement dates to the swap seller. The swap
seller in return agrees to make floating payments tied to some interest rates f, to the swap buyer
on the same periodic settlement dates. By being involved in this transaction, the party that is the
fixed rate payer is seeking to transform their variable nature of its liabilities into fixed rate
liabilities to better match the fixed returns earned on its assets. On the other hand , the parry that
is the variable rate payer seeks to turn its fixed rate liabilities into variable rate liabilities to better
match the variable returns on on its assets.

The above can be best clarified by use of an examaple;Consider Lender 1 who lends $1 million
to Borrower A at a variable rate. Lender 2 lends 1million to Borrower B at a fixed rate of
8%.The two borrowers then agree to arrange a swap agreement so that borrower A will now
make fixed rate payments. Borrower A agrees to pay interest of 7% on the notional amount of
1m and B will be paying LIBOR+1%.On the settlement date lets assume that the Libor will 5%,
this means that A will pay 70,000 to lender 1 ,70.000 to and get 60.000 from B which means in
total A would have paid(70,000+70000-60000) 80,000.On the other hand, B Pays 80,000 to
lender 2,get 70,000(7%*1m),pays 6000 to A meaning B would have paid70,000(80,000+60,000-
70000).The following month the Libor is AT 4%.A will pay 60,000 to Lender1 ,70,000 to B and
get 50,000(5%*1M from B meaning A would have paid 80,000(60000+70000-50,000).As
illustrated by the example, A will pay a fixed amount 80,000 every settlement date as a result of
the swap agreement. On the other hand B will pay a net amount of 60,000.Sincwe first settlement
date he paid an amount of 70000 and second settlement date pays 60,000 it means he is now
paying a variable rate instead of the fixed rate.

Currency Swap also known as a cross-currency swap, is a off balance sheet transaction in which
two parties exchange principal and interest in different currencies. The purpose of the swap is to
hedge exposure to the exchange rate risk or reduce the cost of borrowing a foreign currency. This
can be well illustrated by the use of an example. Assume an Australian company is setting up a
business in the UK needs GBP10 million. Also assuming that Australian Dollars(AUD)/British
Pound(BP) is 0.5, the total comes to AUD 20 million. Similarly a UK based company wants to
set up a plant in Australia needs 20 million. The cost of a loan in the UKIS 10% for foreigners
6% for local while in Australia its 9% for foreigners 5%for locals. Besides the high cost for
foreign companies, it might be difficult to get the loan easily due to procedural difficulties. Both
companies have a competitive advantage in their domestic loan markets. The Australian firm can
take a low cost loan of AUD20 million in Australia, while the English firm can take a low loan
of BP10million in the UK, assume that both loans need six monthly repayments.
Both companies then execute a currency swap agreement. At the start the Australian company
gives AUD20 million to the English firm and receives GBP10million, enabling both firms to
start a business in their respective foreign lands. Every six mont hs the Australian firm pays the
English firm the interest payments for the English loan=Notional GBP amount*interest
rate*period)=10million*6%*0.5=GBP300,000 while the English firm pays the Australian company the
interest payments fro the Australian loan-(notional AUD amount*interest
*period=20million*5%80.5=AUD500,000.

Interest payments continue until the end of the swap agreement at which time the original notional forex
amounts will be exchanged back to each other. By getting g into the swap agreement, both firms were
able to secure low cost loans and hedge against interest rate fluctuations.

Credit Swaps are a credit derivative contract between two counterparties whereby a buyer makes
periodic payments to the seller and in return receives a payoff if an underlying financial instrument
defaults.Thev are basically two types of credit default swaps that is total return swaps and pure credit
swap. A total return swap involves swapping an obligation to pay interest at a specified fixed or floating
rate for payments representing the total return on a loan(interest and principal value changes)of a
specified amount. While, total return swaps can be used to hedge credit risk exposure they contain an
element of interest risk as well as the credit risk.

To get rid of the interest rate issue of total return swap, it has led to the development of a swap called pure
credit swap. This involves payment by the financial institution lender a fixed fee or payment which is the
same as the insurance premium to the counterparty. If the borrowers do not default the Financial
Institution will receive nothing from the counterparty. However, if there is default, the counterparty will
cover the default loss by making a default payment. In essence, a credit swap is like buying credit
insurance. An example could be that of a company which purchases a bond issued by a certain
organization thereby lending that very same organization money. The companies will want to make sure
that the they wont lose their money incase of default so this makes the company to buy a credit default
swap from a third party. The counter party will then agrees to pay the outstanding amount of the bond if
the lender defaults. The third party most of the times is an insurance company or a bank.

One of the advantages of credit default swaps is that it protects lenders against credit risk, this will then
enables buyers to fund riskier ventures than they might otherwise. Investment in risk ventures will spur
innovation and creativity which boost economic growth. It is believed that Silicon valley in America
became innovative because of being involved in swap deals.Companies that sell swaps protect themselves
with diversification. If a company or even an entire industry defaults, they have the fees from
other successful swaps to make up the difference. If done this way, swaps provide a steady stream
ofpayments with little downside risk.

In a nut shell, swaps in particular credit default swaps are very important to financial institutions since it
allows them to maintain long term customer lending relationships without bearing the full credit risk
exposures from those relationships. Credit default swaps allows Financial Institutions to separate credit
risk exposure from the lending process. That is Financial institutions can assess the credit worthiness of
the loan applicant, originate loans, fund loans and service loans without retaining exposure to loss from
default or missed payments. However, it loosens the incentives to carefully perform each and every of the
lending process because they know that they are covered against credit risk .

Interest Rate Caps

A cap is a call option on interest rates, often with multiple exercise dates (Saunders 2015). Financial
institutions purchase interest rate caps if they are exposed to losses when interest rates rise. It normally
happens if Financial institutions are funding assets with floating rate liabilities such as notes indexed to
the LIBOR they have fixed rate assets. If interest rates rise above a cap rate which also a acts like strike
price in options contracts, the seller of the cap often a bank compensates the buyer for example a financial
institution in return for an upfront premium or fee. If a cap rate is 10% and the interest rates goes up to 12
% the buyer will receive the difference multiplied by the notional amount. A cap agreement is more of
like an insurance agreement where one is buying cover against exorbitant interest rates.

Interest Rate Floors

A floor is a put option on interest rates often with multiple exercise date(Saunders
2015).Financial institutions purchase floors when they have fixed costs of debt and they have
variable rates(returns) on assets.They use Floors to obtain certainty for their investments and
budgeting process by setting the minimum interest rate they will receive on their
investments.Moreso, an interest rate floor enables variable rate investors to retain the upside
advantages of their variable rate investment while obtaining the comfort of a known minimum
interest rate.Whenever interest rates fall below the floor rate, the seller of the floor compensates
the buyer of course in return for an upfront premium . Say the floor rate is 4% and the interest rates
falls to 2%, the seller will compensate the buyer the difference of 2% multiplied by the notional amount.
Just like caps, floors have one or more exercise dates.

Interest Rate Collars

A collar occurs when a firm takes a simultaneous position in a cap and a floor that is buying a
cap and selling a floor. Financial institutions use collars to obtain certainty for their borrowings
by setting the minimum and maximum interest rate they will pay on their borrowings. By
implementing this type of financial management, variable rate borrowers obtain peace of mind
from the knowledge that interest rate changes will not impact greatly on the borrowing costs,
with the resultant freedom to focus on other aspects of their business.

An Interest Rate Collar ensures that you will not pay any more than a pre-determined level of interest on
your borrowings. The bank will reimburse you the extra interest should interest rates rise above the level
of the cap. An interest collar, will not allow the financial institution to take advantage of interest rates
below a pre-determined level. The financial institution will be obliged to reimburse the bank the extra
interest should interest rates fall below the level of the floor. An interest rate collar enables
variable rate borrowers to retain the advantages of their variable rate facility while obtaining the
additional benefits of a maximum interest rate, at a reduced cost to an interest rate cap.

REGULATION OF FUTURES AND OPTIONS MARKETS

(Stankovska, 2007) brought to light that large losses associated with the use of derivatives by
firms such as Procter & Gamble ($137 million), Metallgesellschaft ($1 billion), and Barings PLC
($1.3 billion), and by Orange County, California ($1.7 billion) have led to fear among some
market participants that derivatives trading is a very risky activity that could lead to a widespread
disruption of the financial system. In order to minimize this systemic risk and to create well-
functioning market, both safety and integrity need to be ensured. This therefore explains the
importance of regulation in the derivatives market.

(Saunders, 2015) highlighted that Derivative securities are subject to three levels of institutional
regulation. Regulators of derivatives specify:

1. Permissible activities that institutions may engage in.

2. supervisory oversight is subjected upon institutions once permissible activities have been
specified and they are engaging in those activities
 3. regulators attempt to judge the overall integrity of each institution engaging in derivative
activities by assessing the capital adequacy of the institutions and by enforcing
regulations to ensure compliance with those capital requirements

Main Regulators

Functional Regulators:

● The Securities and Exchange Commission (SEC)

The SEC, founded in 1934, has a mission statement “to protect investors, maintain fair, orderly,
and efficient markets, and facilitate capital formation.” It establishes regulations to ensure
fair practices are followed in the markets with complete transparency.
The SEC regulates all securities traded on national securities exchanges, including several
exchange traded derivatives. The SEC’s regulation of derivatives includes price
reportingrequirements, antimanipulation regulations, position limits, audit trail
requirements, andmargin requirements.

● the Commodities Futures Trading Commission (CFTC)

The CFTC has exclusive jurisdiction over all exchange-traded derivative securities. It therefore
regulates all national futures exchanges, as well as all futures and options contracts. The
CFTC’s regulations include minimum capital requirements for traders, reporting and
transparency requirements, antifraud and antimanipulation regulations, and minimum
standards for clearinghouse organizations

The Securities and Exchange Commission of Zimbabwe was established through the enactment
of the Securities Act (Chapter 24:25). Section 3 of the Act provides for the establishment of the
Securities and Exchange Commission which is the regulatory body for the securities and capital
markets in Zimbabwe. Commissioners were appointed on 1 September 2008 whilst the
Secretariat was established in 2009.

What do we do?
The Securities and Exchange Commission of Zimbabwe's Key functions are:

i. To regulate trading and dealing in securities; and

ii. To register, supervise and regulate securities exchanges

iii. To license, supervise and regulate licensed persons

iv. To encourage the development of free, fair and orderly capital and securities markets in
Zimbabwe

v. To advise the Government of Zimbabwe on all matter relating to securities and capital
markets

vi. To promote investor education

Main regulator of accounting standards:

● The Financial Accounting Standards Board, or FASB

These have required all FIs (and nonfinancial firms) to reflect the mark to market value of their derivative
positions in their financial statements. This means that FIs must immediately recognize all gains
and losses on such contracts and disclose those gains and losses to shareholders and regulators.
Further, firms must show whether they are using derivatives to hedge risks connected to their
business or whether they are just taking an open (risky) position.

The main bank regulators:

● The Federal Reserve, the FDIC, and the Comptroller of the Currency
These also have issued uniform guidelines for banks that trade in futures and forwards. These guidelines
require a bank to (1) establish internal guidelines regarding its hedging activity, (2) establish
trading limits, and (3) disclose large contract positions that materially affect bank risk to
shareholders and outside investors.

Overall, the policy of regulators is to encourage the use of futures for hedging and discourage their use for
speculation,
INTERNATIONAL ASPECTS OF DERIVATIVE SECURITIES MARKETS

Largest derivative securities markets globally

( BIS, 2016) explained that the size of both exchange-traded and OTC derivative markets have grown
sharply since the 2000s. The trend was briefly interrupted by the global financial crisis. But the notional
amounts outstanding in both markets have since returned to almost pre-crisis levels. Interest rate futures
and options are by far the most popular instruments traded on organised exchanges.

(Borse, 2009) stated that OTC markets are much larger than those on exchanges. Like on organised
exchanges, interest rate contracts are also the most commonly traded instruments in OTC markets. The
number of OTC-traded derivatives is unlimited in principle as they are customized and new contracts are
created continuously. A broad universe of exchange-traded derivatives exists as well: for example, over
1,700 different derivatives are listed on the three major global derivatives exchanges (Chicago Mercantile
Exchange, Eurex and Euronext.Liffe).

(Borse, 2009) furthermore explained that the OTC segment accounts for almost 84 percent of the market
with around €383 trillion of notional amount outstanding. Recently, however, the exchange segment has
grown faster than the OTC segment. This is widely perceived to be a result of the increasing
standardization of derivatives contracts which facilitates exchange trading. Other contributing factors are
a number of advantages of on-exchange trading: price transparency, risk mitigation and transaction costs
are among the most important

(Saunders, 2015) went on to explain that global OTC trading far outweighs exchange trading. The total
notional amount of outstanding OTC contracts was $632.58 trillion in 2013 compared to exchange-traded
contracts which totalled $59.81 trillion in 2013. In both markets interest rate contracts dominated:
$489.70 trillion in notional value in the OTC markets and $55.60 trillion on exchanges. Notice also the
impact the financial crisis had on these worldwide markets. In June 2008, total OTC derivative contracts
outstanding were $683.81 trillion and contracts traded on exchanges totaled $84.29 trillion. These fell to
$547.98 trillion traded in the OTC markets and $57.72 trillion traded on exchanges in December 2008, at
the height of the crisis.
Currencies most global derivative securities are denominated

(Saunders, 2015) explained that U.S. markets and currencies continue to dominate global derivative
securities markets. On organized exchanges, North American markets traded $25.24 trillion of the $59.81
trillion contracts outstanding in 2013. In the OTC markets, $57.60 trillion of the currency contracts,
$148.68 trillion of the interest rate contracts, and $1.94 trillion of the equity-linked contracts were
denominated in U.S. dollars. The euro and European derivative securities markets, however, are now a
strong second behind, and in some areas actually exceed, the United States.

(BIS, 2019 )The Triennial Central Bank Survey, April 2019 statistics reported that the US dollar remained
the world’s dominant vehicle currency. It was on one side of 88% of all trades in April 2019. The relative
ranking of the seven most liquid currencies did not change from 2016.
Turnover in the Euro, the world’s second most traded currency increased at a somewhat higher rate than
did the aggregate market and its share in global trading edged up to 32% .
By contrast, the share of trades involving the Japanese yen fell some 5 percentage points, although the
yen remained the third most actively traded currency (on one side of 17% of all trades).

Below is a diagramatic presentation of the currency performances in the derivatives market.

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International Swaps and Derivatives Association (ISDA), Inc., Brochure, 2013
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International Swaps and Derivatives Association Harvard Negotiation Law
Peter Ritchken 1999 Forward and future prices
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