Trading in Financial Markets

Trading in Financial
Markets
Chapter 5
Risk Management and Financial Institutions, 4e, Chapter 5, Copyright John C. Hull 2015
Financial Markets (pages 89-90)

Exchange
traded
Traditionally exchanges have used the open-outcry system,

but electronic trading has now become the norm
Contracts are standard; there is virtually no credit risk
Over-the-counter
(OTC)
A network of dealers at financial institutions, corporations,

and fund managers who trade directly with each other
Contracts can be non-standard; there is some credit risk
Clearing Houses
Clearing houses stand between traders in the exchangetraded market.

Clearing houses require traders to post cash or
marketable securities as collateral (referred to as
margin) and clearing house members contribute to a
guarantee fund
The margin is set to be sufficiently high that exchange is
unlikely to lose money if it has to close out a trader
This combined with the guaranty fund means that traders
are subject to virtually no credit risk
Alternatives for Clearing OTC

Trades
Bilaterally
Usually Involves an ISDA Master Agreement

Transactions between two participants netted
May require collateral to be posted
Through
CCPs
CCP behaves like an exchange clearinghouse and

stands between two sides
It required initial and variation margin
All transactions with CCP netted
Regulatory Changes for OTC

Derivatives
Standard OTC derivatives in the U.S. must be traded on

electronic platforms known as SEFs. (In Europe the
electronic platforms are referred to as organized trading
facilities, OTFs)
Standard derivatives traded between financial institutions
must be cleared through CCPs
Non-standard derivatives traded between financial
institutions can be cleared bilaterally but more collateral
than before has to be posted
Trades have to be reported to a central trade repository
Short Selling (Pages 90-92)

Short
selling involves selling

securities you do not own
Your broker borrows the securities
from another client and sells them in
the market in the usual way
At some stage you must buy the
securities back so they can be
replaced in the account of the client
Short Selling (continued)

You must pay dividends and other benefits
the owner of the securities receives
The cash flows from a short position that is
entered into at time T1 and closed out at
time T2 are the opposite of those from a long
position where asset is bought at time T1
and sold at time T2, except that there may be
a small fee for borrowing the asset
Derivatives
Forwards
Futures
Swaps
Options
Exotics
Growth of Derivatives Markets

(Figure 5.1)
Forward Contracts
A
forward contract is an agreement to buy

or sell an asset at a certain price at a
certain future time
Forward contracts trade in the over-thecounter market
They are particularly popular on
currencies and interest rates
10
Foreign Exchange Quotes for GBP

June 17, 2014 (See page 93)
Spot
Bid
1.6961
Offer
1.6965
1-month forward
1.6957
1.6962
3-month forward
1.6950
1.6955
1-year forward
1.6919
1.6925
11
Profit from a Long Forward Position

Profit
Price of Underlying
at Maturity
12
Profit from a Short Forward Position

Profit
Price of Underlying
at Maturity
13
Futures Contracts (page 95)

Agreement
to buy or sell an asset for a

certain price at a certain time
Similar to forward contract
Whereas a forward contract is traded
OTC, a futures contract is traded on an
exchange
14
Futures Contract continued

Contracts
are settled daily (e.g., if a

contract is on 200 ounces of December
gold and the December futures moves $2 in
my favor, I receive $400; if it moves $2
against me I pay $400)
Both sides to a futures contract are
required to post margin (cash or marketable
securities) with the exchange
clearinghouse. This ensures that they will
honor their commitments under the
contract.
15
Swaps
A swap is an agreement to
exchange cash flows at specified
future times according to certain
specified rules
16
An Example of a Plain Vanilla

Interest Rate Swap
An
agreement to receive 6-month

LIBOR & pay a fixed rate of 5% per
annum every 6 months for 3 years on
a notional principal of $100 million
Next slide illustrates cash flows
17
Cash Flows for one set of LIBOR rates

(See Table 5.4, page 99)
Date
Mar.5, 2010
Sept. 5, 2010
Mar.5, 2011
Sept. 5, 2011
Mar.5, 2012
Sept. 5, 2012
Mar.5, 2013
---------Millions of Dollars--------LIBOR FLOATING FIXED

Net
Rate
Cash Flow Cash Flow Cash Flow
4.2%
4.8%
+2.10
2.50
0.40
5.3%
+2.40
2.50
0.10
5.5%
+2.65
2.50
+0.15
5.6%
+2.75
2.50
+0.25
5.9%
+2.80
2.50
+0.30
6.4%
+2.95
2.50
+0.45
18
Typical Uses of an
Interest Rate Swap
Converting a liability from

fixed rate to floating rate
floating rate to fixed rate
Converting an investment from

fixed rate to floating rate
floating rate to fixed rate
19
Quotes By a Swap Market Maker

(Table 5.5, page 100)
Maturity
Bid (%)
Offer (%)
Swap Rate (%)
2 years
6.03
6.06
6.045
3 years
6.21
6.24
6.225
4 years
6.35
6.39
6.370
5 years
6.47
6.51
6.490
7 years
6.65
6.68
6.665
10 years
6.83
6.87
6.850
20
Other Types of Swaps sand

Related Instruments
Floating-for-floating interest rate swaps,
amortizing swaps, step up swaps, forward
swaps, constant maturity swaps,
compounding swaps, LIBOR-in-arrears
swaps, accrual swaps, diff swaps, cross
currency interest rate swaps, equity
swaps, extendable swaps, puttable swaps,
swaptions, commodity swaps, volatility
swaps..
21
Options
A
call option is an option to buy a

certain asset by a certain date for a
certain price (the strike price)
A put option is an option to sell a certain
asset by a certain date for a certain
price (the strike price)
Options trade on both exchanges and in
the OTC market
22
American vs European Options

An
American option can be exercised at

any time during its life
A European option can be exercised only
at maturity
23
Intel Option Prices: June 17, 2014;

Stock Price=29.97 (See Table 5.6; page 101)
Strike
Price
Aug14
Call
Oct14
Call
Jan15
Call
Aug14
Put
Oct14
Put
Jan15
Put
18
2.30
2.45
2.80
0.30
0.66
1.13
19
1.45
1.76
2.17
0.60
0.99
1.53
20
0.84
1.20
1.62
1.04
1.43
2.04
21
0.41
0.82
1.22
1.60
2.02
2.64
24
Options vs Futures/Forwards
A
futures/forward contract gives the holder

the obligation to buy or sell at a certain
price
An option gives the holder the right to buy
or sell at a certain price
25
Hedging Examples
A
US company will pay 10 million for

imports from Britain in 3 months and
decides to hedge using a long position in
a forward contract
An investor owns 1,000 shares currently
worth $28 per share. A two-month put
with a strike price of $27.50 costs $1. The
investor decides to hedge by buying 10
contracts
26
Options vs Forwards
Forward
contracts lock in a price for a

future transaction
Options provide insurance. They limit the
downside risk while not giving up the
upside potential
For this reason options are more attractive
to many corporate treasurers than forward
contracts
27
Interest Rate Options

Caps
and floors
Swap options
Bond options
28
Nontraditional Derivatives (pages

107-111)
Weather
derivatives
Energy derivatives
Oil
Natural gas
Electricity
29
Exotic Options (pages 111-113)

Asian
options
Barrier option
Basket options
Binary options
Compound options
Lookback options
30
Example of the Use of Exotic

Options (Business Snapshot 5.3, page 112)
If
a company earns revenue month by

month in many different currencies, Asian
basket put options can provide an
appropriate hedge
31
Structured Products
Products
created to meet the needs of
clients
A bizarre structures product is the 10/30
deal between Bankers Trust and Procter
and Gamble (See Business Snapshot 5.4)
The payments by P&G were
max 0,
5 yr CMT %
30
yr
TSY
price
5.78%
100
98.5
32
Types of Traders
Hedgers
Speculators
Arbitrageurs
Some of the largest trading losses in

derivatives have occurred because
individuals who had a mandate to be
hedgers or arbitrageurs switched to being
speculators (See for example SocGen,
Business Snapshot 5.5, page 114)
33

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Trading in Financial

Financial Markets (pages 89-90)

Traditionally exchanges have used the open-outcry system,

A network of dealers at financial institutions, corporations,

Clearing houses stand between traders in the exchangetraded market.

Alternatives for Clearing OTC

Usually Involves an ISDA Master Agreement

CCP behaves like an exchange clearinghouse and

Regulatory Changes for OTC

Standard OTC derivatives in the U.S. must be traded on

Short Selling (Pages 90-92)

selling involves selling

Short Selling (continued)

Growth of Derivatives Markets

forward contract is an agreement to buy

Foreign Exchange Quotes for GBP

Profit from a Long Forward Position

Profit from a Short Forward Position

Futures Contracts (page 95)

to buy or sell an asset for a

Futures Contract continued

are settled daily (e.g., if a

An Example of a Plain Vanilla

agreement to receive 6-month

Cash Flows for one set of LIBOR rates

---------Millions of Dollars--------LIBOR FLOATING FIXED

Converting a liability from

Converting an investment from

Quotes By a Swap Market Maker

Swap Rate (%)

Other Types of Swaps sand

call option is an option to buy a

American vs European Options

American option can be exercised at

Intel Option Prices: June 17, 2014;

futures/forward contract gives the holder

US company will pay 10 million for

contracts lock in a price for a

Interest Rate Options

Nontraditional Derivatives (pages

Exotic Options (pages 111-113)

Example of the Use of Exotic

a company earns revenue month by

created to meet the needs of

Some of the largest trading losses in

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