Futures and Options: An introduction
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Not a MyNAP member yet? Register for a free account to start saving and receiving special member only perks. Among the most important changes in world financial markets over the past two decades has been the emergence of a myriad of new and rediscovered financial instruments in the form of derivative products.
Financial derivatives include swaps, options, forwards, and futures for interest rates, currencies, stocks, bonds, indexes, and commodities. Many derivatives futures and options project transactions are international, involving residents of different countries, and they are often conducted in multiple currencies.
Their rapid growth can be attributed to the need of investors and borrowers to manage risks in an environment of fluctuating exchange rates, interest rates, and commodity prices. Adverse changes derivatives futures and options project exchange rates, for example, can derivatives futures and options project a firm's overseas profits; commodity price fluctuations can increase input prices of production; and changes in interest rates can put pressure on a firm's financial costs.
The wave of financial deregulation, technological innovation, and competition among market participants has further facilitated the development of derivatives. In addition, the cost-saving features of these products and the flexibility they afford investors and borrowers have fueled their expansion.
They have been used not only for hedging, but also for trading activities. Particularly since the early s, derivatives have come to account for a significant share of international financial transactions. Since derivative products appear in numerous forms and.
This chapter explores the revolutionary changes that financial derivatives have brought to world financial markets and their implications for the collection of accurate, timely, and derivatives futures and options project data for public and private decision making. It is important to understand the basic features and uses of these instruments and how they have affected the coverage of the existing balance-of-payments data and their interpretation.
Financial derivatives are secondary instruments, the values of which are dependent on changes in the value of the underlying financial instrument or commodity.
They are generally linked to a primary financial instrument or an indicator such as foreign currencies, government bonds, corporate equities, certificates of deposit, stock price indices, and interest rates or to a derivatives futures and options project such as gold, petroleum, copper, wheat, coffee, and cattle.
They usually do not result in a transfer of the underlying primary instrument or commodity at the inception of a contract. Instead, they usually entail an exchange between the counterparties to the contract at some future date.
Derivatives can generally be classified as either ''option-like" or "forward-like. Forwards are a commitment to purchase or sell an underlying financial instrument or commodity at a specified price at a future date. Derivative products can take the form of one or a derivatives futures and options project of several basic financial contracts:.
A financial option contract gives the purchaser of the option the right to buy, sell, or exchange specific financial instruments at a fixed or determinable price called the exercise or strike price at the exercise of the option. Examples include currency, interest rate, stock, index, and commodity options.
A warrant can be considered as a type of option: A financial forward contract is one in which two parties agree to exchange specific financial instruments at derivatives futures and options project future date on predetermined terms. Examples are foreign exchange forwards and interest rate forwards.
A swap contract is the binding of two parties to exchange two different payment streams over time, the payments being tied, at least in part, to subsequent and uncertain market developments.
Examples include swap contracts on interest rates and foreign derivatives futures and options project, equities, and commodities notably gold and petroleum products. A swap can be considered as a series of financial forwards, except that the underlying credit risks of the two types of instruments can be different. A futures contract requires the delivery of a specified amount of an underlying asset at some future date at a price agreed on the day the contract is made.
Examples are currency futures, interest rate futures, index futures, and commodity futures. Futures contracts can also be considered as a form of forward contract traded on public exchanges, except that the underlying credit risks of the two types of contracts can be different.
A primary purpose of these secondary instruments derivatives futures and options project to hedge against exposure to risk. Derivatives futures and options project, therefore, are designed to transfer one or more of the financial risks inherent in an underlying primary financial instrument or commodity to a third party willing to accept the risks. The counterparty buyer or seller to the transaction assumes the risk either for speculative purposes or to derivatives futures and options project an offsetting exposure of its own.
Some derivative instruments are not new but have been rediscovered and promoted since the early s. Others are new products designed to enable borrowers and investors to deal with volatility in exchange rates, interest rates, derivatives futures and options project stock and commodity prices. In principle, portfolio managers can realign financing risks through cash markets without using financial derivatives. For example, borrowers and investors can diversify their foreign exchange risks by holding assets and liabilities in different currencies.
A company that wants to lock in an attractive interest rate to meet future financing needs can issue the debt in the cash market before the funding is needed. In practice, however, the transaction costs of cash market strategies can be daunting, and their liquid. Also, there may be regulatory barriers and tax disincentives.
When used prudently, derivatives can offer cheaper alternatives than cash market products to achieve the same hedging or trading objectives. Derivatives are also designed to provide borrowers and investors with flexibility to unbundle and hedge different risks separately.
In the case of foreign exchange futures contracts, a U. This strategy will avoid the risk of loss if exchange rates move against the firm before payments for the goods are received. Furthermore, financial derivatives can be combined with a debt issuance to unbundle the financial price risk from other risks inherent in the process of raising capital. By coupling its bond issues with swaps, for example, a firm can separate interest rate risk from traditional credit risk Rawls and Smithson, Yet another use of derivatives relates to home mortgages.
Innovative financial derivatives have been one means to support residential refinancings in the United States. Duringas U. Prepayments reduced the income stream of mortgage holders. To hedge against bursts of prepayment exposure, derivatives futures and options project mortgage bankers and other financial institutions were able to transfer prepayment risk by turning to reversed indexed principal notes see Feigenberg et al.
Such instruments are designed to extend cash flows to financial institutions as interest rates decline and to shorten cash flows as interest rates rise. The more prevalent approach to handling prepayment risk, however, has been through the securitization of mortgage assets through collateralized mortgage obligations. Derivatives futures and options project such as futures and options tend to involve lower transaction costs, and at times they offer higher liquidity than cash markets for example, through index trading.
This higher liquidity is useful for investors who can also use derivatives to change their risk exposures—by hedging against downside risk, swapping bond coupons for equity dividends, diversifying into foreign markets—without having to buy or sell the underlying securities. An investor holding a long-term bond can protect asset value through a period of expected interest rate turbulence by a swap with floating rate income during that period, rather than selling the holding outright.
Active participation in derivatives markets requires capital strength, in-depth market information, and technical expertise. Consequently, derivative instruments, and the rights and obligations underlying them, are for the most part created by financial enterprises—either acting as agents or brokers in setting up contracts between two other parties or as principals in contracting with a customer.
That is, activities in financial derivatives are largely conducted at the "wholesale" rather than at the "retail" level. An indication of the institutional nature of swap transactions comes from the International Swap Dealers Association ISDAan international group of commercial, investment, and merchant banks and other swap dealers: Major users of financial derivatives include large business enterprises, banks, savings associations, insurance companies, institutional investors, government agencies, and international organizations.
Derivatives can be traded on organized exchanges or they can be over-the-counter OTC contracts. OTC instruments are generally customized to clients' needs; they often specify commodities or instruments and terms not offered on exchanges.
OTC market transactions are generally negotiated over the telephone before being confirmed in writing.
As in the case of cash instruments, it is not uncommon for financial derivatives to be cross-listed in international capital markets. Through arbitrage, these derivatives futures and options project instruments link different derivative markets, as well as the cash markets.
There are major risks in the use of derivatives—risks both for individual firms that are users or dealers in derivatives and potential risks for the financial system as a whole. At the level derivatives futures and options project the individual firm or other user, there have been several recent cases of major financial derivatives futures and options project through the use of derivatives in often complex and highly leveraged transactions.
Unlike exchange markets, in which orders are brought to a central facility a "floor" to be executed, OTC orders are handled by dealers working over the telephone or through a computerized order execution system. The need for a more disciplined approach by users of derivatives and for greater senior management attention and responsibility has been recognized, and a set of "best practices" for the handling of these instruments proposed by industry sources through a report of the Group of Thirty The issue of systemic risk, that is, the potential impact of derivatives on the financial system as a whole, is also a subject of debate.
Questions have derivatives futures and options project raised about possible scenarios in which derivatives might be a source of a widespread disturbance in the financial system. One area of concern has focused on the high degree of concentration of derivatives' trading in a small number of institutions: A second area of concern has centered on the issue of whether certain risk management techniques, such as dynamic hedging of options positions—techniques that lead market participants to buy assets when prices are derivatives futures and options project and sell when prices are falling—can disturb markets by exacerbating volatility.
From a limited beginning in financial forward and futures contracts in the late s have come a plethora of currency, interest rate, and commodity options, futures, and swaps instruments and many combinations of them.
Among derivatives, swaps have derivatives futures and options project the fastest in recent years. Most swap activity to date has been concentrated on interest rates. According to market participants, swaps are attractive as a way to either hedge against existing risks or transform exposures from one source of risk to another.
In addition, financial swaps are simple in principle and unusually versatile in practice. They are therefore revolutionary, especially for portfolio management. A swap coupled with an existing asset or liability can radically modify effective risk derivatives futures and options project return. Swaps have been a powerful force in integrating global capital markets.
Increasingly, they link currency and money markets and erode price discrepancies that result from differences of liquidity and credit standing across markets. Globally, the key uses of swaps lie in the arbitrage of yield and credit differentials across borders, the management of interest and exchange rate risk, and the global diversification of funding and investing.
Comprehensive statistics are not available on the levels of activity in derivative instruments, but several sources do collect data on these instruments: The Bank for International Settlements BIS publishes estimates of market size for selected derivative financial instruments.
Estimates are in notional principal amounts. BIS estimates are based on its own calculations and data from various other sources, including the International Swap Dealers Association, futures and options exchanges worldwide, industry associations, and U.
There is a very high cutoff point for these reports. These unpublished data include the number of covered long and short call and put contracts and the number of uncovered calls and puts traded on the Chicago Board Options Exchange.
These unpublished data cover the total number of contracts by brokerage firms and by general geographic distribution, but they are not distinguished by type.
The Intermarket Surveillance Group collects daily data on U. Derivatives futures and options project Federal Reserve, the FDIC, and the Office of the Comptroller of the Currency, using derivatives futures and options project Call Report, collect data on interest rate contracts, foreign exchange rate contracts, and contracts on other commodities and equities, as well as on other off-balance-sheet items.
The data are limited to derivatives transac. Lawson of the Bureau of Economic Analysis assisted with the compilation of these sources. The ISDA conducts surveys every six months on turnover and every year on outstanding positions.
Their coverage of derivative products and markets is limited, however.