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Chapter 13:

The derivatives market

© VAN SCHAIK PUBLISHERS

Study outcomes


The objective of this chapter is to provide an overview of the concepts, instruments and participants in the derivatives market

with particular reference to South Africa.

When you have studied this chapter you should be able to

• define derivative instruments

• understand the characteristics of the derivatives market

• define and discuss the features and application of forwards, futures, options and swaps

• list the participants in the derivatives market and understand their roles

• discuss the risk management of derivatives

• explain derivatives market information.

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Introduction


Overview

• Financial weapons of mass destruction?

• Derivatives defined

• Characteristics of derivatives markets

• Instruments

• Participants

• Risk management of derivatives

• Published market information

Financial weapons of mass destruction?

Table 13.1 Notional outstanding value of global derivatives market (USD trillion) (Textbook page 396)


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Table 13.2 Number of derivatives contracts traded on global exchanges (in millions) (Textbook page 397)


Financial weapons of mass destruction?

Derivatives defined


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Characteristics of derivatives markets


Instruments


• Forwards and futures

• Options

• Swaps

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Forwards and futures

• Definition

• Forwards versus futures contracts

• Example of a forward transaction

Figure 13.1 Payoff diagram of a long and short forward position

(Textbook page 400)

8,7

8,8

8,9

9,0

9,1

9,2

9,3

9,4

9,5

9,6

9,7

9,8

9,9

10,

0 10,

1 10,

2 10,

3 10,

4 10,

5 10,

6 10,

7

1,0

0,5

0,0

–0,0

–1,0

–1,5

Longposition

Shortposition

Pro

fit/

loss

1,5

Price of underlying asset(USD/ZAR)


Instruments

• Examples of futures transactions


– Hedging

– Speculating

• Pricing futures and forwards

F.13.1

F.13.2

F.13.3

Box 13.1

• Basis

• Contango and backwardation

Instruments

Forwards and futures

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OptionsFigure 13.2 Payoff diagram for a long call option (Textbook page 406)

70 75 80 85 90 95 10 0 10 5 110

115

12 0 12 5 13 0 13 5 14 0 14 5

Price of underlyingasset

BreakevenR105

Strike priceR100

Pro

fit/

loss

605550454035302520151050

–5–

10–

15


Instruments

Figure 13.3 Payoff diagram for a short call option (Textbook page 407)

70 75 80 85 90 95 10 0 10 5 110

115

12 0 12 5 13 0 13 5 14 0 14

Price of underlying asset

Strike price R100

Pro

fit/

loss

151050

–5–10–15–20–25–30–35–40–45–50 © VAN SCHAIK PUBLISHERS

Instruments

Options

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Figure 13.4 Payoff diagram for a long put option (Textbook page 407)

70 75 80 85 90 95 10 0 10 5 110

115

12 0 12 5 13 0 13 5 14 0 14 5 15

0

–5

–10

Price of underlyingasset

Strike priceR100

Pro

fit/

loss 5

30

25

20

15

10


Instruments

Options

Figure 13.5 Payoff diagram for a short put option (Textbook page 408)

70 75 80 85 90 95 10 0 10 5 110

115

12 0 12 5 13 0 13 5 14 0 14 5 15 0

Price of underlying asset

Strike price R100

Pro

fit/

loss

10

5

0

–5

-10

–15

–20

–25

–30


Instruments

Options

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Table 13.3 Effects of changing market conditions on the value of options(Textbook page 408)


Instruments

Options

Swaps• Interest‐rate swaps

Figure 13.6 Hedging interest‐rate risk (Textbook page 409)

Asset

7,00%

6,50%Company Alpha

Bank

Six-month JIBAR plus credit

spread Six-month JIBARplus credit spread

Debt liability


Instruments

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• Currency swaps

• Hedging exchange‐rate risk

Figure 13.7 Hedging exchange‐rate risks (Textbook page 411)

American parent compan

y

Bank

Exchange of principal USD 10 million

Interest receipt of 3% on USD 10 million

Re-exchange of principal USD 10 million

South African

subsidiary

Exchange of principal ZAR 100 million

Interest payment of 8% on ZAR 100 million

Re-exchange of principal ZAR 100 million


Instruments

Swaps

• Reducing the cost of financing

Table 13.4 Borrowing rates of Alpha and Beta (Textbook page 412)


Instruments

Swaps

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Figure 13.8 Reducing the cost of financing (Textbook page 412)

Debt market

Exchange of principals

Company Alpha

Bank

USD7m

Borrows R70m at 6,40% Borows USD7m at 3,40%

6,40% p.a. ZAR

3,40% p.a. USD

Company Beta

R70m

USD7mR70m

Debt market

Exchange of interest

Company Alpha

Bank

3,20% p.a. USD

Company Beta

6,40% p.a. ZAR

3,40% p.a. USD6,70% p.a. ZAR


Instruments

Swaps

Equity swaps• Hedging equity positions

Figure 13.9 Hedging equity positions (Textbook page 413)

• Gaining entry to foreign markets

• Benefiting from market imperfections

Equity portfolio

Collective investme

nt scheme

ALSIreturn

Bank

8,9%

ALSIreturn


Instruments

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Other derivatives


• Exotic derivatives

• Credit derivatives

• Weather derivatives

• Insurance derivatives

Instruments

Derivatives instruments and leverageFigure 13.10 Use of leverage – impact on position payoff files (Textbook page 416)

20 000

10 000

5 000

0

Cash market position (no leverage)–5 000

–10 000

–15 000

–20 000

Market price in rand

Table 13.5 Use and effect of leverage (Textbook page 417)

27 0 27 2 27 4 27 6 27 8 28 0 28 2 28 4 28 6 28 8 29 0 29 2 29 4 29 6 29 8 30

Pro

fit/

loss

–in

ra

nd

15 000 Futures market position (10 x

leverage)


Instruments

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Participants


Hedgers

Speculators

Arbitrageurs

Risk management of derivatives


Table 13.6 Historic derivatives trading losses (Textbook page 419)

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Published market information

Table 13.7 Published market information for derivatives (Textbook page 421)


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