Trading in Financial

Markets
Chapter 1

1
Contents
1. Financial markets
2. Clearing houses
3. Short selling
4. Derivatives markets
5. Risks facing banques
6. Rik Appetite
7. Lines of defence
8. Risk Managers Challenges
1. Financial Markets
There are two markets for trading financial
instruments:
 Exchange traded markets
 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.
Sometimes trading is facilitated with market makers (they quote
both bid price and offer price)

 Over-the-counter (OTC) markets

 A network of dealers at financial institutions, corporations, and
fund managers who trade directly with each other
3
 Contracts can be non-standard; there is some credit risk
2. Clearing Houses
 Clearing houses stand between traders in the exchange-
traded market.
 Both traders deal only with the clearing house
 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
4
Alternatives for Clearing OTC
Trades
 Bilaterally
 Usually Involves an ISDA Master Agreement
 Transactions between two participants netted
 May require collateral to be posted
 Through Central Counterparties(CCPs)
 CCP behaves like an exchange clearinghouse
and stands between two sides
 It required initial and variation margin
 All transactions with CCP netted
5
Regulatory Changes for OTC
Derivatives
A derivative is an instrument whose value depends on (or
derives from) other more basic market variables
 Standard OTC derivatives in the U.S. must be traded on
electronic platforms known as SEFs or Swap Execution
Facilities (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
 The size of the OTC derivatives market is more than
6
seven times the Exchange Traded derivatives market
4. Growth of Derivatives Markets
800 Size of Market
($ trillion)
700
OTC
600 Exchange

500

400

300

200

100

7
3. Short Selling

 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
8
3. 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

9
Plain Vanilla Derivatives

I. Standard or commonly traded

contracts in derivatives
markets (Plain Vanilla):
• Forward contracts
• Futures contracts
• Swaps
• Options
II. Non Standard derivatives
III. Exotic options and Structured
Products 10
41. 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-the-
counter market
 They are particularly popular on currencies
and interest rates

11
Foreign Exchange Quotes for USD/
GBP Exchange Rate June 9, 2017

Bid Offer
Spot 1.2732 1.2736

1-month forward 1.2746 1.2751

3-month forward 1.2772 1.2777

1-year forward 1.2883 1.2889

12
Profit from a Long Forward Position

Profit

Price of Underlying
K at Maturity

13
Profit from a Short Forward Position

Profit

Price of Underlying
K at Maturity

14
42. Futures Contracts
 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

15
42. Futures Contract continued
 Futures 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.
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 Compairison of Forward and
Futures Contracts

Forward Futures

1. Private contract between two parts 1. Traded on an exchange

2. Not standardized 2. Standardized contract

3. Usually one specified delivery date 3. Range of delivery dates

4. Settled at end of contract 4. Settled daily
5. Contract is usually closed
5. Delivery or final cash settlement out prior
usually takes place to maturity
6. Some credit risk 6. Virtually no credit risk
 43. Swaps

A swap is an agreement to exchange cash flows

at specified future times according to certain
specified rules.
The agreement defines the dates when the cash
flows are to be paid and the way in which are to be
calculated.

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An Example of a “Plain Vanilla”
Interest Rate Swap

 An agreement to receive 6-month

LIBOR & pay a fixed rate of 3% per
annum every 6 months for 3 years on
a notional principal of $100 million
 Next slide illustrates cash flows

19
Cash Flows for one set of LIBOR rates

---------Millions of Dollars---------
LIBOR FLOATING FIXED Net
Date Rate Cash Flow Cash Flow Cash Flow
Mar.3, 2019 2.2%
Sept. 3, 2019 2.8% +1.10 –1.50 –0.40
Mar.3, 2020 3.3% +1.40 –1.50 –0.10
Sept. 3, 2020 3.5% +1.65 –1.50 +0.15
Mar.3, 2021 3.6% +1.75 –1.50 +0.25
Sept. 3, 2021 3.9% +1.80 –1.50 +0.30
Mar.3, 2022 +1.95 –1.50 +0.45

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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

21
 Quotes By a Swap Market Maker
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
The Bid rate of 6,03% means that the market maker is prepared to enter into a 2
years swap where it pays 6,03% and receives EURIBOR. 22
The offer rate of 6,06% has a simetrical interpretatioon
 44 Options
Options trade on both exchanges and in the OTC
market. There are two basic types of options:
 A call option is an option to buy a certain asset
by a certain date for a certain price
 A put option is an option to sell a certain asset
by a certain date for a certain price .
The price in the contract is known as the exercise
price or strike price. The date on the contract is
known as the expiration date or maturity date
23
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 date
Most of the options that are traded on
exchanges are American. European options
are generally easier to analyze than
American options.
24
 Intel Option Prices: June 12, 2017;
Stock Price=35.91

Strike Aug17 Oct17 Dec 17 Aug17 Oct17 Dec17

Price Call Call Call Put Put Put
34 2.48 2.88 3.15 0.63 1.07 1.42

35 1.77 2.23 2.53 0.95 1.41 1.80

36 1.18 1.66 1.98 1.39 1.85 2.25

37 0.74 1.20 1.22 1.98 2.40 2.79

An option price/premium is the cost to acquire an option 25

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 (but the holder
does not have to exercise this right).

26
Hedging Examples
1. A Portuguese company will pay £10
million for imports from Britain in 3
months and decides to hedge using a
long position in a forward contract
2. 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
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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
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Interest Rate Options
 Caps and floors
 Swap options also known as swaptions

Where a swap exchanges a sequence of floating

rates for a fixed rate, a cap “caps” the floating rate
and a floor has a simetrical role.
A swap option is an option to enter into a swap at
some future time where the fixed rate is the strike
price
29
45. Nontraditional Derivatives
Derivatives that have been developed to
meet specific needs
 Weather derivatives
 Energy derivatives
 Oil (*)

 Natural gas

 Electricity
(*) In the over-the –counter market virtually any derivatives that is
available on common stocks or stock índices is now available with oil
as the underlying asset. Swaps, forward contracts and options are
popular.
Exange-traded contracts on oil are also popular. 30
46. Exotic Options
Non standard options
 Asian options

 Barrier option

 Basket options

 Binary options

 Compound options

 Lookback options

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46. Exotic Options
The Asian options provide a payoff based on the
average of the price of the underlying asset over
some specified period
The Barrier options are options that come into
existence or disappear when the price of the
underlying asset reaches a certain barrier
The basket options are options to buy or sell a
portfolio of assets rather than options on a single
asset.

32
46. Exotic Options
 The binary options are options that provide a
fixed euro payoff or a certain amount of the
underlying asset, if some conditions are
satisfied;
 Compound options are options on options
(4:a cal on a cal,a cal on a put,a put on a cal
and a put on a put)
 Lookback otions are options that provide a
payoff based on the maximum or minimum
price of the underlying asset over some
period.
47. Structured Products
 Products created ( by banks) to meet the needs of
clients (investors or corporate treasurers)
 A bizarre structures product is the “10/30” deal between
Bankers Trust (BT) and Procter and Gamble . In this
case ,it is debatable whether BT was meeting a client
need or selling a client a product it did not need.
 The payments by P&G were

  5 yr CMT %  
 98.5    30 yr TSY price 
max 0,  5.78%  
 100 
 
CMT % is the yield on a 5- year Treasury note, The 20yr TSY price is the midpoint of
the bid and offer cash bond prices for the 6,25% treasury bond maturity on August
2023 34
47. Structured Products
 Structured products and exotic options are
tailored to the particular needs of
corporateI treasurers

 For instance, if a company earns revenue

month by month in many different
currencies, Asian basket put options can
provide an appropriate hedge
5. Risks Facing Banks
Banks are required to hold capital for three types of risks:
 Market Risk: It is the risk relating to the possibility that
instruments in the bank’s trading book will decline in
value. It arises primarly from the bank’s trading
operations;
 Credit risk. It is the risk that counterparties in loan and
derivatives transactions will default. It is the one for which
the most regulatory capital is required;
 Operational risk: It is the risk that losses created because
internal systems fail to work as they are supposed to or
because of external events.It is often considered to be the
biggest risk facing banks
6. Risk Appetite
Regulators require banks to develop risk
appetite frameworks
 How much loss and at what confidence level
are we prepared to risk?
 What market risk are we prepared to take?
 What credit rating risk are we prepared to
take?
 How concentrated should we allow our risks to
become?
 etc
37
7. Lines of defence

38
7. Lines of defence
 1. First line of defence

Under the first line of defence, operational management

has ownership, responsibility and accountability for directly
assessing, controlling and mitigating risks.

39
7. Lines of defence
2. Second line of defence

The second line of defence consists of activities covered by

several components of internal governance (compliance,
risk management, quality, IT and other control
departments). This line of defence monitors and facilitates
the implementation of effective risk management practices
by operational management and assists the risk owners in
reporting adequate risk related information up and down
the organisation.

40
7. Lines of defence
3. Third line of defence
Internal audit forms the organisation’s third line of defence.
An independent internal audit function will, through a risk-
based approach to its work, provide assurance to the
organisation’s board of directors and senior management.
This assurance will cover how effectively the organisation
assesses and manages its risks and will include assurance
on the effectiveness of the first and second lines of
defence. It encompasses all elements of an institution’s risk
management framework (from risk identification, risk
assessment and response, to communication of risk related
information) and all categories of organisational objectives:
strategic, ethical, operational, reporting and compliance. 41
8. Risk Managers Challenges
 The same instruments can be used by
different 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
 Need to set up controls to ensure that
derivatives are being for their intended
purpose. 42