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Everything You Wanted To Know About Derivatives (But Were Afraid To Ask)

By: Denis Taillefer

Derivatives provide trading efficiency. Orders are executed quickly with little or any price impact resulting in cost reductions which translate into higher returns.

That is, perhaps, the most important thing you need to know about derivatives and it is why derivative instruments have become essential for anyone interested in enhancing returns and reducing risks. All investors, including individuals investing relatively modest sums as part of a retirement planning process or institutional fund managers investing large sums on behalf of their clients, need to understand the basic types of derivative instruments and how they can be used to enhance the efficiency of the portfolio management process.

What Are Derivatives?
Derivatives are financial instruments (contracts) that derive their value from some underlying asset such as equities, bonds, currencies, rates, and commodities, which are to be delivered in the future. All derivatives fall into one, or a combination of, the three following categories:  Futures  Options  Swaps

Like bonds, all derivatives eventually expire (they all have expiration or maturity dates). However, most derivative contracts expire within two years.

There are two counterparties to every derivative contract. Consequently, the counterparty wishing to purchase the underlying asset is said to be long the contract, while the party intending to deliver the underlying asset is said to be short the contract.

Notice that I did not use the terms buying and selling. Whenever possible, think of derivative positions as either long or short. This will go a long way in helping you visualize the risk/reward trade-off, obligations, and settlement, especially with options and fixed income futures which we will discuss later on.

Derivatives are known to be zero-sum game instruments. Gains and losses offset each other. Where gains are credited to one party, losses are debited to the other. These gains and losses may be realized, or unrealized, depending on whether the derivatives trade on or off the exchange. When a derivative trades off an exchange, it is said to trade in the OTC (over-thecounter) market.

The OTC market can best be described as a decentralized environment where transactions occur by phone or computer among dealers and end users. The major advantage of an over-the-counter derivative contract is that it is customized to satisfy the unique needs of a client. The contracts do not have to meet the requirements set by the exchange and additional features can be incorporated into the contract at the request of the client. Since OTC trades are not supervised by an exchange and not marked-to-market or cleared by a clearinghouse, default risk is always an issue. It is crucial for OTC trade participants to know the creditworthiness of the other party.

Exchange traded derivative participants need not be concerned with default risk since trades are guaranteed by the Canadian Derivative Clearing Corporation (CDCC). In order to have access to the trading system of the exchange, a brokerage firm has to be accepted as an approved participant. Approved participants must satisfy requirements designed to ensure their ability to meet day-to-day financial requirements. A market participant, through its approved participant (broker/ dealer), has an obligation not to the counterparty, but to the clearinghouse, just as the clearinghouse has an obligation to the approved participant on the other side of the trade acting for the benefit of its client.

CDCC ensures the financial integrity and stability in the derivatives market by collecting margin deposits from every approved participant, markingto- market each position, and triggering additional margin calls when necessary in order to cover the market risk. CDCC continuously monitors positions and keeps track of each transaction as it happens to ensure prompt and efficient settlement of transactions between the parties. There has never been an incident where the Clearing Corporation has failed to fulfill its obligations to its participants. As a result of its prudent risk management policies and procedures, CDCC is assigned an ‘AA’rating by Standard & Poor ’s.

Other OTC Issues
Other OTC issues that should be mentioned include the lack of:

Dissolving an OTC contract may not be possible if one party is unwilling to free the other party from its contractual obligations. In this case, the party wanting to dissolve their position would have to find someone else willing to take on their position in the contract. Since two participants in the OTC market must negotiate the terms of the contract with each other, trade anonymity does not really exist.

In contrast, two parties using exchangetraded contracts are normally not known to each other and have the benefit of the anonymity of the market. This may be advantageous if one does not want to reveal a strategy to competitors or to the market.

Exchange traded participants also benefit from both price discovery and transparency.Albeit related, price discovery is the process of arriving at a transaction price for a given contract at a given time and place for all to see.

Leverage
You may remember that you do not buy or sell a derivative contract; you enter into an agreement to buy or sell an underlying asset at some point in the future. Consequently, if it wasn’t for margins and transaction costs, no exchange of cash would occur at the inception of the contract. This creates a ‘gearing’effect known as leverage.

Leverage allows investors to make an investment of much greater value than their own equity will allow. While allowing investors to achieve greater potential profits, leverage simultaneously exposes them to greater downside risk.

Leverage, if left unchecked, is a double-edged sword. It makes the good times roll and the bad times fold. However, when used properly, leverage can be a formidable tool that enables a portfolio manager to hedge risks by freeing capital that might be best used elsewhere. Consequently, leverage should be managed, not avoided. AFutures contract is a firm commitment while an Option contract is a conditional commitment to buy or sell an underlying asset at some point in the future. A Swap contract is a firm commitment to exchange a series of cash flows at various points in the future.

In their most basic form, futures and forwards contracts are almost identical. Both contracts are agreements made today, for an exchange to take place in the future, at a price agreed upon today. Futures contracts, however, are exchange traded while forward contracts are created over-the-counter.

Figure 1 illustrates the payoff profile of a long futures contract. Notice the linear profile. As a matter of fact, if it wasn’t for the leverage available to forward instruments, the risk reward profile would be identical to owning the underlying asset.

Portfolio managers use futures contracts to fix a price for an anticipated purchase or sale. Those exposed to the risk of prices going higher will enter into a long position. Those exposed to declining prices will enter into a short position. As prices rise, those holding short positions must pay cash to those holding long positions. When prices fall, long position holders pay cash to the short position holders. This transfer of cash is usually completed at the end of each trading day based on the closing price.

Portfolio managers use fixed income futures contracts to manage risk associated with interest rate volatility. Those exposed to the risk of rates going higher would enter into a short futures position since the underlying asset will decrease in value as rates increase. Pension plans, for example, are exposed to the risk of falling rates because the duration of their liabilities usually exceeds the duration of their assets. Anticipating a decline at the 10-year part of the yield curve, a portfolio manager would manage this risk by extending the duration of its assets by taking a long position in, for example, a 10-year Government of Canada Bond Future (CGB).

Market participants are not obligated to hold a futures contract until its expiration date. The futures position can be ‘closed-out’ with an offsetting trade prior to the expiration date. However, should the market participants wish to hold their position beyond the expiration date, they can ‘roll’ their initial position by closing-out this contract and taking the same position on the following contract month.

An Option Is A Right
The long position (known as the holder) of an option has the right, but not the obligation, to purchase or sell an underlying asset at a price specified by the option contract. This price is known as the strike or exercise price.

There are two basic types of options: call options and put options. The holder of a call option has the right to purchase the underlying asset, whereas the holder of a put option has the right to sell the underlying asset (See Figures 2 and 3).

The short position (known as the writer) is obligated to sell the underlying asset to the holder of a call option or to buy the underlying asset from the holder of a put option, should it be advantageous for the holder to exercise. Because the exercising of an option contract is clearly against the writer’s interest, the holder must compensate the writer for assuming the risk. This compensation is known as the option premium and is paid by the holder to the writer when the contract is initiated. If the holder never exercises the option, the maximum amount of money lost is the premium paid. Alternately, the maximum amount of money the writer can make is also equal to the premium. Think of an insurance company as an option writer (See Figures 4 and 5).

Options are further categorized into American or European. American options may be exercised at any time until they expire, while European options may be exercised only on their expiry date. Most exchange-traded options are of the American type, although index options, such as the S&P Canada 60 Index Options (SXO), are typically European. Equity options should not be confused with stock options. Stock options are deemed an over-the-counter derivative contract made available by an issuer as an employee benefit.

Equity options however, are created by market participants, made available and listed by the exchange, and guaranteed by the Canadian Derivative Clearing Corporation.

Swaps Contracts
Swaps are customized over-the-counter derivative contracts between a financial institution and either a corporate counterparty or an institutional investor. There is a very strong link between swaps and the futures market because a swap can be viewed as a series of forward contracts.

Swaps are generally based on the principle of comparative advantage. When one market participant has a comparative advantage in one particular market segment and another market participant has a comparative advantage elsewhere, there is an opportunity for each to benefit by swapping cash flows.

For example, a currency swap is used where a market participant may have a comparative borrowing advantage in his home currency, but, for various reasons, requires a foreign currency. The second market participant equally has a comparative borrowing advantage in his respective currency, but also requires a foreign currency. The currency swap is initiated with an exchange of currencies, followed by the periodic exchange of cash flows representing the net debt service payments, and ends with a final exchange of currencies to complete the swap cycle.

Another popular contract is an interest rate swap. This swap is a pure exchange of periodic cash flows between two counterparties, where the size of the payments are determined by the value of an interest rate index. Generally, a counterparty will make a payment based upon a predetermined floating rate index, such as the six-month Bankers’Acceptance rate or the three-month $US Libor rate. The other counterparty will make payments on the same schedule that are based on a fixed rate. This ‘fixed for floating’ interest rate swap is generally known as a plain vanilla interest rate swap.

This concludes our overview of the fundamentals and if you have made it this far … congratulations. You have taken the first step in understanding the fastest growing financial instruments in modern portfolio ally searching for added value solutions to provide cost efficiencies and improve risk management. While it is true that many solutions may be provided using cash market instruments, derivatives offer benefits that are simply not achievable through other means.

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Derivatives Institute
As a regulatory organization, the Montreal Exchange’s website (mx. ca) contains a wealth of educational resources for fiduciaries to solidify their understanding beyond the basic but within the scope and purpose of this topic. Plan sponsor and other related market participants should also look to the Derivatives Institute, the educational services division of the Exchange, whose mission is to inform, educate, and provide specialized training to the general public and finance professionals on the use and value of derivatives in portfolio and risk management.

Denis Taillefer is responsible for the Canadian institutional financial market with the Montreal Exchange.

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