Derivatives usually indicate something of their meaning in their title; for example:

In practice there are many variances on these three basic derivative structures.

Let’s look at some definitions related to the products

A forward contract is where the buyer and seller enter into a legally binding transaction to buy/sell a fixed amount of an underlying asset (most commonly a physical commodity, energy product, or currency) on a specific future date at an agreed (forward) price.

A forward contract differs from a “spot” transaction to buy/sell an asset now at today’s (spot) price. The difference between the spot and forward price is called the “forward premium or discount.” Settlement of a forward contract (ie, delivery of the underlying asset from the seller against payment from the buyer) occurs only on the agreed future date of delivery.

Forward contracts are mostly bespoke and nonstandardized with the exact terms being negotiated “over the counter” (ie, outside any exchange) between the two parties. Forward contracts are used extensively by a wide variety of commercial firms in the normal course of their business activities. Currency forwards are quoted on systems as well as being agreed via telephone.

A forward rate agreement (FRA) is a type of forward contract used by borrowers and lenders in respect of interest rate risk management.

Futures contracts are standardized versions of forward contracts and are only traded on regulated exchanges. Futures contracts are standardized in respect of the underlying asset type and quality (ie, energy and commodity products, government bonds, stock indices, currencies, or interest rates), unit size, price quotation, settlement terms, and conditions, and offer a limited range of delivery (or maturity) dates. Futures contract specifications are fixed in advance and published by the exchange on which the futures contract is traded.

Exchange traded futures contracts are cleared and settled through a central counterparty clearing house structure and this important feature, together with the standardized nature of futures contracts, makes for a very deep and liquid market in the most commonly traded products.

Futures contracts (and options on futures) are “marked to market” every day. This requires the daily receipt of profit or payment of loss against the previous day’s settlement (or closing) price and is known as “variation margin.”

Futures contracts can be bought to create a “long” position or sold to create a “short” position.

Measured in terms of notional value, swaps are the most highly traded of all derivative products, in particular interest rate swaps, which represent a significant amount of the total notional value of all OTC derivatives. As well as interest rates, swaps are also traded with reference to underlying energy and commodity products, bonds, shares, equity indices, credit and even property indices.

Swaps are bespoke, nonstandardized transactions, the detailed terms of which are negotiated between the two parties. However, over the last 20 years, many aspects of the swaps market have become relatively standardized; a trend that has been driven by the work of well respected industry bodies such as the International Swaps and Derivatives Association (ISDA).

Since the market crash of 2008, many of these bilaterally negotiated over the counter products have been moved to trading on systems and or being centrally cleared.

Options have different characteristics from forwards, futures, and swaps.

A Call/Put option gives the buyer the right to purchase/sell an agreed amount of a specific underlying asset at a fixed exercise (strike) price, on or before a specified future expiration date. The buyer chooses whether or not to exercise the option.

The seller of the option is obliged to make (call options) or take (put options) delivery of an agreed amount of a specific asset at a fixed exercise (strike) price, on or before a specified future expiration date. In return for accepting this obligation, the seller receives a negotiated premium from the option buyer. The premium is also known as the market price for an option.

Options are traded both on exchanges (standardized “exchange traded options”) and outside exchanges (over-the-counter “OTC options”). There is often a liquid secondary market for exchange traded options.

As with swaps however regulation is changing the process and so OTC transactions may take place on systems and or be centrally cleared.

Some common terms that are associated with options include:

Expiry date: The last date that an option holder can “exercise” their right. After this date an option is deemed to have expired or have been “abandoned.”

Exercise price: The fixed price, per asset or unit, (also called “Strike Price”) at which an option conveys the right to the buyer to either call (purchase) or put (sell) the underlying asset or instrument.

Premium or option price: The sum of money paid by the option buyer for acquiring the right of the option. It is the sum of money received by the seller for incurring the obligation, having sold the rights, of the option. Premium is normally paid or received on trade day plus one (T + 1).

Thus liquidity in the contracts was created. The market maker was able, if he wanted, to lay off the risk he had assumed from buying and selling with the hedgers, by doing the opposite buying and selling with the speculators. The market maker’s profit was the difference between buying and selling prices of his contracts. In essence, today’s markets do the same job but in hundreds of different products.

In the 1870s, following in CBOT’s footsteps, the Chicago Produce Exchange provided a market for perishable agricultural products like butter and eggs. After some upheaval in 1898, certain traders broke away and formed what is now known as the Chicago Mercantile Exchange (CME). In 1919, the CME was authorized to allow futures trading on a variety of commodities including pork bellies, hogs, and cattle. Similarly in the late 19th century, the early versions of futures contracts on precious metals and crude oil were established in New York—the forerunners of the Commodity Exchange (COMEX) and New York Mercantile Exchange (NYMEX), two futures exchanges now both combined as a division of the CME, where futures and options contracts include crude oil, gasoline, heating oil, natural gas, gold, silver, copper, aluminum, and platinum. NYMEX was acquired by the CME Group in 2008.

The need to be able to hedge (or to protect) against the risk associated with volatile currencies and interest rates became critical for many businesses and industries. Therefore, we saw the birth of the first financial contracts which became the cornerstone of the futures and options industry as we know it today.

In 1972, the CME established a division known as the International Monetary Market (IMM). Its purpose was to enable trading in futures contracts based on foreign currencies. In 1975 the CBOT launched the first futures contract on a financial instrument, the Ginnie Mae Mortgage Bond future, followed by the CME, which listed the Eurodollar (3 month interest rate) contract. Shortly after this, the CBOT listed the Treasury Bond future, which was to become for many years the world’s most heavily traded futures contract. In 1983, the CME started trading futures contracts on the S&P500 Stock Index, one of the first futures contract designed for the equity market.

In the United States, prior to 1975, nearly all contracts traded were agricultural. Volume in these contracts was less than 10 million per year. However, by 1994, after the introduction of energy, metal, financial currency, interest rate, and equity index futures, trading volumes had risen to almost 700 million contracts per year.

Since then, the growth in volume of futures and options contracts in the United States and the rest of the world has been phenomenal, as more and more exchanges have opened and a plethora of financial and commodity products have been listed to meet the demands in many different markets for risk hedging mechanisms. Futures and options exchanges are now well established in Brazil, Russia, India, and China and have been increasingly successful in attracting both local and international trading participants.

The expansion of the European market, the introduction of the Euro currency and the shift of trading activity from physical “open outcry” to much cheaper and more efficient electronic trading systems has led directly to a significant consolidation of European futures trading activity and exchange mergers over the last 13 years. The two most liquid futures and options markets in Europe are now EUREX (founded in 1998 from the merger of DTB and Soffex) and Euronext (formed in 2000 from the merger of the Amsterdam, Brussels, and Paris exchanges and later LIFFE in 2002). In 2007 Euronext was acquired by the NYSE, which was itself acquired in 2013 by ICE. The newest European futures exchange is the European Energy Exchange (EEX) in Germany, which started listing derivatives in 2006 and now offers European natural gas, power/electricity, emission, and coal futures contracts.

Across Asia the geographic spread and growth of new futures exchanges continued into the 1990s. The first Chinese commodity futures exchanges were established from 1993 onward, and the Dalian Commodity Exchange, the Shanghai Futures Exchange, and Zhengzhou Commodity Exchange were all listed in the Futures Industry Top 15 global derivatives exchanges (by contract volume) for 2012. The Korea Exchange (KRX) Kospi 200 Index futures contract (launched in 1996) and the National Stock Exchange of India (NSE) CNX Nifty 50 Index futures (launched in 2000) are now two of the world’s most highly traded futures contracts.

These early forms of option contracts were traded between the buyer and seller and had only two possible outcomes. The option was exercised (ie, the underlying product changed hands at the agreed price) or it expired without the buyer taking up his “option” to exercise the contract for delivery. In other words, there was no “trading” of the option positions, and worse, in the early days there was no guarantee that the seller would honor his obligation to deliver the underlying asset if the buyer exercised his option.

In 1973, the CBOT proposed a new exchange, the Chicago Board Options Exchange (CBOE), to trade stock options in a standardized form and on a recognized market where performance of the option contract on exercise was guaranteed. This was the true birth of “traded options.” Several factors also contributed to the growth of traded option markets. First, the ability to calculate a “fair” price for options was made possible with the introduction of a mathematical formula, which was widely accepted by the market. Second, the market maker system was upgraded to insure there was always a two-way (bid and offer) price quoted thus insuring liquidity. Third was the growth of computer processing, which enabled large numbers of trades to be efficiently matched, cleared, and settled. The United States led the way.

Some of the earliest equity option exchanges included the Australian Option Market (now owned by the Australian Stock Exchange), which opened in 1976, the European Options Exchange in Amsterdam (EOE) in 1978 and the London Traded Option Market (LTOM) in 1978, which was originally part of the London Stock Exchange, but merged with LIFFE in 1993. EOE became part of Euronext in 2000, which is now owned by ICE. Equity option and stock index option trading grew rapidly in Asia during the 1990s as more futures and options exchanges opened to offer trading and hedging opportunities on a plethora of newly launched indices.

Although futures and options contract innovation continues to evolve, nearly all the key benchmark financial futures and options contracts (eg, US T Bond, Eurodollar, S&P500 index, Bund, Bob l, Euribor, DAX, Gilt, FTSE index, JGB, Nikkei 225, Euroyen) were first listed in the 1980s. Although some important new futures and options exchanges have been established since then, particularly in Asia, it is mainly the wider and increased usage by market participants, globalization and the much greater capacity and efficiency of electronic markets that has driven growth in the last 10 years. Increased volatility and economic uncertainty in the markets has also led to additional growth in trading activity as hedgers use derivatives to manage risk. Today there is significant consolidation taking place with exchanges merging and readers of this book should access the FIA website at www.fia.org.

Now we will consider two types of futures contract in more detail: equity index futures and commodity futures.

Physical agricultural and soft commodities have the additional feature of being perishable over time and thus have only a limited lifespan in which they can be consumed. To deal with the complicated issues of physical commodity delivery, the futures exchanges have designed detailed delivery procedures and regulations (eg, regarding warehousing, transportation, and product quality requirements) that must be carefully adhered to by both buyers and sellers involved in any delivery process.

Agricultural and soft commodities are finite in terms of availability and subject to variations in quality due to the forces of nature, such as weather. In order to ensure the product delivered is of the correct quality, as defined in the contract terms, there is a quality checking procedure. Where there is a problem with delivery, arbitration is sought via a trade association or an independent source appointed by the exchange. The delivery months of agricultural and soft commodities are not as standardized as for some other futures contracts. This is because they have to take into account factors such as growing season, harvesting and transportation.

During the delivery period the “clearing house” organization that operates the clearing and settlement system and manages the risk on behalf of the exchange, may demand higher margin deposits from holders of open positions in order to encourage traders who do not wish to go to delivery to close out their positions prior to the maturity/delivery date. Less than 0.1% of futures contracts traded actually result in a delivery of the underlying asset.

Equity index futures are one of the most flexible trading instruments. Traders and speculators can use them to obtain maximum gearing for their strategies on stock market direction, while “arbitrageurs” can use them to take advantage of pricing anomalies.

A speculator believes that BP plc shares, which are currently 490 p, will rise in the next few weeks. He has approx. £50,000 to invest. He could purchase 10,200 shares at 490 p or, in the traded option market, he could buy 200 of the 500 p Jun. call option contracts (1000 shares per contract) for 25 p/share or £50,000. These call options give him an exposure to 250,000 shares, so if the BP share price rises high enough before end of Jun., his potential profit far exceeds the amount he would make buying 10,200 shares.

If the underlying share price goes to 550 p, the 500 p call options would be worth at least 50 p so he could sell them for £100,000 for a profit of £50,000. Had he bought the 10,200 shares he could sell them for £56,100 for a profit of £6,100. However, as with most other forms of trading and speculation, higher potential rewards always involve higher risk of loss.

If the BP share price falls to 475 p by the expiry of the options in Jun., the 500 p options will be worth nothing and the option speculator will lose his entire investment (£50,000). While had he used the more conservative strategy and bought the 10,200 BP shares in the cash market, his loss would only be £1,530, and he would still have a holding of shares worth £48,450, the price of which may rise again in the future.

In order to protect his crop against a fall in prices and to ensure that his overheads are covered, the farmer enters into a futures contract. He sells 25 contracts (20 tons per contract = 500 tons) at £10 per ton for delivery in Oct.

This would cover the £5,000 fixed costs that he has, as he is guaranteed to sell 500 tons at £10 per ton in Oct. He also has his additional 250 tons to sell at the prevailing market price, on which he hopes to make a profit. However, the farmer still has one other problem; what would happen if he were unable to produce the 500 tons that he needs to fulfil his contract?

In this case the farmer enters into a hedging transaction to protect himself. He buys a call option, which gives him the right to buy 500 tons at £10.50 per ton in Oct. To acquire this right costs him £250 in option premium.

This is his insurance in case his harvest fails and in total it costs him £500, because he has paid £250 in option premium and it will cost him an extra £0.50 per ton if he has to exercise his option (500 tons × £0.50 per ton = £250). He would have chosen the £10.50 call option because it was not far from the £10.00 price he wanted and was cheaper to purchase.

At harvest time in Oct. the farmer’s crop is poor and potatoes are in short supply. He has only managed to produce 520 tons from his crop. However, the market price of potatoes, given the shortage, is £16 per ton. The farmer must fulfil his futures contract obligation by selling 500 tons at £10 per ton but he sells his additional 20 tons at £16 per ton.

He also has the option, which he should now exercise because it is “in-the-money” and allows him to buy 500 tons at £10.50 per ton, which he can resell in the market at £16 per ton to make a profit.

Let us look at what would happen if the crop had been successful and the farmer was able to produce 900 tons of potatoes.

Because of the good crop and plentiful supply, the market price of potatoes has fallen to £7 per ton. He fulfils his obligations in the futures market.

The option contracts that he bought as insurance for his crop are “out-of-the-money” and therefore are left to expire worthless.

If the farmer had not entered into any futures or options transactions he would have been able to sell his total crop of 900 tons at the market price of £7 per ton, thus realizing a profit of £6,300. Using the futures and options not only protected his crop but also gave him a better profit than without the protection.

If interest rates were to rise in the first year, the building society would have to raise the rates that they pay to savers but they would not be able to increase the rates that they charge you as the mortgage borrower. In order to balance this mismatch in interest payments, the building society can enter into an interest rate swap transaction with another counterparty, most likely a bank.

The interest swap transaction is an over-the-counter (OTC) derivative (see “Part 2—OTC Derivatives”), which is specifically designed between two counterparties to match their hedging requirements. It involves an agreement to pay the counterparty bank the fixed interest payments that it receives from you as the borrower, and in return the building society receives the floating rate, which is similar to the rate that it pays to its savers. The building society is then back to its matched interest rate status for borrowers and savers.

However, now the counterparty bank has a problem because they are not protected against interest rate changes. Therefore it may choose to hedge this risk using NYSE.Liffe’s 3 Month Short Sterling Interest Rate futures contract. This contract allows the bank to fix the interest rate now that will be paid or received in 3 months time. From time to time the bank will roll the contract over, if market conditions are right, so that the interest rate protection is continued. This involves selling the position that is held in say Jun. futures and buying Dec. futures, thus continuing the protection for another six months. The end result is that everyone has the interest rate protection that they need.

Note: Why would the building society use an interest rate swap transaction? The terms are more flexible and allow them to hedge their requirements in one straightforward transaction. The bank receives a bid/offer spread from the building society, which they would price so that they make a profit on the deal allowing for the hedging costs of their interest rate futures contracts.

Investment Managers

Investment managers can use futures and options in many ways and we will explore these later in this part of the book.

Now let us consider the market infrastructure

While historically exchanges provided a large physical location for the trading activity to take place, these days most futures and option trading is done electronically through computer “screen based trading” systems managed centrally by the exchange organization. The traditional style physical exchanges use “open outcry” where the members gather together on an exchange market floor in “pits” and shout out their bids and offers. Traders use an exchange authorized method of hand signals to communicate with their colleagues and other market members. The largest futures exchange in the world still using physical open outcry is New York’s NYMEX (energy and precious metals) but this activity is undertaken in parallel with screen based trading. However, it is only a question of time before this colorful and visually extraordinary style of trading is finally consigned to history.

Until the late 1990s, the responsibility of the management of most exchanges was vested in a board of directors elected by the membership of the exchange. However, over the years most European and US exchanges have separated exchange membership (ie, trading access) from exchange ownership, allowing exchanges to become stock exchange listed profit-focused commercial organizations (as opposed to “not-for-profit” member owned club style bodies). This change in ownership style also accelerated the consolidation of futures exchanges through a series of corporate acquisitions and mergers. Reporting to the exchange board are the executive staff (employees of the exchange) and various practitioner-based committees who consider specific issues relevant to the day-to-day operation of the exchange. These issues concern price dissemination, trading access and regulations, IT systems, product design, specification and development, marketing and exchange fees from which exchanges derive most of their revenue (and profit).

Exchange members may be divided into a number of different categories, with different trading rights and obligations, in particular with regard to their authority to transact business on behalf of third party customers. The most important sub-division is that between “nonclearing” and “clearing” members. Clearing members are those who have a direct counterparty relationship with the central Clearing House (see later), while nonclearing members need the support of a clearing member in order to trade on the exchange.

The process of establishing a futures contract in the name of the clearing house as counterparty, to each clearing member, is called “novation.” In this process the clearing house becomes buyer to every seller and seller to every buyer, for each transaction. Following novation, the clearing member has no counterparty risk in the market for all their futures trading, other than with the clearing house on one side and their own clients (if any) on the other. The completion of the novation process is called “registration.” Upon registration the clearing member’s open positions in the market are held with the clearing house and it becomes irrelevant regarding which trade counterparties the clearing member actually dealt with originally. Similarly, when closing a position in the market there is no need to seek out the original counterparty of the initial trade. For all registered trades, the clearing house undertakes daily mark-to-market processes and effects automated settlement of the two (buy and sell) transactions the following morning.

There are two categories of clearing house; those that are owned by the same corporate entity as the exchange itself and those that are separately owned and independent of the exchange, with their own financial backing. Today, following extensive exchange consolidation in the United States and Europe, most of the world’s clearing houses are combined with their associated exchanges. There are many examples of this integrated exchange/clearing house model, including the CME (including CBOT & NYMEX contracts), ICE (including LIFFE), EUREX (including ECC), KSE, HKSE, and TSE.

Until 2001, LCH.Clearnet (LCH) was the independent clearing house for all London’s futures exchanges; LIFFE, IPE, LME, and LCE. However, following the acquisition of these exchanges by various overseas exchanges, this centralized clearing has gradually been superseded. Today LCH provides clearing arrangements for the cash equities for the LSE and interest rate swaps in Swapclear (see later section) plus repurchase agreements (RepoCLear) and other products.

Clearing houses need be financially robust in order to sustain a potential clearing member default in the market(s) in which they operate. The most common structure of financial support for clearing houses is a default fund, into which all clearing members are required to pay significant cash deposits, partly in proportion to the volume of their business. In addition, as a condition of clearing membership, clearing member firms may have to accept some contingent liability (or additional assessment) to “top up” the clearing house default fund in the unlikely event that such cash reserves are insufficient to cover a clearing member failure. Over the last 20 years there have been a number of high profile defaults of clearing member firms, including Barings, Refco, Lehman, and MF Global, but in all cases the default handling procedures of the clearing houses have worked well in practice, without any losses being sustained in their default funds. The financial backing of the clearing house is an important consideration for banks and brokers when they are contemplating becoming clearing members of an exchange. It is also an important issue for companies researching the potential of trading on any particular exchange, as they need to know that their trades will be efficiently settled and that their positions will be secure in the event of another unrelated party defaulting on market. As for exchanges, the clearing houses are themselves subject to regulatory oversight by their local government agencies (eg, FCA in the UK, CFTC/SEC in the United States).

If the FTSE100 index stands at 5,000, the value of one futures contract at that price would equate to £50,000 (£10 × 5,000). In practice the fair market price of the FTSE futures contract will not be the same as the cash market index, as there are important differences between the characteristics of an index futures contract and that of the underlying basket of stocks; as follows:

A simple formula for the calculation of fair value is shown:

Where cost of carry = spot index level × (i/100−y/100) × d/365, i = interbank rate, d = the number of days from settlement day for the day of trade to the settlement day for the expiry date of the contract, y = percentage annual yield of FTSE100 Index.

(Source NYSE.LIFFE FTSE Indices booklet)

Assuming an index level of 6000 on 3rd Jan., the first business day of the year, a forecast yield on the index of 4.1% and a three month interbank rate of 5.25%, the above formula can be used to calculate a fair value for the Mar. FTSE future:

If interest rates are generally higher than dividend yields, the futures generally trade at a premium to the underlying index. This premium is determined by comparing the interest that would be earned by buying futures with the dividends that would be paid on the underlying securities during the remaining life of the contract.

Fair value is a benchmark, not an absolute number, since different investors in the market will use different expectations of unknown future dividends and also different funding assumptions. The above formula is simplistic in the sense that the dividends that are to be paid in the future are not discounted to their present value. Supply and demand factors will also affect the price, making the traded price differ from fair value. The futures contract is described as “expensive” when it is at a premium to fair value and “cheap” when it is at a discount to fair value. The difference between the actual level at which the futures trade and the theoretical fair value is sometimes known as the “value basis.”

The margining of option contracts is more complex than for futures contracts due to the much wider range of contract parameters: puts and calls, strike/exercise prices, and expiry dates. In addition options are normally traded in combination with other options and/or futures such that opposing market risk exposures partly net-off with each other. To calculate the appropriate level of initial margin requirement that is appropriate to the market risk of a given option portfolio, all of the world’s main clearing houses now use the SPAN (Standard Portfoilo Analysis of Risk) system, or similar “risk-based” margining software, which is described in more detail later. Option margining requirements also vary depending on whether option premium is payable upfront (eg, equity and index options) or not (eg, options on futures contracts). The OCC use their own process—System for Theoretical Analysis and Numerical Simulations (“STANS”) see appendices.

Equity and index option buyers (holders of long option positions) are not charged initial margin because once the option premium has been paid out (to the seller) on T + 1, the buyer has no further downside market risk. The worst that can happen for the buyer is that the option subsequently expires worthless. Equity and index option sellers/writers (holders of short option positions) are required to deposit initial margin as there remains a risk of the writer being unable financially to fulfil their delivery obligations, should the option be exercised on or before expiry.

In contrast, the traded premium on options on futures contracts only flows from buyer to seller gradually over the life of the option. Thus both buyers and sellers have a remaining risk exposure and both are required to deposit initial margin in a similar way as for futures contracts. Their initial margin requirement changes daily in line with the changing market risk exposure in their option portfolio.

Intraday margins can be called from the clearing members by the clearing house at any time as determined in their rules. It is important to understand that the clearing members must pay the required amount to the clearing house, regardless of whether they are able to obtain any additional funds from their clients. In this respect, it is necessary that clearing members have the systems capability to recalculate margin requirements during the day so that they can accurately determine how they and their clients are affected. Intraday margin calls also highlight the need for clearing members to be adequately capitalized in that they must draw on their own financial resources to meet the call.

SPAN is a relatively sophisticated risk-based margining system. For example, SPAN calculates the “delta” (see later) value of options to convert them to futures contract “equivalents” when calculating any futures/options and intermonth spread margin amounts.

(Note: The delta of an option measures the rate of change in option premium relative, or in proportion, to a given change in the underlying asset price. Roughly speaking, a deep in-the-money option has a maximum delta of 1, a far out-of-the-money option has a minimum delta of 0, while an at-the-money option has a delta of exactly 0.5. As time value decreases toward option expiry, the option delta will also be affected.)

Note: Exchanges may use SPAN or other systems or inhouse developed systems to calculate margin calls.

An example calculation of VM is as follows:

A client buys 1 Sep NYSE Liffe Long Gilt Future at 110.13 on Jun, 1st.

The client sells the position at 110.42 on Jun. 8th.

The contract size is £100,000 nominal value with a minimum price fluctuation of £0.01 per £100 nominal. This gives a tick size of £10.

The overall profit on the trade was 29 ticks, which is the difference between the buying and selling price; (29 × £10 per tick = £290). The daily variation margin amount is always settled by the clearing members with the clearing house in cash in the currency of the contract on T + 1.

As in the above example, an initial margin of £500 (assuming £500 is the applicable initial margin requirement for LIFFE Long Gilt contract) would also be called by the clearing house on Jun. 2nd and held until Jun. 9th when it would be returned.

The form of collateral that a clearing member will accept from their client is negotiable between the parties. However, there may be restrictions about usage of such collateral and additional transaction costs to be borne by the client. If applicable, the client may have to check with their trustees about whether they have any additional restrictions. By physically transferring the collateral into the name of the clearing member or clearing house, the client loses legal title but not the “beneficial ownership” of the collateral. If this transfer of the asset as collateral is made under hypothecation, the taker of that collateral can only use it if the giver of the collateral fails to meet an obligation (defaults). However, if the agreement between the giver and taker of the collateral allows rehypothecation, the taker can use this collateral. This gives rise to a credit risk with the clearing member, as the collateral provided could be used to cover (say) a loan between the clearing member and a counterparty and may be seized in the event of a default by that organization, even though the client is not involved in the default situation. All noncash collateral lodged with any clearing house will be subject to a “haircut” or discount when being valued. A typical haircut for equity collateral may be 30–50%; (eg, a stock priced at 100 would have a collateral value of between only 50 and 70).

However the initial margin calculations of the clearing house and clearing member firms are much harder for customers to replicate, unless their positions are very simple without options and intermonth or intercontract spreads to include in their portfolio margin calculations. Therefore, although risk based margining systems (such as SPAN) are very efficient and result in the client depositing a lower overall initial margin, clients generally have to accept that the clearing broker’s calculated amount is correct. In order for the client to accurately verify the initial margin required, they would need to receive the daily risk arrays from all the relevant clearing houses and have their inhouse system capability to compute the figures; which for many clients is not cost effective. For much larger volume clients, a solution is for them to buy an established commercial futures back-office software package for their own processing and accounting. This software is expensive but has all the margining capability required.

This facility involves the deposit of only one currency by the client, which is equal to or more than the total equivalent amount of all the currency settlements due to the broker. In order to calculate this, each currency is notionally converted to the base currency chosen by the client as the preferred settlement currency. Interest would normally be received on the currency deposited and would be charged on the other currencies which are in debit/overdraft. Both the clearing broker and the client take on an intraday FX risk, as the amount due in the settlement currency is only calculated once overnight, using the end of day FX rates. Where this service is offered to many clients, it needs careful control by the clearing broker’s operations team to ensure that the FX exposures are properly managed. Cash held in any other currency than the selected base currency may be subject to a valuation haircut.

Although no specific fee may be levied for this service, clearing brokers will recoup their expenses through the interest rates that are paid and received. While such rates need to be relatively competitive, in order to make the service viable, they are designed to cover at least any financing costs that the broker incurs on behalf of the client. From the client’s point of view it may make the settlement process more efficient; in particular reducing bank charges and administration for foreign currency transactions.

We can now look more specifically at the use of derivatives by investment funds.

On the surface there does not appear to be a lot of difference in these two strategies. However, there are some important differences, which make the selling of the futures contracts a much more viable choice.

If the pension fund manager is correct and the value of the UK stock market falls over the six months then he can buy back the futures contracts at the lower value. The profit from this transaction would be used to offset the fall in value of the underlying shares, thus protecting the value of the portfolio.

If the pension fund manager gets it wrong and the value of the stock market rises, he can buy back the futures contracts. The loss made on this transaction would be offset against the rise in value of the underlying portfolio. Of course he will not make as much profit in this case as he would have done without the futures contracts hedge in place, but he has the advantage of the temporary protection (or insurance) against the possible fall in value, without disturbing the portfolio. Indeed, the pension fund manager can close out his futures position at any time during the six months if he feels that it is right to do so, thus limiting his losses. He is not locked in for the full six months.

Example: A fund manager has a portfolio made up of US, UK, and Japanese equity shares, plus UK Gilt stocks and cash. The fund’s portfolio is currently made up of 40% US equities, 20% UK equities, 20% UK Gilt stock, 10% Japanese equities and 10% cash.

The fund manager believes that the US equity market is due a fall and that Japan will rise. He expects this to occur in the next six to eight weeks. The fund manager can adjust the balance of the portfolio by selling US shares and purchasing stocks in Japanese companies. He will need to research both markets to determine which shares to buy and sell and then execute the transactions needed, which all takes time to implement. Dealing costs will be incurred on each transaction.

Alternatively the fund manager can use derivatives, in this case index futures, to gain and reduce exposure to the respective markets. He needs to sell S&P Index futures contracts and purchase Nikkei Index futures. If he is correct in his assumptions, the sale of the S&P futures will offset the fall in value of the US equities he holds while the Nikkei futures will rise enabling the fund to participate in the increase.

There are several advantages for the fund manager.

Before a manager uses this strategy he should first ensure that his portfolio closely matches the index. Each index consists of a number of individual stocks, which are “weighted” according to their capitalization. If the manager’s portfolio differs from the index portfolio he may be exposed to “basis” risk when the two portfolios react differently to changes in market; (see also “Part 2—OTC Derivatives”).

Example: He has purchased 500,000 BP shares at 600 p and will be happy to sell half of the holding if the stock rises more than 10%. He notes that the 650 call options expiring in two months can be sold for 25 p. He sells 250 contracts (1000 shares per contract) at 25 p. The fund manager has given the right to the option buyer to call/buy the 250,000 shares at 650 p anytime in the next two months in return for £62,500 (250 × 1000 × 25 p) of premium paid to him immediately.

If the stock rises above 650 p he may have to deliver the stock at 650 p. If it does not rise above 650 p he will not have to deliver the stock.

In the first scenario, he has effectively sold the stock for 675 p (650 + 25) which meets his criteria of selling on a 10%+ share rise. But note that his profit is restricted to the difference between 600 p and 675 p, no matter to what price the stock rises. In the second scenario, he still has the stock but has received income of £62,500 or looked at another way he has reduced the purchase price to 575 p. This means he is protected against a fall to this level on half of his holding.

With the futures contracts, the fund manager risks incurring a loss if the market should rise until he decides to close the position. With the put option he can determine how much the “insurance” against a fall in the market will cost and has the comfort that if the market should rise he will never pay more than the original cost of the option.

Both strategies gave protection against a Fall in the market. The put option restricted the cost of the hedge against a Rise in the market. However bear in mind that while there is a loss occurring on the futures position as the index rises, the value of the stock has increased to compensate. With the option, the rise in the stock prices accrues to the portfolio once the £1000 outlay has been compensated for.

These are very simplistic examples and the decision on whether to use futures or options to hedge a portfolio or stock will be made taking into account many factors. In both cases the position could be quickly closed out if desired. In the above examples, we have seen how the fund manager can disperse or minimize the impact of risk on his portfolio.

If the fund has set a target investment objective of index performance plus x%, then sophisticated fund investment strategies have been designed in which futures and options are used in combination with other instruments to both enhance yields and reduce risk.

While open forward positions can be revalued on a daily basis, for accounting, valuation, and risk management purposes, any profits or losses accrued are not paid out until the settlement date of the forward contract. This applies even if the position is effectively “closed out” by a new equal and opposite trade (at a different price) prior to the settlement day.

Note: The LME is in effect an exchange regulated and cleared forward market, where most of the trading is done on an OT style phone basis, but all the resulting contracts and open positions are then registered with a clearing house, by which initial margin requirements are calculated and profits and losses are settled.

Example: Suppose a manufacturer needs to borrow £5m in one month’s time and needs the loan for a period of three months. Concerned about interest rates rising, the manufacturer decides to buy a FRA that will fix the effective borrowing rate today, even though they have no wish to borrow the money now when it is not needed.

The terms of the FRA are that the fixed rate is 5.25% and the benchmark is LIBOR. It will start in one months time and finish three months later and would be known as a “one versus four” FRA. In one month’s time the calculation of the settlement of the FRA can take place. The prevailing 11.00 am LIBOR is 5.5%.

The formula used to calculate settlement is:

Notional Principal Amount × (Fixed Rate − LIBOR) × days in FRA period/days in year divided by (1 + (LIBOR ×days in FRA period/days in year))

Calculation

The LIBOR rate was higher than the fixed rate so the buyer (the manufacturer) receives this amount from the seller. There is no exchange of the £5 m, the manufacturer will borrow the money from a lending source and the money received from the FRA will offset the higher borrowing costs of around 5.5%. Had LIBOR been lower than the fixed rate, the manufacturer would have paid the difference to the seller but of course would borrow the money at a lower rate. The manufacturer “locked” in a rate of 5.25% for their planned future borrowing.

As far as settlement is concerned, the amount due is known on the settlement date, the date at which the FRA period starts (ie, 1 month time) and the calculation period is known (3 months). Unlike most transactions that settle on maturity a FRA can be settled at the beginning of the calculation period. The amount may be discounted to reflect the interest that would accrue if the amount paid was deposited to the end of the FRA period.

It is possible to have a combination of fixed and floating rates in two currencies in a currency swap; for example,

Unlike an IRS where there is no exchange of the principal amount, with a currency swap there may (or may not) be a negotiated exchange of the principal amounts at both the beginning and end of the swap term, at an FX rate agreed at the beginning.

Example: A UK company plans to expand its business in the United States and needs to borrow USD to do so. The company believes it can borrow money (albeit GBP) much cheaper in the UK (where it is well known to its bankers). To facilitate its currency requirements the company can negotiate a currency swap.

The UK company borrows British Pounds (GBP) on a floating rate basis from its own bank and then swaps this GBP principal amount for USD with the swap bank counterparty. It might agree to pay a fixed rate of interest on the USD and receive a floating rate of interest on the GBP, which it uses to pay the floating rate interest on the original GBP loan from its bank.

It agrees to exchange the principal amounts at the beginning of the term at an agreed FX rate and decide to fund the future repayment of the GBP loan, (which is a totally separate transaction from the swap) from its own resources.

The USD amount is invested in its US business and the subsequent income stream is used to pay the swap counterparty the fixed rate interest on the USD leg of the swap. During the swap term, which will correspond to the loan duration, the payment streams will be settled on reset dates. They are not netted because they are in different currencies.

This currency swap has provided the company with protection against foreign exchange movements during the period of the swap and protection against interest rate movements in the UK market rate during the period of its borrowing.

We also have Puttable and Callable swaps, which allow the fixed rate receiver and fixed rate payer respectively to terminate the swap early. They are traded with European, American, and Bermudan styles of exercise right.

Another popular product used by some investment managers is a total return swap.

Also popular in hedging issuer risk is a credit default swap.

CFD transactions have no fixed maturity date (ie, no time limit) and are not closed until the customer wishes to do so (or in the rare event of a customer default). At no point does the customer ever take or make delivery of the underlying shares.

The CFD broker-dealer requires a margin deposit, typically 10% of the underlying, to protect themselves from the risk of the customer defaulting on the CFD. The position is marked-to-market daily and the broker may call for additional margin. Charges include a commission and a cost-of-carry charge based in the underlying amount.

The main advantages and disadvantages in using CFD’s are:

The confirmation sets out the key trade details to be reconciled (see example). Confirmations should be issued by one counterparty (the bank dealer issuing the OTC product), as quickly as possible so that the trade details can be checked and “affirmed” by the other party. Affirmation can be evidenced either by the return of a signed copy of the initial confirmation, or the receipt of a separate confirmation from the other party. Where no affirmation is quickly forthcoming, the counterparty should be chased up, as the confirmation is not legally enforceable until both parties have acknowledged that the details of the trade have been agreed. [Note: Typically two banks participating in a trade will send each other confirmations while a bank and a client trade will result in a confirmation from the bank to the client which the client will then sign and return.] Over the last 10 years the use of online confirmation and affirmation systems has greatly improved efficiency and reduced delays and costs. Ensuring the efficient settlement of OTC products requires a high degree of skill in managing the flow of trade information both at, and immediately after, the time of trade execution. Accurate trade confirmation details are essential to the subsequent position maintenance and periodic settlement of the resultant OTC derivative position, through to the date of maturity or expiry.

Example: FRA confirmation (which will typically be sent via SWIFT) and would contain information such as:

Example: IRS confirmation for a fixed/floating swap transaction would contain information such as:

There are other pieces of information that may be added to this, such as frequency being modified following convention.

The global OTC derivative market is rapidly automating to improve the way the industry operates. There is significant pressure on OTC dealers to increase efficiency and decrease operational and compliance costs, in part driven by new regulatory requirements. One of the main communication platforms is MarkitSERV. MarkitSERV was originally created from systems collaboration between Markit and DTC. This system provides posttrade confirmation, allocation, clearing, and regulatory reporting solutions to over 2,000 market participants and 12 OTC clearing houses. MarkitSERV supports all the main OTC derivative product types including CDS, IRS, FRA, FX (forwards and options), equity options, and equity swaps. Increased usage of this type of online system service for trade confirmation/affirmation has significantly reduced the manual processing involved.

Trade capture and verification requires all the trade details to be input (whether automated or manual) to the back-office systems. From a risk and control point of view, the system must be capable of handling certain key information about a trade such as:

This list is not exhaustive and certain types of products will need additional information. In cases where the full details cannot be recorded in the main system, additional manual records, processes, and checks must be employed. Details of the settlement instructions, including netting if agreed, will also be input to the system together with information such as the reference sources for fixings and possibly the documentation type (ISDA, BBA) and governing law.

It is important that all this data is captured in the back-office systems so that key reports and information can be supplied to operations, dealers (positions and profits/losses), risk managers, general ledgers, reconciliation systems, etc. There will always be queries related to transactions, settlement, and events and it is important that the respective operations staff at the two parties to the trade work closely together to resolve any problems quickly. This has been highlighted in recent years by the strong guidance issued by the Federal Reserve Board of the United States, and the UK FCA, concerning the length of time taken to match bargains in the OTC credit derivatives market. They were concerned with the number of bargains remaining unmatched for a number of weeks thus exposing both parties to operational and counterparty risk. OTC equity derivatives have come under a similar regulatory spotlight.

Some events are mandatory obligations of the trades done (and/or automatic), such as those involved with swaps, barrier options, caps, collars and floors, FRAs. Other event types may require an instruction and/or decision by the dealer or client, for example, option exercise, credit default events, early terminations of OTC contracts.

The use of collateral in conjunction with OTC trades is also a key risk control, especially where one party has a much lower credit rating than the other. Where collateral has been lodged as part of the risk management process it is important to ensure that the collateral value remains sufficient to cover the exposure risk. Aside from market risk, counterparty default is the second most important concern of OTC derivative market participants. Where a trader has the fixed side of a swap “matched” between two counterparties (eg, he is receiving a fixed rate from one counterparty and paying a lower fixed rate to the other) and the first counterparty defaults, the second counterparty must still be paid. The trader is likely to incur financial loss in replacing the defaulted swap with another at current market prices.

Under the STANS methodology, which went into effect in Aug. 2006, the daily margin calculation for each account is based on full portfolio Monte Carlo simulations and—as set out in more detail below—is constructed conservatively to ensure a very high level of assurance that the overall value of cleared products in the account, plus collateral posted to meet margin requirements, will not be appreciably negative at a two-day horizon. Long option positions held in customer accounts of CMs, and not part of various designated spread positions, are excluded altogether from OCC margin calculations for investor protection reasons. The effect of the exclusion is that the value of such options does not get used to collateralize other customers’ short positions.

Until Feb. 2010, securities posted as collateral were not included in the Monte Carlo simulations, but were subjected to traditional “haircuts.” Since then, the “collateral in margins” scheme has taken effect, whereby some collateral securities—specifically equity securities and, more recently, US Treasury securities (excluding TIPS)—have instead been included in the Monte Carlo simulations. Thus, the margin calculations now reflect the scope for price movements in these forms of collateral to exacerbate or mitigate losses on the cleared products on the account.

The Monte Carlo simulations are based on econometric models of the joint behavior of the risk factors affecting values of CM accounts at OCC. There are currently in the region of 7,000 such risk factors, of which the majority pertain to individual equity securities. The modeling of each risk factor allows for volatility clustering and fat-tailed innovations. The joint behavior is addressed by combining the marginal behaviors of individual risk factors by means of a copula function that takes account of correlations and allows for tail-dependence.

The Monte Carlo simulations use, for the volatility of each risk factor, the greater of the short-term level predicted by the model and an estimate of its longer-run level. In between the monthly reestimations of all the models, volatilities are automatically rescaled upward if a model of the behavior of the S&P 500® Index, reestimated daily, indicates heightened turbulence in the financial markets.

The base component of the margin requirement for each account is obtained from the risk measure known as 99% Expected Shortfall (ES). That is to say, the account has a base margin excess (deficit) if its positions in cleared products, plus all existing collateral—whether of types included in the Monte Carlo simulation or of types subjected to traditional “haircuts”—would have a positive (negative) net worth after incurring a loss equal to the average of all losses beyond the 99% VaR point.

The base component is adjusted by the addition of a stress test component. The stress test component is obtained from consideration of the increase in ES that would arise from market movements that are especially large and/or in which various kinds of risk factor exhibit perfect or zero correlations in place of their correlations estimated from historical data, or from extreme adverse idiosyncratic movements in individual risk factors to which the account is particularly exposed.

Brief technical details concerning the base and stress components are provided in the Appendix. Several other components of the overall margin requirement exist, but are typically considerably smaller than the base and stress test components, and many of them affect only a minority of accounts. CMs on elevated Watch Levels as specified in OCC rules may be subject to additional margin requirements.

For collateral types that are subject to a traditional “haircut,” the impact of a withdrawal or deposit upon the margin excess incorporates the “haircut.”

For collateral types that are subject to “collateral in margins” treatment, the impact of a withdrawal or deposit is based upon a “portfolio specific haircut” (PSH) that is communicated to the applicable CM concerned on a daily basis. The PSH represents the sensitivity of the risk profile of that particular account to its position in the relevant security. In other words, the PSH applicable to any given movement of collateral is designed to provide an estimate of the resulting change in margin requirements if the entire margin calculation was recalculated following the movement.