DERIVATIVE INSTRUMENTS and HEDGING

Burak Saltoglu

04/18/23 2

I. General DefinitionsII. Forward and Futures ContratsIII. Options

04/18/23 3

What is Derivative Product?• Derivative products are the products which derive

their values from other (spot or cash) financial products.

• Derivative contract includes future delivery with known exercise prices. But future spot prices would be unknown by the time the derivative contracts are bought.

• They can be used for speculation, arbitrage and hedging purposes.

04/18/23 4

Futures and Forward Contrats• They can be issued on a varios product ranges.

– Single stocks and indexes, ForEx rates and interest rates– Commodities: Cotton, tobocco, Crude oil, etc. Precious

metals: gold, silver,..,..• Futures Contracts are exchanged in exchange traded

markets.• Product type, delivery etc are determined specifically. • Exchange traded markets (VOB, NYMEX,..) or• Over The Counter (Forward Contracts)

04/18/23 5

Global Derivative ProductsExchange-Traded Derivatives

68%

23%

$53 trn notional $10 trn mkt value

Credit

Interest

Gov-Debt

Stocks

Comm

Equ-Index

FX

2004OTC Derivative Markets

80%

14%

$220 trn notional$6 trn mkt value

US: 35%

EU: 45%

Asia: 20%

Sources: BIS (Dec 2004) ; FIBV (Jan 2005)

0

50,000

100,000

150,000

200,000

250,000

1991 1993 1995 1997 1999 2001 2003

0

10,000

20,000

30,000

40,000

50,000

60,000OTC (bar) and Exchange-Traded (line) Derivatives

(notional outstanding, in billions US$)

Annual growth rates exceed 30%

04/18/23 6

Derivaties Transaction Volume (BIS)

04/18/23 7

Derivaties Transaction Volume

0

100,000

200,000

300,000

400,000

500,000

600,000

2003 2004 2005 2006 2007 2008

Over The Counter Derivative Products(Billion US$)

otc derivative trans.

04/18/23 8

Derivative Types

• Futures and Forward • Swap• Options • Credit Derivatives• Other Structural Products

04/18/23 9

Basic Definitions About Derivatives

• Exercising Derivative: It means to buy or sell the product , at a future date with a specific price.

• Exercise Price: It is the price with which the product will be bought or sold at the delivery.

• Time to Maturity : it is the date at which the contract can be exercised.

04/18/23 10

Forward and Futures Contrats

• The futures and forward contracts set an obligation for the long position to buy the product, at specific date (T) and an exercise price(X).

• At the same time, they set an obligation for the short position to sell the same product under the same conditions.

04/18/23 11

Positions in Futures-Forward Markets

• Long Position : Buying a financial instrument with the expectation of a price increase in the future.

• Short Position: Selling a financial instrument with the with the expectation of a price decrease in the future.

•Settlement Price: It is the price used for determining the daily profit/losses and margin obligations of position holders in the Future Markets. Generally, it is determined like the weighted average of last transactions.

Cash or spot pricesCASH PRICES

Thursday, April 09, 2009

European crude oil Thu Price

Prev Year

Day Ago

Brent 52.29 52.26 108.8

Domestic crude oil

West Texas Intermediate, Cushing 52.24 49.38 110.12

Gold

London p.m. fixing 880.5 880 928

Other metals

Copper, high grade: Comex spot price $ per lb. 2.0705 1.998 3.954

Platinum: free market 1195 1184 2123

Foods

Cocoa, Ivory Coast, $ per metric ton 2907 z 2767

Coffee, Brazilian, Comp. 1.0754 1.0675 1.2976

Grains and Feeds

Corn, No. 2 yellow. Cent. Ill. bu 3.71 3.775 5.58

Soybeans, No. 1 yellow Illinois, bu 9.95 9.945 13.005

Futures on Dow Jones

Month Last Chg Exchange TimeDOW JONES INDUS.-$10  Jun '09 8017 8879 04.09.2009DOW JONES INDUS.-$10  Sep '09 7970 643 04.09.2009DOW JONES INDUS.-$10  Dec '09 7927 0 04.09.2009DOW JONES INDUS.-$10  Mar '10 7887 0 04.09.2009

Gold vs crude oil

04/18/23 15

TurkDex: IMKB30 ve 100 Futures

04/18/23 16

ForEx Futures: TurkDex, 17.12.2008

Gold Futures: 9 April 2009

04/18/23 19

I. Basic DefinitionsII. Forward and Futures Contracts

04/18/23 20

Differences Between Futures and Forward Contracts

• Structural Differences

• Marking to Market

04/18/23 21

Forward ve Futures Contrats

Done between 2 parties Formal MArkets

Non-standard Contrats Standard Contrats

Payment at Contract Maturity Daily Payment

Delivery generally occurs. Contract is closed down before the maturity.

FORWARDS FUTURES

Default risk exist. Default risk is minimized.

04/18/23 22

Credit Risk Controls in Futures Markets

• Marking to Market• Daily Price Change Limits

- Limit-Up- Limit-Down

04/18/23 23

Working Mechanism of Futures Markets: Margins

• Margin: Account which is opened by the broker for the investor in cash(or an asset which have a market)

• Margins are priced every day according to future transaction prices.

• Margins are valued daily as if the contract will be Expired next day.

• Margins are used for to minimize the risk of default of either parties.

04/18/23 24

Margin Accounts and Marking to Market in Futures Contracts

• Inıtial Margin: Minimum required margin(cash) to enter a position. Volatility of the market in that day is determinent.

• Maintenance Margin: Minimum margin level a margin can decrease without a margin maintenance. General it is 75% of Initial Margin.

• Margin Call: If the margin decreases blow the maintenance margin level, the difference between this level and initial margin must be paid to broker by the position holder. This difference is called margin call.

04/18/23 25

USD/YTLUSD/YTL

Contract Size 1.000 USD

Initial Margin 150 TL

Maintenance Margin 112.5 TL

Daily Transaction Limit 10%

Minimum Price Increment 0.0005 TL

04/18/23 26

EUR/YTLEUR/YTL

Contrant Size 1.000 EUR

Initial Margin 200 TL

Maintenance Margin 150 TL

Daily Transaction Limit 10%

Minimum Price Increment 0.0005 TL

04/18/2327

Marking to Marketing in Futures Contracts

Example:Consider the Bank A takes a three-month long position try/usd Futures position of 100,000 USD with the future price of 1.60 contract.

DATE PRICE FUTURES POSITION

VALUE

INITIAL MARGIN

(10%)

MAINTENANCE MARGIN

(7.5%)

MARGIN ACCOUNT

MARGIN CALL

15 JUNE 1.60/ 160,000 16,000 12,000 16,000 -

16 JUNE 1,50 150,000 16,000 12,000 15,000 -

17 JUNE 1.40 140,000 16,000 12,000 14,000 -

18 JUNE 1.20 120,000 16000 12,000 12,000 4,000

04/18/23 28

Marking to Marketing in Futures Contracts

Margin Calls

Margin Account for YEN/USD

Maintenance Margin

Margin Account

Initial Margin

04/18/23 29

Barings Futures (Singapore) Pte Ltd.20 Raffles Place, 24th Floor, Ocean Towers, Singapore 0104

Tel: 5395571 / 5395572  

Client : Baring Futures (Singapore) Ltd. Account No: 88888

Address : c/o Singapore Office20 Raffles Place24th Floor, Ocean TowersSingapore 0104

Date: 24/02/95Page:26

Daily Activity Statement

Attention: Nick Leeson  

  DAILY STATEMENT OF UNREALISED PROFIT AND LOSS

:::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::: 7. Equity Balance 0,00 59,239,120,000.00 (JPY) 8. Collateral Securities Held ....... .......................................

Some observations• You invest only 10% of the notional position.• Your leverage ratio is 1 to 10.• Inital Margin values are determined on the basis of

daily (extreme volatility) estimates and are subject to change.

• ISE30 and S&P500 should not have the same leverage ratio (in S&P it is 4%: i.e. Leverage ratio is 25!)

• You might even have some exotic futures contract so that it will be only 2% (i.e. Leverage ratio is 50!!)

How do we close a futures position

• More than 70% of the futures contracts are not exercised at the maturity.• To take advantage of a market move you may sell your futures contract in

the VOB.• The difference between the price you paid and the price in the second

hand market for the same product will be your profit (or loss).• All you need to do enter a reverse position that you own in the futures

market.• In the previous example: if you take a short position of FX futures with 3

months maturity you will take your profit or loss.• For instance in the FX futures example if close in June 17 with the futures

price of 1.4 you will be making 20,000 TL loss.• Of course you don’t know who will buy it but your counterparty will have

another counterpf you close your position in You invest only 10% of the notional position.

• Your leverage ratio is 1 to 10.

04/18/23 b saltoglu Türev ürün notları 33

Hedging with Futures and Forward Products

• Long position in spot can be hedged with short position in futures or forward.

• Short position in spot can be hedged with long position in futures or forwards.

• Provided that spot product risk, maturity and product directly matches to futures product then this can create a perfect hedge.– Example:

• Short in spot: hedge with long futures:– Dollar/TL debt (short position) in six months and 6 month-futures

contract(long). Exporters.

• Long in spot: hedge with short with futures:importers.

04/18/23 34

Hedging with Using Futures Contracts

• Long in ForEx=>Short in Futures• Short in ForEx=> Long in Futures• Long in Futures=> Short in ForEx• Short in Futures=> Long in ForEx

04/18/23 35

Hedging in Companies• Companies want to eliminate financial risks other than their main

functions(interest rate, currency, or other commodities petrol etc.)• Companies’ purpose is to eliminate the volatility of their profits

because of the other risky determinents.• SEC works on to inform stockholders by rewealing the risks.• In the risk management purposes:What other companies doing and

the cost of the hedging is the main two problems.• For example; hedging continously the cost of petrol worths 147US$

may not be easy process.• However, in terms of legislation and transparency there may be

expected important changes.

04/18/23 36

Hedging in practice?

What is Perfect Hedge?• If a hedge product which totally eliminates the risk of the main product, then there would not be a perfect hedge.

• A written futures product on the same holding term, same risk factor, same currency.• Example: If there does not exist a futures instrument on the jet fuel, or on the same currency, or the maturtiy of the instrument which creates risk is shorter

What can be done under these circumstances?• If the airlines have a jet fuel risk and there exists a futures on the crude oil, then cross hedging might be carried out.•If the maturity of the risky product is longer than the maturity of the protective futures product, then you may conduct a rolling hedge.•If hedge costs much, then the half can be hedged. (Partial Hedge).

04/18/23 37

ForEx Debt exRate: 1.7 US Dollar

-700000

-600000

-500000

-400000

-300000

-200000

-100000

0

100000

200000

1.4000 1.6000 1.8000 2.0000 2.2000 2.4000

pro

fit/

loss

rate

Dollar debt in one month borrowedin 1.7 US$

net profit

04/18/23 38

Futures Long

-200000

-100000

0

100000

200000

300000

400000

500000

600000

700000

1.5000 1.6000 1.7000 1.8000 1.9000 2.0000

futu

res

pro

fit/

loss

exchange rate

futures prof it loss

futures profit loss

04/18/23 39

Hedge: Short Spot+Long Futures

-800000.00-600000.00-400000.00-200000.00

0.00200000.00400000.00600000.00800000.00

1.3000 1.5000 1.7000 1.9000 2.1000 2.3000 2.5000

Spot Exchange Rate

Hedge: Short ForEx+Long Futures

futures profit loss

net profit loss

04/18/23 40

Introduction to Option Markets

04/18/23 41

Option Definitions • Call option, gives option to buy the underlying asset

in a determined time and price. Bullish expectation • Put option, gives option to sell its underlying asset in

with a predetermined time and price.– Bearish expectation of holder.

• European option: contracts can be exercised only in a predtermined date.

• American option: can be exercised any date between the maturity date and the date contract bought.

• Option contracts can be traded in secondary markets.

04/18/23 42

Differences between Options and Futures Contracts

• In Futures contract, there is an obligation at the maturity, but in options there is optionality

• Because of this, there is an additional premium paid for the options unlike in the futures.

• However, in options trade,because the seller should demand a premium to compensate the profit of the buyer.

04/18/23 43

Option Positions

• Long call• Long put• Short call• Short put

04/18/23 44

Example Long Call:IBM Stock Hull 2007

Consider a call option contract which has 5$ contract price (call premium) and 100$ exercise price with time to maturity 2 months. The profit/loss graphic of this contract for long position according to the possible prices can be realized at the maturity is:

30

20

10

0-5

70 80 90 100

110 120 130

Profit ($)

Spot at the maturity of option ($)

04/18/23 45

Long Put: Exxon

Premium for put option on the exxon stock= $7, exercise price = $70

30

20

10

0

-770605040 80 90 100

Profit ($)

Spot at the maturity

04/18/23 46

Short Call:IBM Stock Consider a call option contract which has 5$ contract price

and 100$ exercise price with time to maturity 2 months. The profit/loss graphic of this contract for short position according to the possible prices can be realized at the maturity is:

-30

-20

-10

05

70 80 90 100

110 120 130

Profit/loss ($)

Spot price at the maturity ($)

04/18/23 47

Short Put Exxon

Premium for put option on the exxon stock= $7, exercise price = $70

-30

-20

-10

7

070

605040

80 90 100

Kar ($)Vadedeki fiyat ($)

04/18/23 48

Call/Put• Investor buys call:profit unlimited, loss limited• Person sells call:loss is theorically unlimited,

profit limited• Put buyer: profit may be very high(until stock

price becomes zero) but loss is limited with premium

• put seller: loss may be unlimited(parallel with stock price increase) but profit is limited(limited with put premium).

04/18/23 49

Assets Underlying To Options

• Stocks• ForEx Rates• Stock Indexes• Futures• Energy, weather situation, etc.

04/18/23 50

Some Definitions

Moneyness :– At-the-money options: Stock and exercise prices are

equal– In-the-money option: for call if stock is bigger than

exercise price(for put if exercise price is bigger than stock).

– Out-of-the-money option: for call if stock is lower than exercise (for put if stock is bigger than exercise).

04/18/23 51

Options according to Exercise Terms

• European Type Options:Option type which can be exercised only at maturity.

• American Type Options: Option type which can be exercised any date till to maturity.

To hedge a stock with a cost of 40$

spot in 3 months spot long put protective put

25 -15 12 -3

30 -10 7 -3

35 -5 2 -3

40 0 -3 -3

45 5 -3 2

50 10 -3 7

55 15 -3 12

put+spot: Portfolio insurance

-20

-10

0

10

20

0 10 20 30 40 50 60

spot

kar/

zara

r

long put

spot

protective put

04/18/23 54

Option Sensitivity

• Role of Volatility– Volatility of yield of an finanicial instrument is linearly

realted to potential uncertainity that instrument can face in the future. If this is high possibilty that option(put or call) may be exercised increases and premium also increases .

• Maturity:As the maturity increases, the value of option increases, too.

• Exercise Price: As it increases call loses value.• Asset Underliying to Option:As its price increases, price

of call option increases, too.