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4.7. Derivative markets

We mention spot and forward markets earlier, and now need to elucidate these suitably. When a financial instrument is traded and settled on the same or on the following day or even five days hence, it is termed a spot transaction. This is usually written as T+0 or T+1 (in the case of most money markets), T+3 (in the case of most bond markets), and T+5 (in the case in most share markets). "T" denotes transaction date (or deal date), and the number after the "T" denotes the number of days after the transaction date when the transaction is settled. Settled means the relevant security is delivered and the consideration (the amount owing) paid for (this is termed payment versus delivery). All the instruments mentioned above are traded spot.

The spot settlement dates (T+number-of-days mentioned above) are the administratively convenient settlement days for the relevant markets. If, however, the settlement dates are on days other than the spot dates, they are forward / future dates. Thus, if a share deal is traded today for settlement in, say, two weeks, it is a forward transaction. The price of the forward transaction will be the spot price plus the price of money for a two-week term. A forward is thus derived from the spot market. Forward markets are derivative markets.

The other products (instruments) that are derived from the spot markets are many, and there are also derivatives that are not derived from financial instruments. These derivatives may be categorized as shown in Box 5. Elucidation is required in respect of the categories of derivative instruments:

• The share, bond, money and forex markets essentially have all the derivatives mentioned (with one or two exceptions).

• The money market, in addition to those already mentioned (which are not widely traded), has other derivatives as part of its arsenal, i.e. repurchase agreements (repos), forward rate agreements (FRAs), and caps and floors (C&Fs).

• It should be noted that some researchers would probably not include repos in the list of derivatives. We do because they are derived from other financial instruments, cannot stand alone, and derive their value from the financial markets (the price of money for the relevant period). They can also be used for hedging a desired position.

• The commodities market has all the derivatives. These derivative instruments are financial in nature and therefore deserve to be included under financial instruments.

Credit and weather derivatives are not derived or take their value from financial instruments, but they are financial in nature and should be included here.

• Some researchers may not wish to include certain products of securitization in the list of derivatives, because the products are financial instruments themselves (such as MBS, and CDOs and CP). We believe they are derivative instruments because they are derived from other financial instruments (debtors, mortgages, etc) and obtain part of their value from the underlying securities.

• These sticklers should not have much trouble with products of securitization that emanate from the securitization of the sales of music (as does exist in the US). The products are financial and should be included here.

SHARE MARKET, MONEY MARKET, BOND MARKET AND FOREIGN EXCHANGE MARKET

Forwards Futures

Options on "physicals" (on the actual instrument) Options on futures

Warrants (in some markets, which in LC are retail options) Swaps

Options on swaps (swaptions)

Repurchase agreements (simultaneous spot sale and forward purchase) Forward rate agreements (FRAs) (= forward) Caps and floors(= option-type instruments)

COMMODITIES MARKET (BROADLY DEFINED)

Forwards Futures

Options on "physicals" (ie on the actual commodity)

Options on forwards

Options on futures

Commodity swaps

Options on commodity swaps

Credit derivatives Weather derivatives Products of securitization

We are now able to complete our illustration of the financial markets (see Figure 7).

all financial markets

Figure 7: all financial markets

This is one way of presenting the financial markets. Another is shown in Figure 8.

derivative instruments / markets

Figure 8: derivative instruments / markets

The spot market instruments were briefly described in the test on financial instrument, but the derivatives market instruments were not. This was not done because it was necessary to first put all the spot instruments into place and perspective. We now briefly describe the derivative instruments.

Forwards were mentioned earlier as the sale or purchase of a financial instrument on a date in the future, i.e. on a date other than the spot market date. The price of a forward is equal to the spot price plus the price of money (the interest rate) for the forward period.

Futures contracts are agreements to buy from, or sell to, an exchange established for this purpose, a standard quantity and quality of an asset (i.e. a financial asset, commodity or notional asset - like an index) on a specific date, at a price determined at the time of negotiation of the contract. Thus the holders are obligated to perform.

Options (on "physicals", i.e. on the actual spot instrument), on the other hand, bestow on the holder the right, but not the obligation, to buy (call option) or sell (put option) the underlying asset at a predetermined price (strike price) during (an American option) or at the expiry (a European option) of a specified period. It will be evident that the option holders will exercise their options only if it is profitable to do so. Their potential profit is not fixed, while their potential loss is limited to the amount of the premium paid. The writer has the opposite profile.

Options on forwards are options as described above, but the underlying instrument in a forward contract. Similarly, with options on futures the underlying instrument is a futures contract as opposed to a "physical", i.e. a spot market instrument.

Warrants in some countries are retail call / put options on specific shares and on certain indices. In other countries warrants have a different definition: they are issued by companies and holders have the option to take up shares in those companies.

Swaps are contracts in terms of which certain payment obligations are swapped between two parties. With an interest rate swap (IRS), for example, a floating rate obligation is swapped for a fixed-rate obligation. The payments are based on a mutually agreed notional amount that is not exchanged between the parties.

Options on swaps (swaptions), as the name indicates, are call and put options on swaps, such as an IRS.

As noted, these are certain derivative instruments that are unique to the money market, i.e. repos, FRAs and caps and floors. A repo is simply the sale of a previously issued security at an agreed rate of interest for a specified period of time, at the market value consideration of the underlying instrument. The rate on the repo is the price of money for the period of the agreement (except in the case of repos with the central bank, where it is administratively determined). The repo can be regarded as a simultaneous spot sale and forward purchase.

A FRA is exactly what it denotes, i.e. an agreement that enables users to hedge themselves against unfavorable movements in interest rates, by fixing a rate on a deposit or a notional loan that starts sometime in the future. An example of a FRA is a 3 x 6 (3-month into 6-month) FRA, i.e. the 3 in the 3 x 6 refers to the date in 3 months time when settlement takes place and the 6 to the due date of the FRA. The FRA is a forward.

Caps and floors are similar to options. A cap purchased makes it possible for a company with a borrowing requirement to hedge itself against rising interest rates. The cap contract establishes a ceiling, but the company retains the right to benefit from falling interest rates. On the other hand, a floor contract allows a company with surplus funds to shield itself against declining interest rates by determining a specified floor upfront, while it retains the right to profit from rising interest rates. On the exercise date of the cap or floor contract, the specified strike rate is evaluated against a standard reference-floating rate. The interest differential is then applied to the notional principal amount that is specified in the contract, and the difference is paid by the writer / seller to the holder / buyer.

As noted there are also "other derivatives" and we have identified three: credit derivatives, weather derivatives and products of securitization.

Credit derivatives are bilateral contracts between a protection purchaser and a protection seller that compensate the purchaser upon the occurrence of a credit event during the life of the contract. The credit event is objective and observable, and examples are: default (or failure to pay), bankruptcy, rating downgrade.

Weather derivatives are hedges against weather events. They rely on instruments such as caps, floors, collars, swaps, etc., and are settled in the same way as these. The counterparties to the hedgers use data supplied by independent organizations, such as the weather service data stations located at major airports.

Products of securitization we have already touched upon. Essentially, they are financial securities (products) of an SPV (securitization vehicle) set up to hold assets that have a cash flow. The assets are financial (such as mortgages), or non-financial (such revenue from the sale of music), and they are financed by the securities issued.

 
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