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1.8. Interest rates

As we have seen, interest rates have their genesis in the money market, starting with the KIR. The KIR is made effective by the existence of a borrowed reserves condition (also called "money market shortage" and "liquidity shortage"), which in most countries is a permanent feature of the financial landscape. The KIR has an almost direct influence on the bottom end of the yield curve, which may be depicted as in Figure 7.

market rates and constructed yield curve

Figure 7: market rates and constructed yield curve

The yield curve is a representation of the relationship between interest rates and term to maturity. The money market is represented in the lower end of the yield curve and the bond market the part after one year to maturity. In this respect the bond market can be seen to be an extension of the money market.

1.9. The derivative markets

The word "derivative" means that the product that it describes is "derived" from something. The "something/s" are financial market instruments and the indices (i.e. indices of prices and interest rates) of financial instruments. The latter are debt instruments, share market instruments and forex.

This means that the derivatives cannot exist on their own, i.e. they piggyback on the ordinary financial market instruments or indices. However, it must be rapidly added that there are derivatives that piggyback on other derivatives. Examples are options on futures and options on swaps.

Derivatives are contracts between two parties to buy, sell or exchange (optional or obligatory) a standard or non-standard quantity and quality of an asset or cash flow at a pre-determined price on or before a specified date in the future. The value of the underlying security or index (the spot market instrument that underlies the derivative) changes continuously, and this means that the value of the derivative almost always also changes. For example, the value of a future on a share index changes as the index changes in value. Also, the value of an option on a bond changes because the rate on the bond changes in the secondary market.

derivative markets

Figure 8: derivative markets

The terminology of the derivative markets can be confusing (caps, floors, collars, options, futures, options on futures, FRAs, repos, swaps, swaptions, and the like) and this leads to the need to categorise these markets in a sensible fashion. The derivative markets may be broadly categorised according to:

• Commodity derivative markets.

• Financial derivative markets.

The term financial or financial markets refer to the debt, share and forex markets. Thus we can depict the derivative markets as shown in Figure 8.

This broad categorisation makes sense because there is a fundamental difference between these markets in terms of underlying assets and market turnover. The underlying assets in the commodities derivative markets are various, such as gold, maize, oil, etc., which are fundamentally different to the financial assets or notional financial assets that underlie financial derivatives. Turnover on the latter market dwarfs the turnover on the former.

However, there is much overlap in terms of the types of derivatives that are found in both markets. For example, in both market types forwards, futures, options, and swaps are to be found.

It may also make sense to categorise these markets according to whether they are:

• formalised derivative markets (i.e. exchange-traded), as opposed to

• informal derivative markets (i.e. OTC).

For example, there are formalised markets in futures and options on futures; and there are informal OTC markets in forwards, interest rate caps and floors, forward rate agreements, interest rate and currency swaps, etc. However, this is not the ideal categorisation because there are derivatives that have feet in both the formal and the OTC markets(for example forward rate agreements).

derivative instruments / markets

Figure 8: derivative instruments / markets

Another way in which one may categorise derivatives is according to the broad types of derivatives: forwards, futures (which are similar), options (which include options on futures and swaps), swaps, and other (such as credit and weather derivatives). This classification may be depicted as in Figure 8.

However, this is not ideal because there is a need to relate them to the spot (cash) markets. This is shown in Figure 9. This illustration is also not ideal because it cannot capture the finer distinctions of the derivative markets (for example forwards actually do not apply to all the markets). Table 1 provides the detail of the derivative markets and how they relate to the spot markets.

Even the classification offered in Table 1 is not foolproof, because further explanation is required in some cases to make it absolutely clear. This type of information cannot be captured in an illustration or a table; it requires explanation.

derivatives and relationship with spot markets

Figure 9: derivatives and relationship with spot markets

However, Figure 9 and Table 1 do provide an overarching view of the types of derivative instruments and provides a logical framework for discussion. Taking the above as a cue it makes sense to categorise and discuss derivative instruments in the following order:

• Forwards.

• Futures.

• Swaps

• Options.

• Other derivatives.

Derivatives

Debt market

Share market

Forex market

Commodities market

Forwards

Yes

Yes

Yes

Yes

Futures

Yes

Yes

Yes

Yes

Options:

Options on "physicals"1

Yes

Yes

Yes

Yes

Options on futures

Yes

Yes

Yes

Yes

Options on swaps

Yes

Yes

Yes

Yes

Warrants2

Yes

Yes

Caps and floors

Yes

Yes

Yes

Yes

Yes

Yes

Other:

Credit derivatives3

Yes

Weather derivatives3

1. The actual spot market instruments and indices. 2. Requires explanation (done later). 3. Do not apply to specific financial or commodity markets.

Table 1: Spot markets and derivative instruments

1.10. Summary

The financial system provides the context of the derivatives markets. The instruments and their rates, prices and indices underlie the derivative instruments. The most important input in derivatives' pricing is the rate of interest (which has its genesis in the money market).

The sound classification of derivatives is forwards, futures, swaps, options and other derivatives (and hybrids).

1.11. Bibliography

Bodie, Z, Kane, A, Marcus, AJ, 1999. Investments. Boston: McGraw-Hill/Irwin.

Faure, AP, 2005. The financial system. Cape Town: QUOIN Institute (Pty) Limited.

McInish, TH, 2000. Capital markets: A global perspective. Massachusetts, USA: Blackwell Publishers Inc.

Mishkin, FS and Eakins, SG, 2000. Financial markets and institutions (3e). Reading, Massachusetts: Addison-Wesley.

Rose, PS, 2000. Money and capital markets (international edition). New York: McGraw-Hill Higher Education.

Saunders, A, 2001. Financial markets and institutions (international edition) New York: McGraw-Hill Higher Education.

Santomero, AM and Babbel, DF, 2001. Financial markets, instruments and institutions (2e). Boston: McGraw-Hill/Irwin.

 
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