Transcript Derivatives: The Good, The Bad and … the Necessary?

Derivatives: The Good, The Bad and … The Necessary
The Meeting of the Africa & Middle East Depositories Association
Presented by
Najib Lamhaoaur
Managing Director
Citigroup Global Markets
October 22, 2009
The Meeting of the Africa & Middle East Depositories Association
What is a derivative?
 A derivative is a financial instrument that is derived from some other asset,
index, event, value or condition (known as the underlying asset). Rather than
trade or exchange the underlying asset itself, derivative traders enter into an
agreement to exchange cash or assets over time based on the underlying asset.
How are derivatives used:
 Hedging:
– Designed to eliminate or reduce risk in the underlying asset
– Value of derivative contract is correlated to the value of the underlying position
– Allows risk about price of underlying asset to be transferred from one party to another
 Speculation and Arbitrage:
– Speculator acquires risk to make a profit
– Speculator capital provides increased market liquidity
– Arbitrage opportunities arise based on price of asset versus price in the derivatives market
 Derivatives are often leveraged, such that a small movement in the underlying value can cause a
large difference in the value of the derivative.
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There are two distinct groups of derivative contracts, distinguished by the way they are traded in
the market:
 Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly
between two parties, without going through an exchange or other intermediary.
– The largest market for derivatives
– Largely unregulated with respect to disclosure of information between the parties.
– No central counterparty.
– Subject to counterparty risk, since each counterparty relies on the other to perform.
– Examples:
 Swaps
 Forward rate agreements
 Exotic options
 Exchange-traded derivatives (ETD) are derivatives products that are traded via specialized
derivatives exchanges.
– Exchange acts as an intermediary to all related transactions
– Margin posted from both sides of the trade to act as a “good faith” deposit
– Provide investors access to risk/reward and volatility characteristics related to an underlying
commodity.
– Examples:
 Futures
 Options on Futures
 Cleared Swaps
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Exchange Traded Futures vs. OTC Products
Futures
OTC
Regulated
Unregulated
Standardized
Customized
Exchange Cleared
Principal-to-principal [bi-lateral]
Standard (in-house) documentation
Heavily negotiated ISDA agreement
Close out for virtually any reason
Very specific termination events
Initial margin is required to be maintained
Margin negotiated between counterparties
MTM Daily and Margin Calls issued, if
necessary
Margin negotiated between counterparties
Margin is adjusted for volatility
Margin negotiated between counterparties
Price Transparency
Pricing mechanism is “market convention”
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Examples of products for each of the five major classes of derivatives.
Contract Types
Underlying
Exchange-traded
futures
Exchange-traded
options
OTC Swap
OTC Forward
OTC Option
Equity
S&P500 futures
Options on
S&P500 index
futures
Equity swap
Back-to-back
repurchase
agreement
Long-dated index
option
Interest rate
Eurodollar futures
Option on
Eurodollar futures
Interest rate swap
Forward rate
agreement
Interest rate cap or
floor
Option on interest
rate swap futures
Credit default swap
Repurchase
agreement
Credit default
option
Currency futures
Option on currency
futures
Currency swap
Currency forward
agreement
Currency option
Heating oil futures
Option on heating
oil futures
Commodity total
return swap
Forward purchase Long-dated option
agreement on
on heating oil-crude
heating oil
oil basis
Interest rate swap
futures
Credit
Credit default swap
index futures
Foreign Exchange
Commodity
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Many products and events underlie derivatives ... here are only a few of the listed derivatives
that are available:
Product/Event
Derivative Contract (Most active)
Exchange
 Currencies ........................
$US – Russian ruble
MICEX (Moscow)
 Equities ...............................
S&P500 E-mini
CME (Chicago)
 Money market rates .............
28-day Interbank Interest Rate
Mexder (Mexico City)
 Bonds .................................
Euro Schatz
Eurex (Frankfurt)
 Agriculture ...........................
Soymeal
DCE (Dalian)
 Energy .................................
Crude oil, WTI
NYMEX (New York)
 Industrial materials ...............
Rubber
SHFE (Shanghai))
 Precious metals ..................
Gold
COMEX (New York)
 Base metals ........................
Aluminum
LME (London)
 Credit default ......................
iTraxx Europe 5-year index
Eurex (Frankfurt)
 Shipping ...............................
Freight swap futures, Singapore to Japan.
NYMEX (New York)
 Weather ...............................
U.S. wind event, $20 bin loss trigger
Chicago Climate Exch.
 Emissions ............................
European Union CO2 allowance
ICE (London)
 Housing ...............................
S&P Case-Shiller housing composite
CME (Chicago)
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OTC Markets: Product Overview
 Two parties agree on the terms of obligations.
 Derivatives on unique products are suited to the OTC market.
 Counterparty risk can be a significant factor in the pricing.
 Function best when non-standardized agreements are needed -- that is, when delivery dates,
locations, quantities or quality adjustments are necessary.
 The guarantee that supports an OTC position is as good as the credit-worthiness of the weaker of
the two parties.
 International Swaps and Derivatives Association (ISDA) agreements or similar bilateral documents
required to support trading. These are typically heavily negotiated.
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Futures Markets: Product Overview
 Futures are standardized contracts made today for settlement (delivery) at a future date.
The contracts are linked to “cash market” products.
 Futures are regulated by the CFTC and the NFA in the United States and by the FSA in the
UK and similar bodies worldwide.
 Futures contracts are traded on regulated Futures Exchanges (not an OTC market) as
agency transactions. There is no principal trading permitted.
 Each Futures Exchange is affiliated with a Clearing House. There is no single centralized
clearing house and no fungibility between products. The Clearing House is the counterparty
between every buyer and seller.
 Futures Commission Merchants (FCM’s) provide the link between investors/hedgers and the
Exchanges, accepting orders to buy/sell futures, providing execution and market expertise,
and managing settlement, reporting and margins related to the futures positions
 Futures are global and cross asset classes from physical commodities (e.g., gold, oil,
grains) to financials.
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Derivative Solutions: The Swiss Watchmaker
 The business: In early June, a Swiss-based manufacturer of luxury wristwatches agrees to deliver
a shipment to a major U.S. retailer in mid-September for the upcoming holiday season. The
watchmaker and retailer have negotiated a payment of $10 million to be made to the watchmaker
upon delivery.
 The problem: The watchmaker is concerned that the U.S. dollar’s value against the Swiss franc will
continue to deteriorate, reducing its profit. The exchange rate is currently 1.08 Swiss franc per dollar
so the agreed payment would be worth 10.8 million Swiss francs.
 The solution: The watchmaker buys a quantity of Swiss francs on a forward basis by entering a
long position in 86 September Swiss franc futures. Each futures contract gives the company
exposure to 125,000 Swiss francs at a futures price of $0.92 [1.08 Swiss francs per dollar].
 The result: By mid-September, the watchmaker was
correct, and the value of the dollar has declined against
the Swiss franc, to 1.03 Swiss francs per dollar.
 The watchmaker’s $10 million payment now equals
10.34 million Swiss francs. This results in a 460,000
Swiss franc shortfall from the original expected
payment back in June.
 The company’s long futures position, however, is
closed out at $0.97 [1.03 Swiss francs per dollar],
netting nearly $445,000 or 460,000 Swiss francs.
The Futures hedge protected the watchmaker from US
Dollar weakness.
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Derivative Solutions: The Airline
 The business: A global airline, operating in 40 countries
 The problem: In reviewing its cost structure, the airline observes that fuel costs, which represent just
over 20% of its operating costs, are likely to rise. It determines that it will hedge a portion of its jet fuel
consumption, 50,000 metric tons per month, for Fourth Quarter in 2010..
 The solution: The airline buys 50 cargo lots of fuel originating in the Amsterdam-Rotterdam-Antwerp
(ARA) area forward in the OTC market at $700, $702 and $705 per metric ton for the October, November
and December 2010 contracts through the Chicago Mercantile Exchange’s ClearPort platform.
.
 The result: The settlement prices for the October,
November and December 2010 contracts end up as
$698, $708 and $710 dollars, respectively, per metric
ton. The contracts are financially settled, netting
actual costs savings for the airline’s Q42010 fuel costs
of $9 per metric ton (-$2 loss for October, +$6 savings
for November and +$5 savings for December).
Using Cleared Swaps, the airline was able to reduce
their cost for fuel.
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Derivative Solutions: The Farm Conglomerate
 The business: A large U.S. farm conglomerate.
 The problem: Forecasters expect that oversupply and modest consumption growth following the
current growing season will undercut corn prices, one of its major crops.
 The solution: The conglomerate sells a portion of next year’s crop on a forward basis by taking a short
position in 1,000 corn futures that expire in December of the following year.
 The result: The conglomerate will deliver
the 5,000,000 bushels of corn the following
December, receiving the final futures price
in exchange for the corn.
Using Futures, the conglomerate sold its
corn crop at a more advantageous price.
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Derivative solutions: The Mortgage Investor
 The business: A large U.S. bank buys mortgages for its investment portfolio.
 The problem: The manager assigned to the portfolio needs to protect its value against rising interest
rates. In addition, the mortgage pools will underperform if rates decline enough to induce borrowers to
refinance their loans, returning principle to the lenders before their stated maturity.
 The solution: After determining the current dollar sensitivity of his holdings to a basis point change in
yields, the manager sells the quantity of 10-year U.S. Treasury note futures that represents an equivalent
dollar sensitivity. In addition, the manager, after consulting with his research group, purchases a quantity
of out-of-the money 10-year U.S. Treasury note futures calls that will increase in value if rates decline in
an amount that will compensate for his mortgages’ underperformance.
 The result: Six months later, rising interest rates
depressed the value of the bank’s mortgage
holdings.
 The short U.S. Treasury futures position rose in
value by a similar amount. The short U.S. Treasury
futures position rose in value by a similar amount.
The call options, although not exercised, provided
protection against falling interest rates.
Using futures and options on futures, the portfolio
manager was able to reduce interest rate and
repayment risk.
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The Global Derivatives Markets, 1998-2008
Notional Amounts Outstanding at Year-end
$US trillions
Exchange-Traded, $58 trillion in 2008.
Over-The-Counter, $592 trillion in 2008.
World Economic Output, $69 trillion in 2008.
600
500
400
300
200
100
0
'98
'99
'00
'01
'02
'03
Source: Bank for International Settlements, International Monetary Fund.
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'04
'05
'06
'07
'08
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Over-the-Counter
Derivatives
Market,
Over-the-Counter
Derivatives Market,
2004 & 2008
2004
$294 trillion notional
2004 & 2008.
2008 2008
$592 trillion
$592notional
trillion notional
Foreign exchange contracts, 2004 to 2008 share: 11% to 9%
Interest rate contracts, 74% to 66%
Equity-linked contracts, 2% to 1%
Commodity contracts, 1% to 1%
Credit default swaps, 2% to 10%
… 2008: $33.9
trillion
market
value,
… 2008:
$33.9
trillion
market
Other, 10% to 12%
$5 trillion net credit exposure.
value,
$5 trillion net credit exposure.
Source: Bank for International Settlements.
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Global
Volume,
2004
& 2008.
Global
2004
& 2008.
Global Futures Volume,
2004Futures
& Futures
2008 Volume,
2008
2008
17.7
billion
contracts
17.7
billion
contracts
2004
2004
billion
contracts
8.98.9
billion
contracts
Equity
Indices
, 42.6%
to 36.8%
Equity
Indices
, 42.6%
to 36.8%
Interest
Rate,
25.6%
to 18.2%
Interest
Rate,
25.6%
to 18.2%
Individual
Equities,
22.6%
to 31.2%
Individual
Equities,
22.6%
to 31.2%
Ag
Commodities,
3.4%
to
5.0%
Ag Commodities, 3.4% to 5.0%
Energy
Products,
2.7%
to 3.3%
Energy
Products,
2.7%
to 3.3%
Foreign
Currency/Index
, 1.2%
to 3.3%
Foreign
Currency/Index
, 1.2%
to 3.3%
NonPrecious
Metals,
1.2%
to
1.0%
NonPrecious Metals, 1.2% to 1.0%
Precious
Metals,
0.7%
to 1.0%
Precious
Metals,
0.7%
to 1.0%
Other,
0.0%
to 0.3%
Other,
0.0%
to 0.3%
100%
increase
from
2004
to 2008
100%
increase
from
2004
to 2008
Souce:
Futures
Industry
Magazine.
Souce:
Futures
Industry
Magazine.
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Top Derivatives Exchange, 2008
3.5
Billions of Contracts
3.0
2.5
2.0
1.5
1.0
0.5
0.0
CME Group
Korea Exchange
Eurex
CBOE
NYSE Life
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International
Securities
Exchange
BM&F/BOVESPA
National Stock
Exchange of
India
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Top Exchanges for Equity Index Futures, 2008
Top Exchanges for Interest Rate Futures & Options, 2008
Milions of
Milions of
1600
900
800
1400
700
1200
600
1000
500
800
400
600
300
400
200
200
100
0
0
CME Group
Eurex
National Stock
Osaka Securities
Exchange of India
Exchange
Top Exchanges for Currency Products, 2008
Milions of
NYSE Life
BM&FBOVESPA
MexDer
Australian SE Tokyo Financial
Exchange
NASDAQ OMX
Nordic
Exchange
Milions of
160
140
140
120
120
100
100
80
80
60
60
40
40
20
20
CME Group
Eurex
Top Exchanges for Commodity Products, 2008
160
0
CME Group
NYSE Life
BM&FBOVESPA
Tokyo Financial
Exchange
Turkish
Derivatives
Exchange
National Stock
Exchange of India
Korea Exchange
0
International
Securities
Exchange (ISE)
17
CME Group
Dalian
Com m odity
Exchange
Zhengshou
com m odity
Exchange
ICE Futures
Europe
Shanghai
Futures
Exchange
London Metal
Exchange
ICE Futures US
Mercado a
Térm ino de
Buenos Aires
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Credit Default Swaps (CDS)
 Definition: CDS are a financial instrument for swapping the risk of debt default. Credit default swaps
may be used for emerging market bonds, mortgage backed securities, corporate bonds and local
government bond
– The buyer of a credit default swap pays a premium for effectively insuring against a debt default. He
receives a lump sum payment if the debt instrument is defaulted.
– The seller of a credit default swap receives monthly payments from the buyer. If the debt instrument
defaults they have to pay the agreed amount to the buyer of the credit default swap
The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than
$45.5 trillion.
>
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The Housing And Mortgage Markets Collide On The Way Down
 Housing market: root of all bad?
– Growth of subprime and Alt-A loans to meet investor demand.
– Mortgage loans were not only securitized but were in many cases highly leveraged.
– Portfolios that included a growing array of derivative products, notably collateralized debt
obligations.
– Credit default swaps were written on, and by, major participants in the mortgage market.
Subprime defaults and CDS prices of U.S. banks
400
45
Average CDS price level of
banking group
Percent
40
350
35
Credit default swap level of major U.S. banks
300
Percent of subprime loans 30 days or more delinquent
30
250
25
200
20
150
15
100
10
50
5
0
Jan-06
0
Jul-06
Jan-07
Jul-07
Jan-08
Jul-08
Source: Bloomberg,
L.P.
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Jan-09
Jul-09
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Regulatory Reform
 In response to heightened concern, governments worldwide are acting to rationalize markets, and to rein
in risks.
 In the U.S., proposed legislation will address the credit risks posed by the nature of the bilateral
agreement, as well as the risks posed to the financial system from fraud and market manipulation.
 The “Over-the-Counter Derivatives Markets Act of 2009” drafted by the U.S. administration in August
contains rules that are likely to find their way into law in the near future.
 A major thrust of this draft legislation is to force OTC derivatives away from bilateral agreements and into
central clearing houses. OTC derivatives, including credit default swaps, will be classified as
“standardized” or “non-standardized.”
– Contracts that are accepted by a clearing house would be put into the standardized category.
 Standardized contracts would be required to be centrally cleared.
– Standardized contracts would be required to be traded on a CFTC- or SEC-regulated exchange or
on alternative swap execution facilities approved by regulators.
 The CFTC and SEC would be given authority to prevent market participants from using spurious
customization to avoid central clearing and exchange trading. Higher capital requirements and margin
requirements will be required for non-standardized derivatives.
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Growth in Derivatives: Driving Factors
By the end of 2008, the global derivatives market had grown to over $600 trillion* ($592trln OTC + $58trln ETD),
tracking the dramatic increase in the size and complexity of the financial industry.
Driving that growth are:
 Global Economy To Fuel Increased Capital Flows – (Trade & Financial)
– “Global Recession is Ending” (IMF World Economic Outlook, October 2009).
 World Growth +2.9% 2010 F
-1.4% 2009 F
+2.6% 2008 A
 Risk management (Transfer & Sharing of Risk)
– Price Risk
– Liquidity Risk
 Leverage
– Capital intermediation can increase value of capital investment
 Market Efficiency
– Technical innovation
 Liquidity
– Deeper markets have made participation less costly
Source: BIS and WFE
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