Trading in Financial

Markets
Unit 5

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Financial Markets
l Exchange traded
l Traditionally exchanges have used the open-outcry system,
but electronic trading has now become the norm
l Contracts are standard; there is virtually no credit risk

l Over-the-counter (OTC)
l A network of dealers at financial institutions, corporations,
and fund managers who trade directly with each other
l Contracts can be non-standard; there is some credit risk

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Clearing Houses
l Clearing houses stand between traders in the exchange-
traded market.
l Clearing houses require traders to post cash or
marketable securities as collateral (referred to as
margin) and clearing house members contribute to a
guarantee fund
l The margin is set to be sufficiently high that exchange is
unlikely to lose money if it has to close out a trader
l This combined with the guaranty fund means that traders
are subject to virtually no credit risk

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Short Selling

l Short selling involves selling

securities you do not own
l Your broker borrows the securities
from another client and sells them
in the market in the usual way
l At some stage you must buy the
securities back so they can be
replaced in the account of the client
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Short Selling (continued)
l You must pay dividends and other benefits
the owner of the securities receives
l The cash flows from a short position that is
entered into at time T1 and closed out at
time T2 are the opposite of those from a long
position where asset is bought at time T1
and sold at time T2, except that there may
be a small fee for borrowing the asset

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Example 1:
l A trader shorts 500 shares in April and
buys back in July
l Price per share is $120 in April and $100
in July
l A dividend of $1 is paid in May
l Net profit?

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Example 2: Margins
l A trader shorts 100 shares at $60
l Margin required is 150% of value of
shares
l A maintenance margin of 125%
l Share price rises to $80, what happens?

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Derivatives
l Forwards
l Futures
l Swaps
l Options
l Exotics

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Derivatives Markets
800 Size of
700 Market
($ trillion) OTC
600

500 Exchange

400

300

200

100

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Forward Contracts
l A forward contract is an agreement to buy
or sell an asset at a certain price at a
certain future time
l Forward contracts trade in the over-the-
counter market
l They are particularly popular on currencies
and interest rates

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Foreign Exchange Quotes for GBP
June 9, 2017

Bid Offer
Spot 1.2732 1.2736

1-month forward 1.2746 1.2751

3-month forward 1.2772 1.2777

1-year forward 1.2883 1.2889

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Profit from a Long Forward Position

Profit

Price of Underlying
K at Maturity

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Profit from a Short Forward Position

Profit

Price of Underlying
K at Maturity

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Futures Contracts
l Agreement to buy or sell an asset for a
certain price at a certain time
l Similar to forward contract
l Whereas a forward contract is traded
OTC, a futures contract is traded on an
exchange

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Futures Contract continued
l Contracts are settled daily (e.g., if a contract is
on 200 ounces of December gold and the
December futures moves $2 in my favor, I
receive $400; if it moves $2 against me I pay
$400)
l Both sides to a futures contract are required to
post margin with the exchange clearing house.
This ensures that they will honor their
commitments under the contract.

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Forward vs Futures
Forward Futures
Private contract between two Traded on an exchange
parties
Not standardized Standardized
Usually one specified delivery date Range of delivery dates
Settled at end of contract Settled daily
Delivery or final cash settlement Contract is usually closed out prior
usually takes place to maturity
Some credit risk Virtually no credit risk

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Swaps

A swap is an agreement to
exchange cash flows at specified
future times according to certain
specified rules

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An Example of a “Plain Vanilla”
Interest Rate Swap

l An agreement to receive 6-month

LIBOR & pay a fixed rate of 3% per
annum every 6 months for 3 years on
a notional principal of $100 million
l Next slide illustrates cash flows

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Cash Flows for one set of LIBOR rates

---------Millions of Dollars---------
LIBOR FLOATING FIXED Net
Date Rate Cash Flow Cash Flow Cash Flow
Mar. 3, 2019 2.2%
Sept. 3, 2019 2.8% +1.10 –1.50 –0.40
Mar. 3, 2020 3.3% +1.40 –1.50 –0.10
Sept. 3, 2020 3.5% +1.65 –1.50 +0.15
Mar. 3, 2021 3.6% +1.75 –1.50 +0.25
Sept. 3, 2021 3.9% +1.80 –1.50 +0.30
Mar. 3, 2022 4.4% +1.95 –1.50 +0.45

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Typical Use of an Interest Rate
Swap
l Converting a liability from
l fixed rate to floating rate
l floating rate to fixed rate

l Converting an investment from

l fixed rate to floating rate
l floating rate to fixed rate

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Example
l Borrowing at LIBOR+1% à Borrowing at fixed
rate 4%
1. Pay interest at LIBOR+1% under loan
agreement
2. Receive LIBOR under swap agreement
3. Pay 3% under swap agreement

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Example
l Investment earning at 2.5% à Investment
earning at LIBOR-0.5%
1. Receive 2.5% on the investment
2. Receive LIBOR under swap agreement
3. Pay 3% under swap agreement

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Quotes By a Swap Market Maker
Maturity Bid (%) Offer (%) Swap Rate (%)
2 years 2.55 2.58 2.565
3 years 2.97 3.00 2.985
4 years 3.15 3.19 3.170
5 years 3.26 3.30 3.280
7 years 3.40 3.44 3.420
10 years 3.48 3.52 3.500

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Options
l A call option is an option to buy a
certain asset by a certain date for a
certain price (the strike price)
l A put option is an option to sell a certain
asset by a certain date for a certain
price (the strike price)
l Options trade on both exchanges and in
the OTC market

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American vs European Options
l An American option can be exercised at
any time during its life
l A European option can be exercised only
at maturity

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Intel Option Prices: June 12, 2017;
Stock Price=35.91

Strike Aug17 Oct17 Dec17 Aug17 Oct17 Dec17

Price Call Call Call Put Put Put
34 2.48 2.88 3.15 0.63 1.07 1.42

35 1.77 2.23 2.53 0.95 1.41 1.80

36 1.18 1.66 1.98 1.39 1.85 2.25

37 0.74 1.20 1.51 1.98 2.40 2.79

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Options vs Futures/Forwards
l A futures/forward contract gives the holder
the obligation to buy or sell at a certain
price
l An option gives the holder the right to buy
or sell at a certain price

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Hedging Examples
l A US company will pay £10 million for
imports from Britain in 3 months and
decides to hedge using a long position
in a forward contract
l An investor owns 1,000 shares currently
worth $28 per share. A two-month put
with a strike price of $27.50 costs $1.
The investor decides to hedge by
buying10 contracts
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Options vs Forwards
l Forward contracts lock in a price for a
future transaction
l Options provide insurance. They limit the
downside risk while not giving up the
upside potential
l For this reason options are more attractive
to many corporate treasurers than forward
contracts
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Interest Rate Options
l Caps and floors
l Swap options (swaption)

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Nontraditional Derivatives

l Weather derivatives
l Energy derivatives
l Oil
l Natural gas
l Electricity

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Exotic Options
l Asian options
l Barrier option
l Basket options
l Binary options
l Compound options
l Lookback options

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Example of the Use of Exotic
Options

l If a company earns revenue month by

month in many different currencies, Asian
basket put options can provide an
appropriate hedge

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Structured Products
l Products created to meet the needs of
clients
l A bizarre structures product is the “5/30”
deal between Bankers Trust and Procter
and Gamble
l The payments by P&G were
é æ 5 yr CMT % ö ù
ê 98.5 ç 5.78% ÷ - 30 yr TSY price ú
max ê0, è ø ú
ê 100 ú
êë úû

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Types of Traders
l Hedgers
l Speculators
l Arbitrageurs
Some of the largest trading losses in derivatives
have occurred because individuals who had a
mandate to be hedgers or arbitrageurs switched
to being speculators (SocGen lost 4.9 billion
euros in 2008 due to speculations of a junior
trader)

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