Derivative

Securities Markets

Boliche, Marianne
Chan, James
Chua, Tomas
Papa, Jade
 DERIVATIVE SECURITY
A financial security whose payoff is linked to another
previously issued security
Derivative Securities

➔ An agreement between two parties to exchange a standard quantity of an asset

or cash flow at a predetermined price and at a specified date in the future.
➔ Value of the underlying security to be exchanged changes -> value of the
derivative security changes
➔ Buying and selling (transference) of risk

Derivative Securities Markets

● Markets in which derivative securities trade
 2 Main Uses

1 To hedge risk
● Hedgers -> to minimize or limit the risk by using
derivatives

2 To speculate on derivatives
● Speculators -> Driven by the opportunity for profit;
Motivated by profit rather than a desire to mitigate
risk
Hedging risk
➔ Ex: Buyer and seller
“lock in” the price of an
asset
BUYER Contract SELLER
➔ Enter into a contract
fixing the future price
in which the asset is to Buyer: protection Seller: protection
be sold/bought, from the from the
regardless of the expected expected
future price increase in price decrease in price
Role of Derivatives during the Financial Crisis

➔ Losses associated with the off-balance sheet derivative securities created and
held by FIs; Falling values of subprime mortgages
◆ Mortgage-backed security (MBS) is a derivative; value is based on the
value of the underlying security (mortgage)

Prices ↓ Interest Borrowers

rates ↑ defaulted
Philippine Derivative Securities
Market
 History of Philippine Derivatives Market
1980s

➔ Philippine universal & commercial banks - engaged in foreign currency

forwards & swaps

➔ Manila International Futures Exchange (MIFE)

◆ Established in 1985
◆ Functioned as PH’s main commodity & derivatives market
◆ Regulated & controlled by SEC
◆ Offered sugar & soybean futures contract and expanded to coffee &
copra
 History of Philippine Derivatives Market
1990s

➔ First financial futures contract to be traded in 1990 - Philippine treasury bills

➔ Manila International Futures Exchange (MIFE)

◆ Closed down in 1997 due to governance issues
● Fraud & irregularities done by brokers & officials
 History of Philippine Derivatives Market
2000s

➔ Bangko Sentral ng Pilipinas (BSP)

◆ In 2008 - replaced its dealer approval process with a list of generally
authorized derivatives markets activities
◆ Applicable to all universal and commercial banks
Regulations Governing Derivatives

➔ Philippines has no trading platform for derivatives

◆ Derivative transactions involve OTC derivatives offered by banks

➔ Regulation done by the BSP

◆ Banks are often the counterparties of derivatives
◆ Regulates the financial derivatives activities of banks operating in the
Philippines
 Regulation by the BSP

BSP Circular No. 594

● Guidelines on derivatives activities of banks

● Universal & commercial banks can offer the following without prior BSP
approval:
○ FX forwards, FX swaps, & currency swaps with a tenor of 3 years or less
○ Interest rate swaps & forward rate agreements with a tenor of 10 years or
less

● Universal & commercial banks with appropriate derivative licenses can offer
other hedging/derivatives instruments
 Regulation by the BSP

BSP Circular No. 668

● Guidelines on derivatives activities of non-bank financial institutions with

quasi-banking authority

● Quasi-banks may enter in any financial derivatives transaction with

BSP-authorized dealers & brokers without need of prior BSP approval
solely for hedging purposes
○ Apply for prior BSP approval of additional derivatives authority to
engage in all other financial derivatives activities
Spot
 Spot Contract
Agreement between a buyer and a seller at time 0 for
the seller to deliver the asset immediately and the buyer
to pay for the asset immediately
Spot Contract

➔ Involves the immediate exchange of assets and funds

➔ Delivery versus Payment
◆ Immediate and simultaneous exchange of cash for securities
Forwards
 Forward Contract
Agreement between a buyer and a seller at time 0 to
exchange a non-standardized asset for cash at some
later date at a price set at time 0
Forward Contract

➔ Future (spot) price or interest rate on an asset is uncertain

➔ Hedge the risk that future spot prices on assets will move against the
participant by guaranteeing a future price for the asset today
Forward Contract

➔ Can also be based on a specific interest rate (ex: LIBOR)

◆ Called Forward Rate Agreements or FRAs
◆ Buyer of FRA agrees to pay the contract rate based on the notional principal
amount
◆ Seller of FRA agrees to sell the funds to the buyer at the stated rate
➔ Underlying assets are non-standardized
◆ Terms of each contract are negotiated individually between the buyer and
seller
◆ Transact with each other in the OTC market
Forward Markets

➔ Major participants: commercial banks, investment banks, brokers & dealers

➔ Over-the-counter transactions
➔ Secondary markets
◆ Made by traders to communicate the buy and sell prices on the forward
contracts over computer networks
Futures
 Futures
A futures contract is an agreement between a buyer
and a seller at time 0 to exchange a standardized,
prespecified asset for cash at some later date.
 Futures Market

Participants:

Floor Broker
Open Outcry Auction
Margin Requirements:
Method
Professional Traders
Initial Margin
Rings (Pits)
Position Traders
Maintenance Margin
Globex
Day Traders

Scalper
Options
 Options
An option is a contract that gives the holder the right,
but not the obligation, to buy or sell an underlying asset
at a prespecified price for a specified time period.
 Call Options
A call option gives the purchaser (or buyer) the right to
buy an underlying security (e.g., a stock) at a
prespecified price
 Call Options

If underlying stock’s price is The call option is “in the money”

GREATER THAN exercise price (Profit)

If underlying stock’s price is LESS The call option is “out of the

THAN exercise price money” (Loss)

If underlying stock’s price is EQUAL

The call option is “at the money”
TO exercise price
 Buying a Call Option Writing a Call Option

The buyer of a put option on a stock has the right (but The writer or seller of a put option receives a fee or
not the obligation) to sell the underlying stock to the premium in return for standing ready to buy the
writer of the option at an agreed upon exercise price underlying stock at the exercise price.
by paying a premium.

Potential Payoffs

1. The lower the price of the underlying stock, the
higher the profit.
2. As the stock’s price increases, the probability of a
negative payoff increases. However, the maximum
loss is limited to the put premium paid.
1. When the stock price is higher than the exercise
price, the writer will make a maximum profit equal to
the put premium.
2. When the stock price falls, the writer is exposed to
large losses.

When to buy/sell a put option

When the price of the asset is expected to fall When the price of the asset is expected to rise
 Put Options
A put option gives the option buyer the right to sell an
underlying security (e.g., a stock) at a prespecified price
to the writer of the put option.
 Put Options

If underlying stock’s price is LESS The put option is “in the money”
THAN exercise price (Profit)

If underlying stock’s price is MORE The put option is “out of the

THAN exercise price money” (Loss)

If underlying stock’s price is EQUAL The put option is “at the money”
TO exercise price (Loss)
 Buying a Put Option Writing a Put Option

The buyer of a put option on a stock has the right (but The writer or seller of a put option receives a fee or
not the obligation) to sell the underlying stock to the premium in return for standing ready to buy the
writer of the option at an agreed upon exercise price underlying stock at the exercise price.
by paying a premium.

Potential Payoffs

1. The lower the price of the underlying stock, the
higher the profit.
2. As the stock’s price increases, the probability of a
negative payoff increases. However, the maximum
loss is limited to the put premium paid.
1. When the stock price is higher than the exercise
price, the writer will make a maximum profit equal to
the put premium.
2. When the stock price falls, the writer is exposed to
large losses.

When to buy/sell a put option

When the price of the asset is expected to fall When the price of the asset is expected to rise
3 ways an option holder can liquidate his/her position

1. Let the
option expire
unexercised

2. Sell options
on the
underlying
3. Exercise the
asset with the
option
same exercise
price and
expiration date
 2 forms of options

1 American Option
gives the option holder the right to buy or sell the
underlying asset at ANY TIME before and on the
expiration of the option.

2 European Option
gives the option holder the right to buy or sell the
underlying asset ONLY on the expiration date.
Option Values: The Black-Scholes Pricing Model

➔ Most commonly used model by practitioners and traders to price and value
options.
➔ Examines five factors that affect the price of an option
1. The spot price of the underlying asset
2. The exercise price on the option
3. The option’s exercise date
4. Price volatility of the underlying asset
5. The risk-free rate of interest

Intrinsic Value
● The difference between the underlying asset’s spot price and exercise price
● The intrinsic value is zero if the option is out of or at the money.
● At the expiration, the option’s value is equal to its intrinsic value.
Option Values: The Black-Scholes Pricing Model

Time Value
● The difference between an option’s price (or premium) and its intrinsic value
● Associated with the probability that the intrinsic value could increase between the option’s
purchase and expiration date
● A function of price volatility and expiration date

The Risk-Free Rate of Interest

● An increase in the risk-free rate of interest creates two effects:
1. Increases stock price growth rate
2. Decreases the present value of any future cash flows
● For a call option, the first effect tends to increase the price of the option while the second
tends to decrease it. Overall, the first effect dominates the second.
● Both effects tend to decrease the value of a put option.
 Options Market
The Chicago Board of Options Exchange Options markets started growing rapidly
(CBOE) opened in 1973. It was the first since the mid-1980s, from a notional
exchange devoted solely to the trading value of less than $2 trillion in 1992 to
of stock options. more than $32 trillion in 2012.
1973 From mid-1980s

1982

Financial futures options contracts

(options on financial futures
contracts, e.g., Treasury bond
futures contracts) started trading.
 Trading process for options

1 2 3
The broker directs this Once an option price is
An investor calls his or
order to its agreed upon, the two
her broker and places
representative on the parties electronically
an order to buy or sell a
appropriate exchange send the details of the
stated number of call or
for execution in trading trade to the option
put option contracts
pits through an clearinghouse, which
with a stated expiration
open-outcry auction breaks trades into buy
date and exercise price.
method. and sell transactions.
 Stock Options
➔ The underlying asset is the stock of a
publicly traded company.
➔ One option generally involves 100 shares
of the underlying company’s stock.
Stock Index Option Multiplier
The dollar value associated with each stock index
option is established by a particular multiplier. The
value of a stock index option is equal to the index
times its multiplier.
● S&P 500 index option = 500 multiplier
● S&P 100 index option = 100 multiplier
● DJIA option = 100 multiplier
● NYSE Composite index option = 500
multiplier
Stock Index Options
➔ The underlying asset is the value of a
major stock market index.
➔ Upon expiration, stock index options are
settled in cash. The option holder receives
the intrinsic value if the option is in the
money and nothing if the option is out of
the money.
➔ Allow investors to invest indirectly in a
diversified portfolio that replicates a major
market index
➔ Allow investors to earn returns without
investing a large amount of money
➔ Give investors a way to hedge their
existing stock portfolios
Options on Futures Contracts
➔ The underlying asset is a futures contract
➔ Advantages
1. Can be more attractive than options
on an underlying asset when it is
cheaper or more convenient to
deliver futures contract
2. Price information about futures
contracts is generally more available
than the price information on the
asset of the contract is (e.g., T-bonds).
Credit Options
➔ A relatively new phenomenon to hedge
credit risk of a financial institution.
➔ Two alternative credit option derivatives:
1. Credit spread call options
● A call option whose payoff
increases as the yield spread
on a specified benchmark bond
of the borrower increases
2. Digital default options
● Option writer pays the financial
institution the par value of the
defaulted loans
Regulation of Futures and
Options Markets
Regulation of Futures and Options Market
Derivative securities are subject to three levels of institutional
regulation.

1 Regulators of derivatives specify “permissible

activities” that institutions may engage in.

2 Once permissible activities have been specified,

institutions are subjected to supervisory oversight.

3 Regulators judge overall integrity by assessing

capital adequacy and enforcing regulations.
 Regulation of Futures and Options Market
Regulators
“Functional” Regulators
Securities and Exchange Commission (SEC)
● Regulates all securities traded on national
securities exchanges
● Requires price reporting, audit trails, and
margins
● Regulations include antimanipulation and
position limits
Commodities Futures Trading Commission
● Has exclusive jurisdiction over all
exchange-traded derivative securities
Accounting Standards
Financial Accounting Standards Board
● Requires all financial institutions and
nonfinancial firms to reflect mark to
market value of their derivatives positions
in their financial statements
● Financial institutions must immediately
recognize all gains and losses and
disclose them.
● Additional disclosures must be made on
the purpose of using derivatives.
 Regulation of Futures and Options Market
Regulators

Bank Regulators
Main Bank Regulators
1. Federal Reserve
2. Federal Deposit Insurance Corporation
3. Comptroller of the Currency
Purpose of Guidelines
● To encourage the use of futures for
hedging and discourage their use for
speculation
Uniform Guidelines
1. Establish internal guidelines
regarding regarding its hedging
activities
2. Establish trading limits
3. Disclose large contract positions
that materially affect bank risk to
shareholders and outside
investors
Swaps
 Swaps
It is an agreement between two parties or
counterparties to exchange specified periodic cash
flows in the future based on some underlying
instrument or price.
 Five Common Types
1 Interest Rate Swaps

2 Currency Swaps

3 Credit Risk Swaps

4 Commodity Swaps

5 Equity Swaps
Interest Rate Swaps Currency Swaps Credit Swaps

➔ A succession of forward
contracts on interest rates
arranged by two parties.
➔ Usually in the form of Direct Swap Agent
fixed-floating rate swaps. Arrangement

Swap buyer Swap seller

Parties to an
Receive variable, Receive fixed, pay
IRS Contract
pay fixed variable
 Money Center Bank Savings Bank
Amount Rate Amount Rate

Assets (Loans to) 50,000 LIBOR 50,000 7%

Liabilities (Loans from) 50,000 7% 50,000 LIBOR

 7% 5% 9%
MCB SB MCB SB MCB SB

Interest income 3,500 3,500 2,500 3,500 4,500 3,500

Interest expense 3,500 3,500 3,500 2,500 3,500 4,500

Net interest income (expense)

0 0 (1,000) 1,000 1,000 (1,000)
before hedge

Swap collection (payment) 0 0 1,000 (1,000) (1,000) 1,000

Net interest income (expense) 0 0 0 0 0 0

Interest Rate Swaps Currency Swaps Credit Swaps

➔ It is used to immunize or hedge

against exchange risk when firms
mismatch the currencies of their
assets and liabilities.
➔ This swap converts an entity’s
foreign currency-denominated
liability to its own local currency.
 Philippine Bank American Bank

Assets Php 10,000,000 $ 200,000

Liabilities $ 200,000 Php 10,000,000

Time 0 Time 1 Time 2

Foreign Exchange Rate

(Php N : $ 1) 47 45 49
 47:1 45:1 49:1

Philippine American Philippine American Philippine American

Bank (Php) Bank ($) Bank (Php) Bank ($) Bank (Php) Bank ($)

Payment 0 0 9,000,000 222,222 9,800,000 204,082

Swap collection 0 0 9,400,000 212,766 9,400,000 212,766

Difference 0 0 (400,000) 9,456 400,000 (8,684)

Forex gain (Loss) before

0 0 400,000 (9,456) (400,000) 8,684
hedge

Net forex gain (loss) 0 0 0 0 0 0

Interest Rate Swaps Currency Swaps Credit Swaps

➔ A type of swap developed by financial institutions to help them hedge their

credit risk

Two Types of Credit Swaps

Total Return Swap Pure Credit Swap

A party receives the returns on an asset of another Commonly known as a credit default swap, a party
party in exchange for payments based on a set pays the financial institution a fixed fee similar to
rate. an insurance premium. In case of default, the
financial institution pays the party its default loss.
 Swap Markets

➔ Transactions are heterogeneous, there are no standard contracts.

➔ Swap dealers keep the swap market liquid by looking for compatible
counterparties.
➔ In contrast to futures and options markets, swap markets are less
regulated.

Advantage of Swap Dealers Changes in Swap Market After Financial Crisis

● Finding compatible ● Central clearinghouses were introduced
counterparties will be ● Trend towards international standardization of
costly credit swap contracts
● Swap dealers guarantee ● Wall Street Reform and Consumer Protection Act
swap payments over the of 2010: All OTC traded swaps will be traded
life of the contract through an exchange
Caps, Floors, and Collars
Caps $ 2,000
(100,000 x
$ 7,000
(100,000 x
➔ It is a call option (7%-5%)) 7%)
on interest rates,
often with multiple
dates.
➔ For a fee, the cap
buyer is
CAP $ 1,000 CAP BUYER LENDER
SELLER
compensated by
the cap seller if
rates exceed the EXAMPLE
cap rate. Current LIBOR = 7%
➔ Generally bought Cap Rate = 5%
when rates are Notional Principal = $
expected to 100,000
increase.
Floor $ 2,000
(100,000 x
$ 3,000
(100,000 x
➔ It is a put option (5%-3%)) 3%)
on interest rates,
often with multiple
exercise dates
➔ For a fee, the floor
buyer is
FLOOR $ 1,000 FLOOR BORROWER
SELLER BUYER
compensated by
the floor seller if
rates fall below the EXAMPLE
floor rate. Current LIBOR = 3%
➔ Generally bought Floor Rate = 5%
when rates are Notional Principal = $
expected to 100,000
decrease.
Collar $ 2,000
(100,000 x
$ 7,000
(100,000 x
➔ It occurs when a (7%-5%)) 7%)
firm
simultaneously
purchases a cap
and sells a floor.
➔ Done to finance
CAP $ 1,000 CAP BUYER/ LENDER
SELLER FLOOR SELLER
the cost of the cap

EXAMPLE
$ 1,000 $ 2,000
(100,000 x
Current LIBOR = 7% (8%-7%))
Cap Rate = 5%
Floor Rate = 8%
Notional Principal = $
100,000
 International Aspect

➔Global OTC > Exchange Trading

➔The 2008 financial crisis caused a significant decline in
the derivative securities market

➔US dominates global derivative securities markets

Game
 Q1. True or False.

The underlying assets of a forward

contract are standardized.
False. Non-standardized.
 Q2.

Name at least three factors that

affect the price of an option.
 1. Spot price
2. Exercise price
3. Exercise date
4. Price volatility
5. Risk-free rate of interest
 Q3. Modified True or False.
A firm with a variable-rate liability
expects that interest rates would
rise. A floor derivative would help
the firm hedge against interest
rate risk.
False. Cap.
 Q4.

Give at least three types of swaps.

1. Foreign currency swap
2. Interest rate swap
3. Credit swap
4. Commodity swap
5. Equity swap
 Q5.
When the exercise price of a put
option is greater than the stock
price, it is said to be ______?
In the money
 Q6.
What was the Philippines’ main
commodity & derivatives market
that was established in 1985?
 Manila International
Futures Exchange (MIFE)
 Q7.
What was the first exchange
devoted solely to the trading of
stock options?
Chicago Board of Options
Exchange
 Q8.
Name two derivatives that
universal & commercial banks can
offer without prior BSP approval.
(Include their tenor/term)
 ● FX forwards, FX swaps, &
currency swaps with a tenor of
3 years or less
● Interest rate swaps & forward
rate agreements with a tenor of
10 years or less
 Q9. Modified True or False.

Europe is dominating the

international derivative market.
False. United States.
 Q10.
__________ is a forward contract
that is based on a specific interest
rate.
Forward Rate Agreement
or FRA
 Q11. True or False.
Swap transactions are generally
heterogeneous, there is no
standardized contract.
True.
 Q12.
Name the two “functional”
regulators of futures and options
markets.
 1. Securities and Exchange
Commission
2. Commodities Futures Trading
Commission