Over-the-Counter (OTC) Derivative Primer 1: The Instruments
\nDerivatives are financial instruments that are linked to specific financial instruments,\u00ac\u2020 indices, indicators or commodities, and through which specific financial risks can be traded in financial markets in their own right. Derivatives contracts are usually settled by net payments of cash, that often occurs before maturity.
\nIn terms of notional amounts outstanding the vast majority of derivatives are traded over the counter (OTC) as opposed to trading on an exchange or other centralized trading venue (table). The notional amount is the amount of principal underlying the derivative contract, to which interest rates are applied in order to calculate periodic payment obligations. End users typically execute transactions with dealers, who in turn trade with each other. Being bilateral the transactions leave counterarties with direct credit exposure to each other.<\/p>\n
Global Derivatives Market (Notional outstanding in U.S.$ billions at end-June 2015)<\/p>\n
\u00ac\u2020<\/p>\n
Over-the-counter (OTC)<\/p>\n
Exchange-traded<\/p>\n
Interest rate contracts<\/p>\n
434,740<\/p>\n
61,822<\/p>\n
Foreign exchange contracts<\/p>\n
74,519<\/p>\n
389<\/p>\n
Credit default swaps<\/p>\n
14,596<\/p>\n
–<\/p>\n
Equity-linked contracts<\/p>\n
7,545<\/p>\n
?<\/p>\n
Commodity contracts<\/p>\n
1,671<\/p>\n
?<\/p>\n
Total<\/p>\n
552,909<\/p>\n
?<\/p>\n
Source: Bank for International Settlements (BIS)<\/p>\n
Note: The sum of the OTC column includes what the BIS calls \u201a\u00c4\u00faunallocated\u201a\u00c4\u00f9 amounts, which is essentially an estimate of amounts attributed to non-reporting institutions.<\/p>\n
\u00ac\u2020
\nForward-based derivatives have symmetrical rights and obligations between counterparties, and effectively lock in a price or rate of an exchange that will occur on an agreed future date. Also, the prices of forward-based derivatives tends to be linear in that their price changes closely track those of the underlying right or interest. Some examples:
\nA forward foreign exchange (FX) contract involves the exchange of two currencies at a rate agreed on the\u00ac\u2020 date of the contract for value or delivery (cash settlement) at some time in the future (more than two business days later). This category also includes forward FX agreements, non-deliverable forwards and other forward contracts for differences.
\nAn FX swap involves the exchange of two currencies (principal amount only) on a specific date at a rate agreed at the time of the conclusion of the contract, and a reverse exchange of the same two currencies at a date further in the future at a rate (generally different from the rate applied to the short leg) agreed at the time of the contract.
\nA forward rate agreement (FRA) is an interest rate forward contract in which the rate to be paid or received on a specific obligation for a set period, beginning in the future, is set at contract initiation. FRAs are settled by net cash payments; that is, the difference between the rate agreed upon and the prevailing market rate at the time of settlement. The FRA buyer receives payment from the seller if the prevailing rate exceeds the rate agreed upon, and vice versa.
\nA swap is a derivative contract in which cash-flow streams are exchanged over a period of time according to a pre-arranged formula. In an interest rate swap (IRS), a series of interest payments denominated in the same currency are exchanged. In a currency swap, a series of interest payments denominated in different currencies is exchanged. There is no exchange of principal in an IRS, but a principal payment is exchanged at the beginning and upon maturity of a currency-swap agreement.
\nFutures contracts are standardized forward contracts traded on organized exchanges. They are cash settled daily based on mark-to-market valuations, whereas forward contracts generally only settle on the delivery day.
\nOptions give a right, rather than obligation, to deliver or receive the underlying right or interest on or before an agreed future date. \u201a\u00c4\u00faAmerican\u201a\u00c4\u00f9 options may be exercised at any time before the option expires, while \u201a\u00c4\u00faEuropean\u201a\u00c4\u00f9 options may be exercised only at expiration. (For other exercise terms see: http:\/\/en.wikipedia.org\/wiki\/Option_style). Hence, one side of the contract has a contingent obligation if the other side chooses to excercise the option. They have non-linear payoffs and price behavior due to the asymmetrical nature of the rights and duties on each side of the contract.
\nOptions can be written on individual or baskets of underlying commodities, equities, interest rates, and securities. They can also be written on other derivatives,such as swaptions, which are options on swap contracts, and exercise triggers can sometimes be quite complex \u201a\u00c4\u00ec e.g., average rate, barrier, binary, Bermudan, lookback, rainbow and reload options (i.e, \u201a\u00c4\u00faexotic options\u201a\u00c4\u00f9). For descriptions of some of the more exotic options see the Kolb and Overdahl Futures, Options, and Swaps book and http:\/\/en.wikipedia.org\/wiki\/Option_style. For exotic option pricing models see Espen Haug\u201a\u00c4\u00f4s The Complete Guide to Option Pricing Formulas.
\nCredit derivatives are swap, forward, and option contracts that transfer part or all of the credit risk of an obligation (or a portfolio of obligations), without transferring the ownership of the underlying asset(s). For example, credit default swaps (CDS) protect against pre-defined credit events (such as default) in return for fees paid to the protection seller.
\nAnother type of credit derivative is a total-rate-of-return swap (TROS) that transfers the returns and risks on an underlying reference asset from one party to another. The \u201a\u00c4\u00fatotal return buyer\u201a\u00c4\u00f9 pays a periodic fee to a \u201a\u00c4\u00fatotal return seller\u201a\u00c4\u00f9 and receives the total economic performance of the underlying reference asset in return. Total return includes all interest payments on the reference asset plus an amount based on the change in the asset\u201a\u00c4\u00f4s market value.
\nFor more detail on credit derivatives, including pricing and risk management issues see Dominic O\u201a\u00c4\u00f4Kane\u201a\u00c4\u00f4s Modelling Single-Name and Multi-Name Credit Derivatives book. Other good references include the J.P. Morgan Guide to Credit Derivatives and the ISDA and Markit CDS glossaries.<\/p>\n
Global OTC Derivatives Market (Notional outstanding in U.S.$ billions at end-June 2014)<\/p>\n
\u00ac\u2020<\/p>\n
Interest rates<\/p>\n
Foreign Exchange<\/p>\n
Credit Risk<\/p>\n
Equity<\/p>\n
Commodities<\/p>\n
Forwards<\/p>\n
92,575<\/p>\n
35,190 \/1<\/p>\n
n\/a<\/p>\n
2,433<\/p>\n
1,602<\/p>\n
Swaps<\/p>\n
421,273<\/p>\n
26,141<\/p>\n
19,462<\/p>\n
Options<\/p>\n
49,442<\/p>\n
13,451<\/p>\n
n\/a<\/p>\n
4,508<\/p>\n
604<\/p>\n
Source: Bank for International Settlements (BIS)<\/p>\n
Note: Foreign exchange forwards includes foreign exchange swaps (as opposed to currency swaps)<\/p>\n
Since 2009 CDS started trading with standardized annual premia rates with upfront payments. Prior to that they were quoted in par spread (the spread that equates the expected net present values of the premia and the contingent payment at the trade\u201a\u00c4\u00f4s outset. The pre-2009 exceptions were high-yield CDS that were quoted with standardized 500 basis point premia. Also, upfront premia may have been invoked if counterparty risk was a concern. North American investment-grade contracts now trade with 100 or 500 basis point premia and upfront payments. European contracts trade with 25, 100, 500, and 1,000 basis point premia.
\nSuch contract standardization facilitates closing out contracts prior to expiration. Without premia standardization, one of the counterparties can be left with residual risk. For example, an investor who bought five-year protection at 150 basis points and offset it at 375 basis points could be left with a 225 basis point annuity that would be lost if a credit event subsequently takes place. A complete offset could be effected with an upfront payment of about nine percent of notional, but this just transfers the annuity risk to the other counterparty. The standardized premia eliminate these residual annuities by reflecting annuity values in upfront payments when contracts are initiated and unwound. Markit and OpenGamma have written up nice summaries of these and other elements of the CDS contract standardization.
\nStructured Credit
\nAlmost half of all notional outstanding CDS are multi-name contracts, referencing portfolios of credit products according to the Bank for International Settlements (BIS). Of these multiname products about 90 percent referenced standardized indices of single-name CDS. These indices are tradable products based on specific credit markets or market segments, including the Dow Jones CDX indices for North America and emerging markets, and the iTraxx indices for Europe, Japan, and Asia. Of these index-based contracts about 10 percent are \u201a\u00c4\u00fa\u201a\u00c4\u00fastructured credit\u201a\u00c4\u00f9 or \u201a\u00c4\u00fatranched\u201a\u00c4\u00f9 products, according to the Depository Trust & Clearing Corporation (DTCC).
\nStructured credit products use securitization structuring techniques to transfer the credit risk associated with portfolios of reference entities. They include multiname CDS such as basket and portfolio swaps, and are often reflect \u201a\u00c4\u00fatranched\u201a\u00c4\u00f9 risk transfer. A popular basket swap structure is the nth-to-default (N2D) swap. The credit event-contingent payouts and contract termination of an N2D swap is linked to one in a series of events (such as first-, second-, or third-to-default) against a reference portfolio of typically five to seven credits. N2D swaps are popular for transferring the risk associated with emerging market-based credits. The risk-return profiles of such tranches are determined by both the performance of underlying portfolios and tranche seniority in the capital structure (i.e., the priority of claims on the cash flows of the reference pool).
\nA typical capital structure comprises an \u201a\u00c4\u00faequity\u201a\u00c4\u00f9 tranche that reflects the reference portfolio\u201a\u00c4\u00f4s first default-related losses up to a \u201a\u00c4\u00fadetachment point\u201a\u00c4\u00f9 of say 3 percent of the portfolio. Then there are one or more \u201a\u00c4\u00famezzanine\u201a\u00c4\u00f9 tranches that absorb losses that exceed the 3 percent \u201a\u00c4\u00faattachment point\u201a\u00c4\u00f9 up to a 10 percent detachment point, one or more \u201a\u00c4\u00fasenior\u201a\u00c4\u00f9 tranches (10\u201a\u00c4\u00ec30 percent), and a \u201a\u00c4\u00fasuper-senior\u201a\u00c4\u00f9 tranche (the final 30\u201a\u00c4\u00ec100 percent).
\nTraditional \u201a\u00c4\u00facash\u201a\u00c4\u00f9 collateralized debt obligations (CDOs) are backed by bonds and\/or loans, whereas \u201a\u00c4\u00fasynthetic\u201a\u00c4\u00f9 structured credit products reference portfolios of other credit derivatives. CDS indices and related subindices track the performance of baskets of the most actively traded single-name CDSs. The standardized features of indices (i.e., maturities and risk tranches, credit ratings, and sector delineations) have increased the liquidity of credit risk trading.
\nSynthetic structures allow arrangers to offer tranches in unfunded form, because underlying reference assets need not be owned. In addition, in contrast with \u201a\u00c4\u00fafull capital structure\u201a\u00c4\u00f9 cash CDO transactions, where all of the risk is transferred, in synthetic structures, only specific portions of the reference portfolio can be transferred (with the retained risk hedged by the structurer). This risk retention would also be possible with a cash CDO, but the structurer would then have to fund the risk it retains. A \u201a\u00c4\u00fapartially funded\u201a\u00c4\u00f9 CDO structure will typically transfer credit risk in both funded (most or all of the first 15 percent of potential losses) and unfunded form (the losses above 15 percent).<\/p>\n","protected":false},"excerpt":{"rendered":"
Financial derivatives are financial instruments that are linked to specific financial instruments, indices, indicators or commodities, and through which specific financial risks can be traded in financial markets in their own right. Financial derivatives contracts are usually settled by net payments of cash, that often occurs before maturity.<\/p>\n","protected":false},"template":"","meta":{"_acf_changed":false},"knowledge_category":[4259],"acf":[],"_links":{"self":[{"href":"https:\/\/theotcspace.com\/wp-json\/wp\/v2\/knowledge_item\/165850"}],"collection":[{"href":"https:\/\/theotcspace.com\/wp-json\/wp\/v2\/knowledge_item"}],"about":[{"href":"https:\/\/theotcspace.com\/wp-json\/wp\/v2\/types\/knowledge_item"}],"wp:attachment":[{"href":"https:\/\/theotcspace.com\/wp-json\/wp\/v2\/media?parent=165850"}],"wp:term":[{"taxonomy":"knowledge_category","embeddable":true,"href":"https:\/\/theotcspace.com\/wp-json\/wp\/v2\/knowledge_category?post=165850"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}