Consider the so-called derivative financial instruments, the complexity of understanding which frightens many beginners. The price of these instruments depends (is derived) on the price dynamics of the underlying asset, that is, the asset on which the corresponding derivative is based. The underlying asset can be a security (stock or bond), or any other exchange commodity or index (for example, the RTS index). However, not every stock exchange instrument can be a base asset for derivatives. It is important that at any time it was possible to determine the market price for the underlying asset. This means that there must be enough people on the market to trade this asset.
In this chapter, we consider only three types of derivatives: forwards, futures, and options. A common property of these derivatives is the possibility of acquiring them without the need to purchase (or sell) the underlying asset. For example, when buying a futures contract on OAO Gazprom, the investor does not become the owner of the shares, but only enters into a contract to purchase these shares in the future. In essence, trading in derivatives is trading in liabilities, which requires significantly fewer resources than making deals in the underlying asset market.
The first derivatives were created on the basis of commodity underlying assets, such as wheat, metals, coal, etc. Later, tools based on securities and currency appeared.
The derivatives market was born a long time ago. Back in the 18th century in Japan, forward deals were concluded for the supply of rice, but the technology of trading in derivatives was developed in the 19th century in Chicago, when the Chicago Board of Trade was organized. It is still the largest trading platform for various derivatives. We begin to consider the types of derivatives with forward as the easiest to understand derivatives. A forward is an agreement between two parties to a transaction that one party undertakes to sell the underlying asset (for example, shares of RAO UES of Russia) at an agreed price today at some point agreed by the parties in the future (for example, after three months). The second party undertakes to pay at this time for this underlying asset the price fixed today,
Forward contracts are not traded on the exchange, transactions are concluded directly between the two parties. As a rule, forward transactions are concluded between professional market participants and significant amounts. Although few readers may encounter a forward transaction in real life, we will take a closer look at it, since other derivatives in many ways resemble forward contracts, but they are more difficult to understand.
Shares of OAO Gazprom on September 1, 2005 cost 109 rubles apiece. Let’s say that the two parties (A and B) conclude a forward deal on these shares on September 1. The parties cannot reliably know how the stock market will change in the future, but given that the selected shares tend to increase, they agree on a deal with the following conditions: Party A is obliged to sell to party B 1000 Gazprom shares on December 1, 2005 at the price 150 rubles apiece.
As of December 1, 2005, Gazprom shares are already worth 179 rubles. It turns out that party A is forced to sell its shares at a price substantially lower than the market price, and thus loses (or, more precisely, does not earn) a considerable amount of money. Party B wins because, having bought shares from A, has the opportunity to immediately sell them on the market and earn 29,000 rubles from this.
However, the situation is possible when stocks, instead of rising in price, suddenly fall. Then party A will benefit, and party B will suffer losses, since it will be forced to buy shares from A at a price higher than the current market price. A striking example is the Yukos campaign, which fell several times after the arrest of M. Khodorkovsky. Thus, the conclusion of a forward contract can be considered as a kind of insurance in case of a fall in the share price.
Futures are very similar to the forward in its meaning. This is also an agreement on the sale of the underlying asset at a certain date in the future. However, unlike a forward, futures are an exchange instrument. If a forward can be entered into on any asset, any date, any quantity of an asset, then futures are a standard contract, the terms of which are determined by the exchange and described by the specification of the contract and the rules of trading on the relevant exchange. No other futures contracts, other than those admitted to trading by the exchange (described by specifications and trading rules), cannot be concluded.
As an example, let us consider a brief specification for a futures contract on ordinary shares of RAO UES of Russia on the RTS Stock Exchange.
Underlying asset is ordinary shares of RAO UES of Russia. The volume of the contract is 1000 shares. Futures contract code – EERU-mm.yy. Traded months – March, June, September, December. The last trading day is the trading day preceding the 15th day of the execution month. Day of execution – the 15th day of the month of execution or the next trading day.
In the performance of one contract, the seller is obliged to transfer and the buyer to accept and pay 1000 (one thousand) ordinary shares of RAO UES of Russia at the price of the contract. This price is equal to the estimated price fixed on the last day of the futures contract. The full text of the specification for the above contract takes six sheets.
The Russian trading system – the rules of trading on the exchange stipulate the parameters of trading common to all contracts, such as the duration of trading sessions, trading procedures and settlements, access to trading, the procedure for settling disputes between counterparties, etc. Trading rules, specifications of contracts, as well as other documents regulating trading can be viewed on the websites of exchanges. Futures trading takes place in electronic trading systems, where the trader sees the requests of other participants, which are usually shown without specifying by whom the specific application is filed. The transaction occurs automatically if the prices of the counter orders for the purchase and sale are the same. At the same time they say that the buyer of the contract opened and is in a long position, and the seller has opened and is in a short position. Currently, the list of available contracts on Russian stock exchanges is not very large. The underlying assets are a couple of dozen financial instruments. Usually at the same time for each underlying asset in the auction are contracts for two maturities. For example, June and September futures for shares of RAO UES of Russia. Another important difference between futures and forward is that all futures transactions are concluded between the exchange trader and the exchange.- Thus, the exchange assumes full responsibility for the timeliness and completeness of settlements under futures contracts, removing the other party’s failure to fulfill its obligations deal. Usually at the same time for each underlying asset in the auction are contracts for two maturities. For example, June and September futures for shares of RAO UES of Russia. Another important difference between futures and forward is that all futures transactions are concluded between the exchange trader and the exchange.- Thus, the exchange assumes full responsibility for the timeliness and completeness of settlements under futures contracts, removing the other party’s failure to fulfill its obligations deal. Usually at the same time for each underlying asset in the auction are contracts for two maturities. For example, June and September futures for shares of RAO UES of Russia. Another important difference between futures and forward is that all futures transactions are concluded between the exchange trader and the exchange.- Thus, the exchange assumes full responsibility for the timeliness and completeness of settlements under futures contracts, removing the other party’s failure to fulfill its obligations deal.
To reduce the risks arising from the exchange at the conclusion of a futures transaction, the availability of funds in the amount determined by the rules of the exchange, the so-called “initial margin”, or collateral, is required.
In addition, the exchange produces daily clearing: every day recalculates the positions of bidders taking into account changes in the market price of the contract. Profit or loss from a futures contract is formed daily. Variation margin is the profit accumulated at a given time or the resulting loss on the contract. Negative variation margin may lead to a situation where the money in the participant’s account will be less than the level of the initial margin. This will require adding funds to the account or closing a losing position at the current market price. Otherwise, the exchange will close the position forcibly to avoid further accumulation of losses. In contrast to the forward, a bidder on the futures market does not have to wait for the date of execution of the contract. You can close a position by making an opposite transaction. If the bidder is in a long position, to close it you must make a sale of the same futures contract in the same volume. To close a short position, you need to buy the appropriate futures. The possibility of concluding a counter transaction makes it easy to use futures not only for insuring (hedging) an investment portfolio in the derivatives market, but also for daily speculation in order to generate income on constant fluctuations of futures contracts quotes.
When the execution day of the futures contract, depending on the conditions of the specification for a particular contract, is possible both the delivery of the underlying asset to the buyer’s account and the transfer of the difference between the contract price and the current market price of the underlying asset to the “winning” party (“estimated Futures). It is clear that futures for some underlying assets (for example, for indices or for weather) are only settlement. Many traders try not to participate in the contract delivery procedure and close their positions with counter transactions until the due date. At the conclusion of a futures transaction, an exchange fee is charged, the amount of which depends on the type of contract. Rates of exchange fees can also be found on the websites of exchanges.
Consider the process of opening and closing positions in the market of futures contracts on an example.
On Friday, May 12, 2006, the shares of RAO UES of Russia cost 20.5 rubles per share on the market.
On the same day, it was possible to open a position on the June futures market (supply of shares on June 15, 2006) at the price of 20,427 rubles (contract for 1,000 shares of RAO UES of Russia) or on September futures (delivery of September 15, 2006) at a price of 20 975 rubles per contract. To open a position at these prices will require a guarantee of 15% of the value of the contract. Suppose a bidder decided to purchase the June contract. Then its costs will amount to 15% of 20,427 rubles (3,064 rubles), plus an exchange fee of 1 ruble per contract. Moreover, the costs will be the same regardless of whether a short position or a long position is opened. Let’s see what happens with the position of participants in the transaction on the next business day. On Monday, May 15, quotes of almost all stocks declined markedly, including the shares of RAO UES of Russia. Shares on the stock exchange fell to the level of 18.7 rubles per share, and the quotations of June futures contracts fell to 19,280 rubles. As a result of this decline, stockholders see only virtual losses (if they do not sell their shares). And holders of long positions in futures will get real losses by the end of the day, since their accounts will be debited with a negative variation margin in the amount of about 1,147 rubles per contract (or 37% of the money invested in the acquisition of a contract). At the same time, holders of short positions in futures will see the corresponding real profit. As a result of this decline, stockholders see only virtual losses (if they do not sell their shares). And holders of long positions in futures will get real losses by the end of the day, since their accounts will be debited with a negative variation margin in the amount of about 1,147 rubles per contract (or 37% of the money invested in the acquisition of a contract). At the same time, holders of short positions in futures will see the corresponding real profit. As a result of this decline, stockholders see only virtual losses (if they do not sell their shares). And holders of long positions in futures will get real losses by the end of the day, since their accounts will be debited with a negative variation margin in the amount of about 1,147 rubles per contract (or 37% of the money invested in the acquisition of a contract). At the same time, holders of short positions in futures will see the corresponding real profit.
Fast forward to the end of this week unsuccessful for holders of long positions. By Friday, May 19, 2006, the quotations of securities declined even more and the shares of RAO UES of Russia dropped to the level of 17 rubles per share. In the futures market, contract quotes for delivery in June dropped to 17,010 rubles per contract. Thus, according to the results of Friday’s closing of the day, the contract buyer would receive real losses in the amount of 3,417 rubles (or 110% of the invested funds), and the seller would receive the corresponding profit. If, as a result of writing off the variation margin, the amount of funds in the buyer’s account is below the initial margin level, it will be necessary to add money to the account or close all or part of the positions. Otherwise positions will be closed forcibly. To close an unprofitable position, a contract purchaser may conclude a counter transaction – sell the same June contract for RAO UES of Russia shares at the current price. In this case, the buyer of the contract may not be the previous seller from our example (he may refuse to close his lucrative position), but any other buyer in the market.
Finally, let’s move on to the most difficult to understand derivative. An option is also an agreement between the parties to conclude a future purchase and sale transaction for the underlying asset at the price agreed today. However, the obligation to execute an option contract is only for one party – the seller of the option (in the terminology of the exchange – “subscriber”). While the other party, the buyer (“holder”), has only the right to demand performance. For this right, the buyer pays the seller a premium, which is the market value of the option and the seller’s income. The underlying asset of the option can also be any stock exchange instrument, including futures. In Russia, options of the so-called American type are circulated when the option buyer has the right to demand the option to be exercised on any day of the expiration date. There are also options of European type which can only be executed at the time of their expiration. An option, like futures, is an exchange instrument, the terms of which are also stipulated by the specification. On the last day of the validity period, options in money relative to the futures settlement price are not automatically executed. When one option is exercised, the purchase and sale transaction of one futures contract, which is the underlying asset of the option, is recorded at a price equal to the option’s exercise price. An option code consists of several parts: the base asset code, the type of option (“call” or “put”) and the strike price (strike price). The specifications of the option contract specify the range of strikes that can be simultaneously traded on the exchange. In practice, on most strikes, trading activity is low. As a rule, only a few of the most popular ones trade more or less actively.
Now briefly consider how an investor can use the derivatives market. First, hedging .
Hedging – using derivatives market instruments for insuring investment portfolios against market risk.
It is possible to insure a portfolio against an adverse market situation as with the help of futures contracts, and options. The results will vary somewhat due to differences in the properties of options and futures. Hedging with a futures contract is done by selling futures for the assets that make up the investment portfolio. Thus, the investor actually fixes the possible income on the portfolio in the amount of the difference between the prices of futures and real assets. The cost of insuring against losses in the event of a fall in the market is unearned extra profit if the market goes up. In addition, when opening a futures position, you must have cash in the trading system in the amount of the initial margin. Additional money transfers may also be required if negative variation margin on an open position is formed. Difficulties are also caused by a narrow range of futures contracts traded on the market, which makes it difficult to hedge on most stocks. In the absence of a liquid market for futures contracts on a specific security, the investor will have to build a risk protection strategy using market index futures.
When hedging with options, the investor buys a put option on the assets in the portfolio. Everything happens as in the case of classical insurance, that is, the investor pays the subscriber a premium for the latter compensating the investor’s losses when the share price falls below the agreed level (strike). When the market grows, the investor receives all the income from a positive price change. If the market goes down steadily, it is possible to sell securities from the portfolio, at the same time buying a call option for insurance in case of an unexpected change in trend. From the point of view of insurance against market risks, work in the options market is more convenient. However, unfortunately, the number of available options is significantly less than futures, not to mention the real stock market.
In addition to hedging risks, derivatives are widely used for speculation . Moreover, for a professional speculator, the use of instruments on the derivatives market is more convenient and more efficient than working in the stock market, for the following reasons:
1. Commissions in the futures contract market, as a rule, are significantly lower than the commissions in the real assets market.
2. Opening short positions on shares requires borrowing shares from a broker, while transactions on the purchase and sale of futures do not essentially differ from each other and require only the availability of funds in the amount required for the operation.
3. Work with the “leverage”, that is, the use of borrowed money, is associated with the payment of interest on the amounts borrowed from the broker. In addition, the size of a possible loan from a broker is limited, its amount is currently equal to the cost of the investor’s liquid securities (for some clients, the size of a possible loan may be equal to three times the value of securities). When working in the futures contracts market, the speculator as if performs operations with a significantly higher level of borrowed funds. Indeed, for opening a position, it is enough to have an initial margin in the amount of 15% of the contract value
4. Price fluctuations of futures contracts over time, as a rule, are significantly larger than price fluctuations of the underlying asset
5. When buying options, the investor fixes potential losses in the amount of the premium paid to the subscriber. While the potential profit in a favorable market situation is not limited.
In addition to simple speculations on price changes, the derivatives market allows building more complex strategies using several tools at once. For example, strategies are possible that allow you to play on the differences or the volatility of the underlying asset (the difference in the magnitude of price fluctuations over time), or future expectations, while buying and selling futures with different delivery times.
An investor operating in the derivatives market must be prepared for the higher risks inherent in this interesting market. Attention should be paid to the following sources of risk.
In the derivatives market, quotes change faster and more compared to price fluctuations in the underlying asset market. And speculation in this market requires more attention. All derivative instruments have an expiration date, and regardless of the investor’s will or unwillingness, the position will be closed at the time of the instrument’s expiration date. Opportunities for opening and closing positions for many derivative instruments are severely limited. The derivatives market is still in the initial stage of its development, the range of well-traded instruments is constantly expanding, and in the future the risk of being unable to open or, worse, close positions, if necessary, will constantly decrease. Another risk is associated with daily clearing, which may result in the obligation to replenish the account,
To avoid such a risk, you always have to keep in the trading system some excess amount of money, and not just what is needed to open a position. Transactions on the exchange market of futures contracts are concluded between bidders and the exchange, therefore, in any crisis situations it may happen that the exchange does not have enough of its own funds, as well as funds contributed as a guarantee margin to ensure settlement of all concluded contracts . Similar situations have already arisen in the Russian stock market, in particular in 1998. Since then, the reliability of exchange platforms has increased significantly, but the volumes of transactions concluded on the market have also significantly increased. However, the higher risks of the derivatives market relative to the underlying assets market should not be the sole basis for refusing derivatives transactions. In the derivatives market, one can receive income substantially exceeding the income of any other financial instruments. And high risks serve as a kind of payment for these opportunities.