Summary: Part 3: Financial Market And Products
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Reading 1 - Introduction
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How big is the derivatives market?Huge, bigger than the stock market when measured in terms of underlying assets (USD >600 trillion). But of course this is not the value of the respective derivatives, the gross value is estimated at USD 25 trillion. The total transactions is bigger on exchanges, but the size of the OTC is bigger (due to larger deals).
Derivatives play a key role in transferring a wide range of risks in the economy from one entity to another. A derivative is a financial instrument whose value depends on (or derives from) the values of other, more basic, underlying variables.
How about their role in the crisis?They've brought a lot of good things, like more liquidity. But consciously or unconsciously also speculation for some investors. Derivatives played a huge role in the securitization of risky mortgages.
Post-crisis more attention to capital (also investment banks) and liquidity (not only short-term). As well as more valid proxies for funding rates instead of using "the risk-free rate".
What about exchange markets?They trade standardized contracts that have been defined by the exchange; tenor, notional. The products are primarily futures, which are to arrive-contracts. Greatest characteristic is that is uses an exchange clearing house for settlements. The advantage of this arrangement is that traders do not have to worry about the creditworthiness of the people they are trading with (unlike OTC). The clearing house takes care of the credit risk by requiring each of the two parties to deposit funds/margin.
Exchange evolved from open outcry system to electronic system, which increased frequency of trades and algorithmic trading without human intervention.
What about futures contracts?Like a forward contract, a futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. Important difference is that it is traded on an exchange and has standardized features. The exchange mechanism also guarantees that the contract will be honored. Lots of commodities trade a futures, but also bonds and stock indices.
What type of traders exist?Derivatives attracted many different type of traders, which made it such a success. There is always someone willing to take the other side. Because the derivatives market is in the end a zero-sum game.
- Hedgers: use derivatives to reduce risk that they face from potential future market movements.
- Speculators: use them to bet on the future direction of a market variable.
- Arbitrageurs: take offsetting positions (long and short) to lock in a profit.
What about hedge funds?Less regulated, lock in investments for a longer time (unlike mutual funds). Usually speculating or arbitrage positions. Must:
- Evaluate risks
- Decide which are acceptable
- Devise strategies (usually based on derivatives)
- Long/short (over- or undervalued)
- Convertible arbitrage (long in undervalued bond, short the equity)
- Distressed securities (speculate on bankruptcy)
- Emerging markets (less liquid)
- Global Macro (anticipate on macroeconomic trends)
- Merge Arbitrage (bet on deal regarding M&A)
Reading 2 - Mechanics of Futures Markets
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What about a clearing house?Acts as an intermediary in transactions. It guarantees the performance of the parties to each transaction based on a guaranty fund that all clearing house members are required to contribute to. Basically no maintenance margin, but variation margin up to the initial/clearing margin on a daily basis.
Advantage: when price drops significantly the shorters are still being paid. While the long positions still owe a debt to the clearing house.
What about the OTC market?Credit risk is central here, no exchange is involved. They either use:
- CCP, central counterparty: are clearing houses for standard OTC transactions that perform much of the same as an exchange clearing house. Using daily variation margin and the initial margin. As well as a guaranty fund. If OTC participant is not a member, it should find one. More legislation on this
- Bilateral clearing, no CCP, using credit support annex (CSA) and collateral requirements (both sides mostly). Normally no initial margin, but this is changing. Collateral significantly reduces the credit risk.
LTCM: liquid vs illiquid (flight to quality is deadly)
What about market quotes?Settlement price is the price used for calculating daily gains and losses and margin requirements (usually price at which the contract is traded immediately before day end trading session).
Trading volume: in number of contracts traded (can be higher than outstanding)
Open interest: outstanding
Normal market, future prices are increasing function of the maturity of the contract (contango). Inverse is backwardation when the price is declining (due to benefit of holding future, due to storage costs).
What type of futures traders?FCM, futures commission merchants who trade for clients. Locals that trade for themselves: hedgers, arbitrageurs and speculators. Last are most interesting:
- Scalpers: watching for very short-term (minutes)
- Day traders: unwilling to take risk on overnight adverse movement
- Position traders: longer period (benefit from major movements)
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