Exchange-Traded Derivatives

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What are derivatives?

A derivative is a security whose price is dependent on, or derived from, one or more underlying asset. The derivative itself is merely a contract between two or more parties.

There is a crucial difference between a direct investment and an investment in a derivative:

• when directly investing in a financial instrument such as a stock or a bond, the investor participates directly in its risks, gains, and losses.
• when investing in a derivative, the investor invests in a contract, note, unit, or certificate. This adds specific characteristics, risks, obligations, and/or rights to the assets on which the derivative is based.

An underlying can consist of a single asset or multiple assets. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates, and market indices.

The value of the derivative depends in a non-linear way on the price of its underlying.

A derivative may be traded over the counter (unlisted) or be standardised and traded on public exchanges.

Advantages / disadvantages

Advantages

• Cost efficiency by leverage: the gross amount invested is smaller than trading the individual underlyings.
• Hedging instruments: losses can be limited by long options (buying a right).
• Flexibility: ability to trade a wide range of underlyings and to lock in prices.
• They are usually liquid instruments.

Disadvantages

• Options have a 'time decay'; the time value of the option decreases over the investment period.
• They can have higher spreads and commissions per dollar invested.
• If used with a speculative intention, strategies such as leverage and short selling bear the risk of overproportional or even unlimited losses.

What are options?

An option represents a right (if 'long') or an obligation (if 'short') to sell or buy an asset (underlying) at a specific price (strike price) on a specific date (exercise date).

There are two basic types of options:

Important risks to consider

What to expect from options

Important to know before investing in call options

Option value changes are not linear with price movements of the underlying asset. Depending on the option type, exercise can be on a single date (European option) or at any time until expiration (American option).

Important to know before investing in put options

Option value changes are not linear with price movements of the underlying asset. Depending on the option type, exercise can be on a single date (European option) or at any time until expiration (American option).

A closer look at options

General types of options (1/2)

The right (option) is only exercised when it is favourable to the buyer. An option is exercised at specific dates. The most common date schemes are either at maturity only (European option) or anytime during the lifetime (American option).

General types of options (2/2)

How options work (1/2)

Example: Buying a European call option

Buying a call option is buying the right to buy an asset (underlying): at a specific date (exercise date) and at a specific price (strike price).

The option premium is paid at inception. During the lifetime, the price of the underlying, and thus of the option itself, changes on a daily basis.

A decision is made at maturity:

• if it is profitable to the buyer, the right is exercised
• if it is a potential loss, the right is not exercised

How options work (2/2)

Profit and loss profiles examples

(1) In case the underlying asset has a value of zero, the loss is the strike price (minus the option premium collected).

‘Moneyness’ and risks

Buyers will exercise the option when it is profitable for them. The ‘moneyness’ indicates if an option is in the ‘profit zone’ or would represent a loss.

• The risks of long options (buying call or put) are limited to the option premium.
• The risks of short options can theoretically be unlimited, specifically if the sale is uncovered (i.e. not in possession of the underlying asset).
• The option price varies with the price of the underlying asset. However, option prices do not respond in a linear way to price movements of the underlying, since many factors contribute to the option price (see below). Thus, the investor carries risks in addition to the pure market risks to which the underlying is exposed.
• When trading standardized options, the trading is executed on an exchange (e.g. Chicago Board Options Exchange, Eurex), thus the counterparty risk is minimized. If options are traded over-the-counter, the credit risk of the issuer needs to be taken into consideration.

Option price factors (1/2)

Intrinsic value and time value

The price of an option is composed of two components: intrinsic value and time value. The intrinsic value of the option is the difference between the strike price and the spot price of the underlying asset. The intrinsic value is never negative, since the buyer is never forced to exercise the option.

The time value of the option is the difference between the actual value of the option and its intrinsic value. The time value compensates the seller for price movements of the underlying (volatility), as well as for foregoing interest. The time value decreases with remaining time to the exercise date and is zero at the maturity date itself.

Note that the expected price fluctuation due to dividend payments on the underlying is already considered in the option price.

Option price factors (2/2)

Intrinsic value and time value

The time value of an option is higher the longer the time remaining to the exercise date. This is due to two factors:

• the volatility of the market value of the underlying asset: the longer the remaining time to maturity, the higher the probability that the market price will change in favour of the option buyer. The implicit volatility expresses the expectation regarding the future volatility of the underlying asset's market value.
• foregoing interest: holding the underlying results in capital costs for the call seller/put buyer (so-called 'opportunity costs'). These costs take into account the interest that could have been earned when investing the same amount in a money market instrument over the lifetime of the option. The rate applied is the so-called 'risk-free' rate (the minimum rate that a risk-free investment would offer). The counterparty has to compensate for these costs and the lost opportunity.

Example - Intrinsic value and time value

A share on 14 January is quoted at CHF 493.50. June call options for a strike of CHF 480 are quoted at CHF 36.10. June put options for a strike of CHF 480 are quoted at CHF 25.92.

Difference between options and warrants

Warrants are securitised options. Warrants are similar to long options (buying a call/buying a put) and have a very similar trade-off between risk and return. The main differences between options and warrants are displayed in the following table.

Due to the differences in maturity, liquidity, and issuer risk, warrants have general and specific risks that are characteristic of structured products. The use of warrants thus requires the relevant additional knowledge.

What are futures?

A future is a contractual obligation of the buyer to purchase or sell an asset (underlying) at a predetermined price in the future.

Futures are highly standardised contracts for which a liquid market exists. Futures are available on a number of underlyings. The most common are:

• index futures
• commodities (e.g. wheat, crude oil) / precious metals
• equity futures
• interest rates
• foreign exchange rates (forwards)

There are two investment positions: long and short (buying and selling a future).

Important risks to consider — Futures

What to expect from futures

Important to know before buying a future

Profit from a future due to price changes. In this example, the agreed upon price is 90 at time t₀ and the trade is executed at t₁, when the actual price is 100. The price of the future (and therefore the gains or losses) depends linearly on the price of the underlying.

Futures may be settled by delivery of the underlying (physical delivery) or by the cash equivalent (cash settlement). Gains/losses are taken into account daily.

Important to know before selling a future

Profit from a future due to price changes. In this example, the agreed upon price is 90 at time t₀ and the trade is executed at t₁, when the actual price is 80. The price of the future (and therefore the gains or losses) depends linearly on the price of the underlying.

Futures may deliver (by underlying physically delivered or cash equivalent). When selling (i.e. short position), the seller is in a short position in the corresponding underlying asset. The seller is forced to buy the underlying asset at market conditions if the buyer exercises. The seller is thus forced to buy the underlying asset at market conditions that may be unfavourable. Gains/losses are taken to account daily.

A closer look at futures

General properties

Futures are obligations, i.e. future contracts need to be closed out prior to maturity if not wished to be exercised. If a future is not closed out before maturity, it can be settled in the following two ways.

Contracts that have a physically existing asset as an underlying (e.g. commodities such as crude oil, wheat, iron ore) are usually settled by physical delivery. Contracts that are based on a reference rate (e.g. index) can only be settled in cash.

How futures work

Example: Buying an equity future

At the exercise date, the difference between the actually observed price and the agreed-upon price is settled by either delivery of the equity or by a cash settlement of the difference.

Price of a future

Futures' prices are determined by so-called opportunity costs or the cost of carry. Cost of carry describes the costs for the seller of the future for remaining in possession of the underlying asset. Consider the following example.

• Farmer Doe would like to buy from Farmer Smith a forward on ten cows deliverable and payable in one year. The current market price for a cow is CHF 5,400.
• Farmer Smith needs to keep those 10 cows alive and calculates the costs and gains from the cows during the year until delivery date.

Similar calculations can be done for any other underlying, including complex financial instruments such as an index. The costs would be expressed by the interest earned in a risk-free alternative investment, while the profit is any dividend paid.

Leverage and margin

Futures require the maintenance of a margin account as a prerequisite. When opening a futures contract, the investor makes a cash deposit, the so-called 'initial margin', which is a minimum deposit required to process the contract.

• The margin account is used to debit/credit losses/gains on the futures contract on a daily basis (mark to market).
• At liquidation of the contract, the initial margin is refunded plus/minus all accumulated gains/losses.
• When accumulating losses, and when the balance of the margin account falls below a defined value (maintenance margin), the investor will be required to make an additional deposit up to the initial margin (margin call).

The initial margin required depends on the volatility of the underlying. However, it will be substantially less than the actual contract volume. Therefore, a small investment amount moves a far larger value in terms of the underlying. This leverage amplifies potential gains and losses. It contributes significantly to the risks of the instrument.

Differences between futures and forwards

Forwards are similar to futures with regards to their purpose: they allow the investor to buy/sell an asset on a specific date at a specific price. The major difference is that futures are standardised exchange-traded contracts, while forwards are basically private agreements between two parties that are less rigid in terms and conditions.

Settlement and delivery differ.

Due to these differences, futures and forwards differ in their risk exposure.

Futures and forwards with a commodity underlying

In the case of forwards or futures with a commodity underlying, physical settlement results in the delivery of the good to the buyer. If futures or forwards on commodities are used as pure investment vehicles, they need to be closed out prior to maturity to avoid unwanted physical delivery. (Note that commodities are traded in bulk and futures/forward contracts on commodities such as ores, oil, and agricultural goods are common.)

• Forward contracts are often used for hedging purposes and tend to be settled in cash or by delivery of the underlying.
• Futures contracts are frequently closed out prior to maturity without actual delivery at all.

As stated previously, the forward/futures price is calculated based on the cost of carry or opportunity costs. Two situations may arise:

Contango and backwardation are particularly important in the case of a commodity underlying, since a contango /backwardation can occur in addition to the normal cost of carry. This may be the result of seasonal effects, climate, limited storage capabilities – situations that may arise suddenly for perishable or consumer goods. Thus, the forward price may change suddenly even if spot prices do not.

Important legal information

Contact information

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