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Derivative Trading

Derivative Trading. Sidney Launspach. Contents. Derivative Instruments Futures Options Share Installments Contracts for Difference (CFD’s) Individual Equity Futures Warrants Swaps and Bonds Yield-X. Derivative Instruments. Derivative Instruments.

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Derivative Trading

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  1. Derivative Trading Sidney Launspach

  2. Contents • Derivative Instruments • Futures • Options • Share Installments • Contracts for Difference (CFD’s) • Individual Equity Futures • Warrants • Swaps and Bonds • Yield-X

  3. Derivative Instruments

  4. Derivative Instruments • Derivative instruments rely on the underlying asset to derive their value and are negotiable tools. They are found on all the above. • Cash settlement versus physical delivery • Exchange traded versus Over the counter traded

  5. Derivative Instruments • The Financial Markets can be grouped into four markets: • The Foreign Exchange Market • The Capital Market: Which consist of the Equity Market, as well as the Bond and long term debt market to source long term funds. • The Money Market • The Commodity Market

  6. Derivative Instruments Spot or Cash Market: • The spot market or cash market is a market where a supplier can sell his goods today to the highest bidder. Prices in a spot market are governed by supply and demand. • A cash market underpins all futures markets.

  7. Derivative Instruments Forwards or forward contracts • A forward contract is an agreement between two parties to respectively buy and sell something at a future date. • OTC • Physical delivery mostly

  8. Derivative Instruments The contract would typically stipulate the following: • The number of bags to be supplied; • The minimum quality required; • Delivery dates and • The price.

  9. Futures

  10. Futures • A future is an agreement to buy or sell, on an organised exchange, a standard quantity and quality of an underlying asset, at a future date, at a specific price, place and time, determined at the time of trading the contract. Daily settlement creates present values of the contracts. Most result in cash settlement, others in physical settlement. • Financial- and non-financial futures

  11. Futures • Futures are available on the following: • Equity indexes: ALSI, INDI, FINI, FNDI, RESI, GLDX, CTOP & DTOP • Individual Equities/ Single Stocks • Bond Index: GOVI • Individual Bond: R150, R151, R152, R153, R157,R186, R194 & R201 • Interest Rate: 3 month JIBAR • Currency/ Gold: Rand/ dollar, Kruger Rand • Agricultural commodities: White maize, yellow maize, wheat, soybeans, sunflower seed.

  12. Contract Dates • Contract periods for Equity indices and individual equity futures: March, June, September and December on the 3rd Thursday of the month. • Contract periods for Interest rate futures: March, June, September and December on the 3rd Wednesday of the month. • Contract periods for Currency futures: March, June, September and December on the Monday preceding the 3rd Wednesday. • Contract periods for Agricultural products: March, May, July and September, with expiry on the 8th last business day of the month but settlement anytime during that month. • Contract months for the bond index and individual bonds are February, May, August and November on the 1st Thursday of the month.

  13. Futures Contracts • A futures contract is a standardised contract traded on an exchange, specifying a specific quality and quantity of a particular commodity, which will be delivered at a designated place or places during a specific month at a specific date in the future. A futures contract is a legal contract in which the buyer is obliged to take delivery of the underlying asset and the seller is obliged to deliver the underlying asset. Summary of a futures contract: • An agreement to buy or sell • A standard quantity and quality or type • Of financial asset, commodity or notional asset • On a specified future date and place • At a price determined at the time of entering into the contract.

  14. Summary • Futures are derivative instruments because they derive their value from an underlying asset. • From a historical point of view, the futures market is essentially the same as the commodities market. • A cash or spot market is a market where goods are exchanged for cash. • A forward contract is an agreement between two parties to respectively buy and sell a specified commodity or asset at a future date at a specified price. • Forward contracts have certain disadvantages, amongst which are limited price dissemination, limited price discovery, uncertainty of performance, no secondary market, and a multiplicity of contract specifications. • Futures markets are risk transfer markets and not in the first instance a method for delivering commodities to willing buyers. • The total number of contracts for a specific delivery date that have not been closed out is known as the open interest. • Financial futures do not result in actual delivery of the underlying asset but are settled in cash. • A "short" is a seller in a futures transaction and a "long" is a buyer. • The margin in a futures transaction is a good faith deposit which helps to guarantee due performance.

  15. Summary • The futures market is an exchange floor or an electronic screen network, which facilitates the trading of futures contracts. • The broking firm earns commission by acting as an agent on behalf of institutions and private speculators. • The broking firm may act either as a principal for its own account or on behalf of clients. • The clearinghouse processes all transactions made. • Clearinghouse members place unencumbered funds with the exchange to guarantee due performance and also act as market makers. • Hedging is a mechanism whereby the price risk of an existing position in the cash market is transferred or reduced. • Speculators voluntarily bear the risk of price volatility in the hope of making substantial trading profits. • Arbitrage is the simultaneous purchase and sale of a commodity in two different markets in order to profit from a price discrepancy. • From an economic point of view, futures markets allow the risk-averse to transfer market risk to the risk prone. • Futures trading, which involves derivative instruments rather than financial assets, are referred to as a zero-sum game because it does not create or raise capital but merely transfers it.

  16. Summary • Marking-to-market is the process of adjusting a client’s account on a daily basis for any changes in the quoted price of the contract. • The difference between spot prices and futures prices is known as the basis. • Spot prices and futures prices tend to converge as the contract approaches the delivery date and are equal at expiry. • On delivery the difference between the spot price and the contract price is used to calculate the settlement value which is the net sum of all the mark-to-market debits and credits. • |In an inverted market, the futures price is lower for each far-out contract. • The fair value of a future is the theoretical price calculated taking into account net carry costs and the value of

  17. Options

  18. Options Definition of an Options Contract: • An option conveys the right, not obligation, to buy or sell the underlying instrument, a specific quantity, at a specified pre-determined price, at or before a known future date. Options can be abandoned without further penalty. The maximum loss is the option cost. The buyer or holder exercises the right to buy or sell the underlying asset or derivative. The seller or writer of the option has the obligation to take delivery of the underlying asset or derivative. The potential loss of the seller is unlimited. • Options offer price protection without limiting the potential to make a profit. For the farmer this means having protection from falling prices, while still having the opportunity to benefit from rising prices.

  19. Types of Options Put Option • A put option gives the holder the right but not the obligation to sell the commodity at the predetermined strike price at or before the future date. Call Option • A call option gives the holder the right but not the obligation to buy the commodity at the predetermined strike price at or before the future date.

  20. Other Options American Option • An American can be exercised at any point in time during the life of the option. European Option • An European option can only be exercised upon the strike or expiry date of the option.

  21. Cost of an Option • The price at which an option is traded is referred to as a premium. • The premium or option price is made up of an intrinsic value and a time value or theta. • The option price is thus the difference between the strike price and the current market price.

  22. In-the-Money, Out-the-Money or At-the-Money Options • An option is in-the-money, if exercising it will result in a profit, while an option is said to be out-the-money if exercising it will result in a loss.

  23. Time Value The time value of an option can be calculated by deducting the intrinsic value from the option premium. Thus, time value is determined by the following factors: • Time to expiry • Strike price relative to the assets spot price • Risk-free rate • Volatility of the underlying asset

  24. Open Interest • This refers to the number of contracts which have been entered into but which have not yet been exercised or closed out. Open interest can either be net long or net short. • Net long means that most of the participants have bought contracts, while net short means that most of the participants have sold contracts.

  25. Differences Between Options and Futures • The risk for buyers of options differs from buyers of futures. Shorts and longs in the futures market bear unlimited risk. For the buyer of an option, the risk is limited to the premium paid for the option. The buyer of a call option cannot lose more than the premium paid, although the seller’s risk is potentially unlimited if the option is uncovered. • The buyer of an option pays a once-off premium and the seller receives a once-off premium, whereas there are no premiums involved in the futures market. The margin, which is required to make a future transaction, is simply a good faith deposit and not a charge against the cost of the future. • Futures are exchange traded where options are traded Over the counter. • Futures has contract dates where contracts can be rolled over to the next period where options have expiry dates.

  26. Differences Between Options and Futures • The margining requirements are different in the futures and options markets. In the futures markets both buyers and sellers deposit margins with the clearinghouse but in an options transaction only the seller is required to deposit a margin. This is in line with the respective rights and obligations of the parties to an option contract. The buyer has the right but no obligation and therefore no guarantee of performance is required. The seller of the option by contrast, has the obligation to deal in the underlying asset if the option is exercised. In order to guarantee due performance the clearinghouse (SAFCOM) calls for margin deposits from the writers of options. • Unlike the situation in futures, the profit opportunities are not unlimited for all participants. The buyer of an option does enjoy the possibility of theoretically unlimited profit but the seller’s potential profit is limited to the size of the premium, which he receives.

  27. Options Summary • An option contract transfers to the buyer the right to trade the underlying asset at or during a specified time and on the seller the obligation to trade the asset at a predetermined price, if the holder exercises his right.  • American options can be settled at any time up until delivery or expiry, whereas European options can only be settled on the strike or expiry date. • A call option transfers the right to buy the underlying asset up to the exercise date, while a put option confers the right to sell the underlying asset at the strike price. • Intrinsic value is the difference between the spot price of the underlying asset and the strike price of the option. • Time value is the amount which the buyer pays in excess of the intrinsic value. • Time value diminishes along a negative exponential curve as an option approaches the exercise date. • The over-the-counter options market in equities lacks a secondary market and tends to command high premiums. • The gilts options market has standardised contracts trading on an OTC basis. • An option on a future provides a way of taking a futures position without bearing the obligations of the future. • A key difference between futures and options is that the risk for both the long and the short in a futures contract is unlimited, whereas the long in an option contract limits his risk to the option premium.

  28. Options • Risk and return • Dealing costs • Practical aspects • Bids and offers • Standard lots • Closing out • Settlement • Intrinsic value • Time to expiry • Volatility • Interest rates • Price expectations

  29. Factors influencing option premiums • The price of the underlying asses and the strike price of the option, i.e. thin intrinsic value • The remaining life of the option • The volatility of the option • The current risk-free rate • The yield or dividend from the asset

  30. Share Installments

  31. Share Installments Definition • Share Installments allow investors to gain enhanced exposure to some of the JSE Securities Exchange's leading • companies. Holder of the Share Installment enjoys many of the benefits like capital growth and dividends of directly owning some of the country's leading stocks without having to pay the full purchase price on day one. • Investors only pay a portion of the cost of the underlying stock upfront, which means that you gain geared exposure through the Share Installment. This allows you to magnify potential gains arising from movements in the underlying share price. Thus, enhanced exposure with only a partial payment, receiving capital gains and dividends but no voting rights unless exercised.

  32. Trading Share Installments What am I buying when I purchase a Share Installment? • When buying a Share Installment you are purchasing the underlying share. The initial upfront payment provides you with exposure to the share over which the Share Installment is issued. There is an optional 2nd payment, the exercise price, which can be paid at any time up to the expiry of the Share Installment. At this point full ownership of the underlying instrument is taken. For the term of the Share Installment you will receive all the ordinary dividends paid by the underlying. Trading Share Installments • Banks issue Share Installments. Banks will continuously quote prices at which you can both buy and sell the product.

  33. A Wide Choice of Share Installments Share installments are issued over a range of blue-chip South African shares. These include: • Anglo American (AGL) Investec PLC (INP) Sasol (SOL) AngloGold (ANG) MTN Group (MTN) Satrix 40 (STX 40) • Billiton (BIL) Richemont (RCH) Standard Bank (SBK) Firstrand (FSR) SAB Miller (SAB) Telkom (TKG) • Goldfields (GFI) Sanlam (SLM) Impala Platinum (IMP) Sappi (SAP)

  34. Share Installment Codes • Share Installments are recognised by their coding, a 6-letter short code. • Example: installment AGLNIA/ AGLSIA • AGL (Anglo American) = JSE code for the underlying share • N = Nedbank or S for Standard Bank • I = Installment • A = installment series (A being the first series and B the second series)

  35. How Do Share Installments Work? • You initially pay only a portion of the current share price and the bank lends you the balance to purchase the share. The share is then held in trust for you until you make the completion payment. This entitles you to the same benefits that • you would enjoy were you to have paid for the shares in full. You may pay the balance of the share price (i.e. the loan amount) at any time before the share installment matures, but this is not compulsory. Gearing levels are 50%, and up to 12 months’ interest is potentially deductible. The final (‘completion’) installment is optional.

  36. Options During the Term As a Share Installment holder you have several options: 1. If you wish to take full ownership of the share, you exercise the Share Installment at any time up to expiry, by making the final payment. 2. If you wish to maintain your exposure to the underlying share, you can sell out of your existing Share Installment and buy a new one over the same underlying with a longer term to maturity. 3. If upon expiry of the Share Installment the share price has fallen significantly and you choose not to exercise your right to take up the underlying share, you will still receive a cash payment if the share price exceeds the Share Installment's exercise price. 4. If you want to close down your exposure to the underlying share you can simply sell the Share Installment on the market.

  37. Pricing • The price of a Share Installment is approximately 55 per cent of the prevailing share price at listing, yet the investor still receives the full ordinary dividend. The price of the Share Installment will change with any movement in the price of the underlying security. The Share Installment will move on a 1:1 basis with the underlying security i.e. if the underlying moves by R1 then the Share Installment will move by R1. On a daily basis, a matrix of the price of the Share Installment in relation to the underlying Security is published.

  38. Share Installments at Work • When you first buy share installments: • You pay a fraction of the share price upfront. • You pay interest from the loan proceeds. • You borrow the remaining amount (the completion payment) for the term of the share installment. • The shares are bought and held in trust for you. • The term of the loan is usually set for 365 days. • During the life of the share installment: • You receive all capital growth and dividend income on the shares. • Each year on the annual reset date: • The loan amount is revised upwards depending on the movement in the underlying share price; interest for the next • 12 months are payable. • At the end of the loan: • You can choose: to roll over your investment into a new series of share installments or pay the completion installment and receive the underlying shares.

  39. Strategies • Diversified strategy • Geared Strategy Example: • You have R100 000 available to invest and is weighing up alternatives. You are looking to invest in well-known TOP40 shares paying good dividend yields. The kind of companies that you are familiar with are Anglo American Plc, Sanlam Ltd and so. Consider whether you should invest the entire R100 000 directly into your favourite TOP40 companies or utilise Share Installments to give you equivalent exposure and free up some cash to diversify into other asset classes. Also considering whether you should look to leverage your investment by investing the same amount of money in the Share Installments, as in the underlying stocks so as to gear up your share exposure. • It is important to realise that no matter what the choice, the performance of the portfolio will be driven by the movements of the underlying securities. The diversified approach will reduce his capital at risk when compared to a direct share investment, whilst the leveraged approach will magnify the potential profit/loss of the portfolio.

  40. Key Benefits • Geared Share exposure. • Full ownership of the underlying share. • Enhanced dividend yield • Full ordinary dividends payable on the underlying share. • For example, for a share trading at R100 paying an annual dividend of R5, the dividend yield on an outright share purchase would be 5%. With an initial Share Installment of R55, the tax-free dividend yield would be 9,09%. • Share Installments offer a perfect opportunity to participate in multiple upcoming dividends from numerous companies using the same capital investment. This strategy, known as a ‘dividend yield play’, entails rolling out of one share upon becoming ex-dividend and into another for its imminent dividend payment. • Share Installments have added appeal when trading for dividends, as they provide a leveraged exposure to the share while passing on the full dividends benefit. As a result you are able to boost your tax-free dividend income stream.

  41. Key Benefits • No Margin Calls • Partial share price protection • You are not obligated to make the final payment and take up the underlying share; your maximum loss is limited to the initial amount invested. • Flexibility to restructure existing share portfolios • By selling out the underlying shares and replacing them with Share Installments, you can maintain exposure to the • underlying shares and free up cash while still maintaining your dividend income stream. • Potential to accelerate your capital growth by leveraging an existing share holding without having to invest additional capital. This strategy, known as ‘Cash Extraction’, allows you to convert your existing share holding into an equivalent number of Share Installments plus a significant cash payment. The extra cash can either be reinvested into more Share Installments to increase share exposure or deployed for other uses.

  42. Disadvantages • Voting rights will only pass to the holder upon exercise of the Share Installment. • When the underlying share’s price reduces to the level of the exercise price, the full investment will effectively be lost.

  43. Contracts for Difference (CFD’s)

  44. Contracts for Difference (CFD’s) Definition: • An agreement between two parties to exchange the difference between the opening and closing price of the contract. • This is an Over the Counter product, in other words not exchange traded, so no voting rights apply. CFD’s trade at the cash price of the underlying share price.

  45. CFD History CFD’s were used by Institutions only but since 2000 CFD’s were used as professional retail products. This alternative financial product has been developed over the past 30 years in the UK. Currently CFD’s account for 30% of the total daily turnover on the London Stock Exchange.

  46. Why Trade CFD’ s • Making money up and down • If one thinks the underlying share is going up, a long position will be taken on the underlying share. • If one thinks the underlying share is going to fall, a short position can be taken on the underlying share. • Gearing or leverage • This enables one to match the market exposure of an underlying share, with as little as 10% of the capital which one would require to buy the underlying share itself. In other words this enables you to make more money over a shorter period, with less capital, than buying the underlying share. • Low cost • Due to the gearing or leverage on the instrument, which enables you to have the same exposure as the underlying share but with a much smaller capital layout. No stamp duty, UST, VAT or other charges associated with trading on the exchange applies to CFD’s. Borrowing fees are priced into the interest rate. • No disadvantages of script custody • No voting rights • No tracking of dividend payments. • No expiry • Trade at cash price of underlying share

  47. Longs, Shorts, dividends & Corporate Action • A long position • If a long position is held, the holder there-of makes money if the share price of the underlying stock rises and looses money if the underlying share price falls. • One pays a daily financing charge. • A short position • If a short position is held, the holder there-of makes money if the share price of the underlying stock falls and looses money if the underlying share price goes up. • One receives a daily financing charge. • Dividend adjustment • In the case of a long position being held at the close of business the day before the ex-dividend date, a dividend adjustment/ payment is credited to your account on the ex-dividend date. • In the case of a short position being held at the close of business the day before the ex-dividend date, a dividend adjustment/ payment is debited to your account on the ex-dividend date. • Corporate action • CFD positions held the day before corporate action takes place, will be adjusted to replace the corporate action on the underlying share. • Corporate action e.g. rights issues

  48. CFD trading strategies Efficient Trading: Tax – and cost efficient • This is done to protect a share that one holds from loss, by instead of selling the share one takes a short position on that share. By doing this one protects your share capital and does not incur the brokerage on the share and make money in a geared position on the downside. This is called hedging. Paris Trading • This implies taking two positions, a short and long simultaneously. For example, a short on an overvalued share and a long position on an undervalued share. Equity Conversion • To free up capital, sell shares that you are holding and by the equivalent long CFD position, which will cost you less but give you the same exposure. Shot Term Trading • Increase returns over a shorter period with a smaller capital layout than on shares but the same exposure.

  49. Trading Products • CFD’s can be traded in 5 base currencies namely the: Pound (GBP), Euro (Eur), Canadian Dollar (CAD), US dollar (USD) and rand (ZAR). • CFD’s are traded on thousands of international stocks including: • UK – FTSE 350 shares • Europe – Euro Stoxx 50 on shares of main indices • US – DOW 30, Nasdaq 100, S& P 500 shares • Eastern Europe – shares that make up main indices • Asia - shares that make up main indices • Ireland – Biggest liquid shares • South Africa – Alsi 40 shares and more • Canada – TSX 60

  50. CFD’s • No expiry • Cash underlying • Cash equity product • Priced off the cash price of the underlying • Equity based • Issued on liquid shares and spot or cash share indices • Cost of funding charged daily on a long position or earned on a short position

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