Chapter- 18 Exchange Traded Interest Rate- Futures and Options

Exchange Traded Derivatives

Now since we have a basic idea regarding what derivatives really are and the function that they
perform, it time to get into a little more detail. At this point, it is essential to introduce the concept of
exchange traded derivatives and over the counter derivatives. We have briefly brushed on them in the
previous few articles. However, now we will understand them in more detail. The idea is to grasp why
this bifurcation amongst the type of derivatives matters and how one can make best use of both types
of derivatives. What are Exchange-Traded Derivatives?

Exchange-traded derivatives consist mostly of options and futures traded on public exchanges, with a
standardized contract. Through the contracts, the exchange determines an expiration date,
settlement process, and lot size, and specifically states the underlying instruments on which the
derivatives can be created.

Exchange-Traded Derivatives

Hence, exchange-traded derivatives promote transparency and liquidity by providing market-based

pricing information. In contrast, over-the-counter derivatives are traded privately and are tailored to
meet the needs of each party, making them less transparent.

Summary

Exchange-traded derivatives are futures and options with a standardized contract, traded on public
exchanges.

Common ETDs include stock, index, currency, commodities, and real estate derivatives.

Standardized contracts increase liquidity and market depth. On the other hand, it reduces flexibility
and eliminates the benefits of negotiation.

Types of Exchange-Traded Derivatives

1. Stock derivatives

Common stock is the most commonly traded asset class used in exchange-traded derivatives. Global
stock derivatives are seen to be a leading indicator of future trends of common stock values.

2. Index derivatives

Index-related derivatives are sold to investors that would like to buy or sell an entire exchange instead
of simply futures of a particular stock. Physical delivery of the index is impossible because there is no
such thing as one unit of the S&P or TSX.

3. Currency derivatives

Exchange-traded derivatives markets list a few currency pairs for trading. Futures contracts or options
are available for the pairs, and investors can choose to go long or short.

4. Commodities derivatives

The commodity market relates to the raw materials sector. Derivatives trading in commodities
includes futures and options that are secured by physical assets or commodities.
5. Real estate derivatives

Real estate derivatives allow people to invest in real estate without ever owning physical buildings.
They are widely traded and were at the heart of the 2008 Global Financial Crisis.

Clearing and Settlement of Exchange-Traded Derivatives

Exchange-traded derivatives require an initial deposit settled through a clearinghouse. Clearinghouses

will handle the technical clearing and settlement tasks required to execute trades. Most are also
traded with a central clearing counterparty (CPP), which are highly regulated institutions that manage
credit risk between two trading parties.

Benefits of Exchange-Traded Derivatives

1. Highly liquid

Exchange-traded derivatives have standardized contracts with a transparent price, which enables
them to be bought and sold easily. Investors can take advantage of the liquidity by offsetting their
contracts when needed. They can do so by selling the current position out in the market or buying
another position in the opposite direction.The offsetting transactions can be performed in a matter of
seconds without needing any negotiations, making exchange-traded derivatives instruments
significantly more liquid.High liquidity also makes it easier for investors to find other parties to sell to
or make bets against. Since more investors are active at the same time, transactions can be completed
in a way that minimizes value loss.

2. Intermediation reduces the risk of default

Exchange-traded derivatives are also beneficial because they prevent both transacting parties from
dealing with each other through intermediation. Both parties in a transaction will report to the
exchange; therefore, neither party faces a counterparty risk.

The intermediate party, the exchange, is believed to be a credible party by most traders around the
world. The exchange will act as an intermediary and assume the financial risk of their clients. By doing
so, it effectively reduces default and credit risk for transacting parties.

3. Regulated exchange platform

The exchange is considered to be safer because it is subject to a lot of regulation. The exchange also
publishes information about all major trades in a day. Therefore, it does a good job of preventing the
few big participants from taking advantage of the market in their favor.

Features
Easy To Offset

Since, exchange traded derivatives can be brought off the market at any given point of time, they
provide the users with a lot of opportunity to offset their previous contract as and when required.
Consider the case of a farmer who has agreed to sell wheat to a merchant at a later data at a price
fixed today. Later on, the farmer believes that he can get a better price in the market and wants to
reverse the contract, what shall he do? In case of a customized contract, the farmer will have to
negotiate with the other party and hope that they agree to reverse the contract. This puts the farmer
at a competitive disadvantage if they change their mind.
This is not the case with exchange traded derivatives. Exchange traded derivatives can be offset in two
ways:

By selling the current position out in the market

By buying an offsetting position at the updated price

Since both of these actions can easily be performed in a matter of seconds and without any
negotiations, exchange traded derivatives are much more user friendly than their counterparts.

Intermediation

The exchange traded derivatives provide another major advantage. In case of exchange traded
derivatives, neither party is directly facing a counterparty risk. This is because neither party is actually
directly dealing with the other party. Let’s say, A enters into a contract with the exchange wherein
exchange goes short and A goes long. The exchange will simultaneously enter into another contract
with B wherein the exchange takes an offsetting position i.e; goes long. Hence, both parties are
contractually bound to the exchange. Since the exchange is a credible counterparty, the chances of
default are greatly reduced making exchange traded derivatives a safer bet when it comes to credit
risk. Most traders around the world take it as given that the exchange will never default on its
liabilities. The day the exchange defaults, it will be out of business.

Regulation

The exchange is a neutral body. Also, exchanges are subject to a lot of regulation. It is for these reasons
that exchange traded derivatives are a safer bet. When one trades in exchange traded derivatives, it
is unlikely that they will come across a scenario wherein a few participants have cornered the market
i.e. have complete control over the commodity in the market. Events like short squeezes do happen
but they are not as easy to execute while trading exchange traded derivatives because the exchange
has to publish information about all the major trades executed on a given day. This prevents the big
parties from cornering the markets.

Market Depth

Lastly, exchange traded derivatives have a lot of market depth. This means that these markets are
highly liquid. Hence, if any person holding exchange traded derivatives wants to reverse their position,
they will easily find a counterparty to sell their stake to or make an opposite bet against. Since the
markets are so liquid, these parties can be found at the click of a button and the stake can be sold
without any major loss in value.

Disadvantage of Exchange-Traded Derivatives

Loss of flexibility

The standardized contracts of exchange-traded derivatives cannot be tailored and therefore make the
market less flexible. There is no negotiation involved, and much of the instruments’ properties have
been already outlined in the contracts.

Standardization

The defining feature of the exchange traded derivatives is that they are standardized contracts. Let’s
use an example to explain this. Let’s say we want to fix the price of 1260 kgs. of wheat that we expect
to produce in the harvest season. We want to find a buyer in the derivatives market. Now the issues
that we will face are:

It might be difficult to find a buyer that wants a delivery on the exact same date that you plan to
deliver. There may be a few days here and there in the delivery process

It might be difficult to get a buyer in the exact geographical area that we are located in. Of course,
buyers can and will be everywhere. However, locating them in a matter of seconds will be difficult

It might be difficult to find a buyer that agrees on the exact terms of the contract that you want to
draw out. It is likely that the buyer may feel that the contract is biased towards you.

It might be difficult to get a buyer that might want the exact amount i.e. 1960 kgs of wheat. Instead,
some buyer may want 450 kgs whereas others may want 2000 kgs.

The point, therefore is , that making buyers and sellers meet when they have extremely specific needs
is a difficult job and cannot be done on an exchange.

In contrast, exchange traded derivatives are standardized contracts. Each contract will have a fixed
expiration data, each contract will be for the same amount of quantity i.e. 100 kgs (assume). Hence,
all the above mentioned difficulties become redundant. The biggest and differentiating factor of
exchange traded derivatives is that they are standardized contracts.

Margin Mechanism in Exchange Traded Derivatives

When it comes to exchange traded derivatives, one of the first things that need to be understood is
the margin mechanism. Since most people that use exchange traded derivatives also use leverage, this
is the procedure that they have to follow. The process may seem to be complicated. However, it is
one of the wonders of risk management and allows markets as risky as derivatives markets to work
relatively smoothly.

What is Margin Trading

Margin trading, at its core is a risk management procedure. Since most of the contracts pertaining to
exchange traded derivatives are highly leveraged, a margin procedure is required. It allows the
investor to borrow money from the market and invest this borrowed money. Even though the
derivatives market is highly speculative, the safety of the principal and interest of the borrowed money
is guaranteed via margin trading.

At first, the buyer i.e. the borrower puts up a small fraction of their own money. This is called an initial
margin. Then, as the market prices move concepts like margin call and revaluation margin come into
picture. Let’s have a closer look at them :

Initial Margin

The initial margin is like a down payment on a loan. Just like when we buy a house we need to put a
certain amount of money down, similarly in case of exchange traded derivatives we need to put a
certain amount of money in the form of an initial margin.

Let’s say that a person wants to buy a contract worth Rs.1000. However, they only have Rs.100. In this
case, they can begin the trade using their own Rs.100 as initial margin and borrowing the rest of the
Rs.900 from the broker. The broker lends this money at a certain interest rate. The interest on this
money is calculated on a daily basis and is calculated till the borrower returns the entire amount in
full. Also, it needs to be understood that not all borrowers are allowed to lend money to buyers. There
are certain approved brokers that are authorized to do so because these approved brokers in turn
maintain margin accounts with the exchange. Hence, the initial margin basically acts as collateral. It
can be used to offset any losses from any adverse price movements by the lender.

Variation Margin

Once the trade begins i.e. the money has been borrowed and has been invested in the contract, the
buyer is then exposed to the fluctuating prices in the markets. The derivative securities are marked to
market every few hours or at least once at the end of the day.

So, now let’s say that the Rs.1000 contract that was purchase by the borrower is worth Rs.1200. This
means that Rs.200 profit has been made by the investor. This money is instantly available in their
account.

On the other hand, if the contract which was purchased for Rs.1000 is now worth only Rs.950, the
investor is expected to pay this shortfall of Rs.50 with immediate effect to keep holding the position.

Variation margin, therefore is, the settlement of profits or losses by the exchange’s account to the
brokers account and by the brokers account to the investors account on an intraday or daily basis. This
is distinctly different from the initial margin that was used as collateral.

Margin Call

When there is any adverse movement to the position of the investor i.e. price of the contract falls to
Rs.950, an immediate margin call of Rs.50 is sent to the broker and then to the investor. The investor
must pay up Rs.50 to continue being a part of the trade. This additional Rs50 is called a “margin call”.
It is an urgent and immediate demand for cash infusion to ensure that the initial margin is maintained
at Rs.100 and that any additional losses are paid for by the investor.

If the investor fails to pay up on time i.e. within a few minutes, the broker will simply sell out the
contract on behalf of the investor even without their will and any losses will be adjusted from the
initial margin which had been held as collateral.

Logic of the Margin Mechanism

The margin mechanism is basically a system in which Brokers maintain margin accounts with the
exchange and are allowed to trade up to a certain limit. Brokers too face margin calls and are supposed
to maintain initial margins. However, brokers usually do not deal on their own account. The margin
calls that they receive are simply passed on to the customer.

Hence, for the exchange, they have the cushion of deposits by a known party. The same is the case
with the broker. All of this forms an intricate system wherein the exchange, lenders and brokers
provide services and finance the trades. However, the risks pertaining to the trades are born by the
investors themselves.
Examples of Exchange Traded Derivatives

Exchange traded derivatives are of many types. They are traded all over the world in different stock
exchanges. Hence, there are many different types of exchange traded derivatives. In this article, we
will have a closer look at some of the more prominent types of derivatives.

Stock Related

The foremost asset class used in exchange traded derivatives is common stock. These types of
derivatives are called stock related derivatives. Stock derivatives are available in a few types meaning
that there can be stock forwards and stock options. Usually stock swaps are not traded over any
exchange even though they may become part of over the counter transactions. Stock forwards and
options enable people to make highly leveraged bets on the price movement in a particular stock if
they are confident that the given stock will surely rise or fall in value. Worldwide stock derivatives are
considered to be leading indicators predicting the direction of the future movement of stock.

Index Related

Just like there are stock derivatives, there are also index related derivatives. This means that instead
of buying or selling futures and options in a given stock, the investors can buy or sell the entire
exchange. Since the exchange is nothing but a portfolio of stocks, these can also be considered to be
a class of stock related derivatives.

However, there is one important difference. Stock options can be settled in cash or in kind meaning
that somebody can demand actual delivery of the stocks. Index derivatives however cannot be settled
in kind. Since there is no such thing as one unit of S&P 500, physical delivery is impossible.

Some of the commonly traded index related derivatives include the S&P 500, Nikkei, Nasdaq, Nifty 50
etc.

Currency Related

Derivatives contracts pertaining to currencies are also commonly listed on many exchanges for
trading. Thus investors can go long or short on these currency pairs. The over the counter market
provides a wide range of contracts that can negotiated as and when needed. Contrary to this, the
exchange traded derivatives market only provides a few popular currency pairs that are listed. Since
the contracts are standardized and liquidity is a concern, the index offers standardized contracts on
for a few pairs of currencies which are highly traded.

For instance, the National Stock Exchange in India offers exchange traded derivatives on only four
pairs of currencies which are:

• Indian Rupee and United States Dollar

• Indian Rupee and Euro
• Indian Rupee and Great Britain Pound
• Indian Rupee and Japanese Yen

Futures contracts are available for these four pairs. However, options are available for only one pair
viz. Indian Rupee to US Dollar.

Commodities Related
In most countries, commodities are the widely used for derivative trading. Even the first derivative
exchange i.e. the Chicago Board of Trade was created to facilitate derivative trading in commodities.
In most countries there are multiple exchanges that offer trading opportunities in thousands of
commodities. Hence, there are thousands of contracts available in these markets. This is what makes
it difficult to trade these markets. Commodities markets were earlier used by people to hedge their
risks. However, in the recent past it has become highly speculative.

Real Estate Related

Real estate derivatives were at the heart of the recent economic meltdown in 2008. Derivatives have
not left the world of real estate untouched. Instead, it was common practice to break down the cash
flow from real estate rentals into bond payments. This is what securitization of assets was all about.
These assets were listed on some of the premier exchanges in the US and were amongst the widely
traded.

Recently, Eurex has also listed a new kind of derivative called Property Index Futures. Real estate
exchange traded derivatives are highly structured and complex instruments and require special skills
and knowledge from investors.

Therefore, exchange traded derivatives are available in a wide variety of underlying assets. This has
made it possible for the average retail investor to trade them. The scope of exchange traded
derivatives is expanding even further every year. Although, their association with economic meltdown
has reduced the popularity, many investors still consider them to be good avenues for investments

Futures
A futures contract is merely a contract specifying that a buyer purchases or a seller sells an underlying
asset at a specified quantity, price, and date in the future. Futures are used by both hedgers and
speculators to protect against or to profit from price fluctuations of the underlying asset in the future.

A myriad of products can be traded on the futures exchanges, with contracts ranging from agricultural
products such as livestock, grains, soybeans, coffee, and dairy to lumber, gold, silver, copper to energy
commodities such as crude oil and natural gas to stock indices and volatility indices such as the S&P,
the Dow, Nasdaq, and the VIX, as well as interest rates on Treasury notes and foreign exchange for a
diverse array of major emerging markets and cross currency pairs.

There are even futures based on forecasted weather and temperature conditions. Depending on the
exchange, each contract is traded with its own specifications, settlement, and accountability rules.

Options
Options are derivatives that grant the holder the right, but not the obligation, to buy or sell an
underlying asset at a pre-specified date and quantity.

Types of Exchange-Traded Options

Equity options are options in which the underlying asset is the stock of a publicly-traded firm. Stock
options are normally standardized into 100 shares per contract, and the premium is quoted on a per-
share basis. For instance, an Apple Inc. (AAPL) 115 strike call option for March 20 expiry is being traded
for $12.15 per share or $12.15 per option contract.

Index options are options in which the underlying asset is a stock index; the CBOE currently offers
options on the S&P 500 and 100 indices, and the Nasdaq 100. Each contract had different
specifications and can range in size from the approximate value of the underlying index to 1/10th the
size.

ETF options are options in which the underlying is an exchange-traded fund.

VIX options are unique options in which the underlying is the CBOE’s own index which tracks the
volatility of the S&P 500 index option prices. The VIX can be traded via options and futures, as well as
through options of the ETFs that track the VIX, such as, the iPath S&P 500 VIX Short-Term Futures ETN
(VXX).7

Bond Options are options in which the underlying asset is a bond. The call buyer is expecting interest
rates to decline/ bond prices to rise and the put buyer is expecting interest rates to climb/bond prices
to fall.

Interest Rate Options are European-style, cash-settled options in which the underlying is an interest
rate based on the spot yield of US Treasurys. Different options are offered for bills expiring at different
time spans, e.g. a call buyer is expecting yields to rise and a put buyer is expecting yields to decline.

Currency Options are options in which the holder can buy or sell currency in the future. Currency
options are used by individuals and major businesses to hedge against foreign exchange risk. For
instance, if an American company is expecting to receive payment in euros in six months’ time and
fears a drop in the EUR/USD, say from $1.06 per euro to $1.03 per euro, they can purchase a EUR/USD
put with a strike of $1.05 per euro to ensure they can sell their euros at the spot market for a better
price.

Weather Options and (futures) are used as hedges by companies to guard against unfavorable
weather changes. They are not the same as catastrophe bonds that mitigate the risks associate with
hurricanes, tornadoes, earthquakes, etc. Weather derivatives instead focus on daily or seasonal
temperature fluctuations around a predetermined temperature benchmark. More information on
these derivatives can be found at the CME Group’s website.

Options on Futures: As previously mentioned, there are futures contracts for a variety of assets, and
exchanges like the CME that offer options contracts on said futures. The futures options holder is
entitled to buy or sell the underlying futures contract at the pre-specified date at a fraction of the
margin requirement of the original futures contract.

Securitization: The Making of an Exchange Traded Derivative

The metamorphosis of real estate from a capital intensive illiquid asset to a small denomination highly
liquid asset class took place through a process called securitization.We will discuss this process in more
detail.

The Problem with Real Estate:

Lack of Liquidity

During the early 2000’s real estate was providing highest returns in the market. Banks and investors
had the opportunity to make more and more mortgage loans, benefit from the prevailing low interest
rates and make a good return in the process. However, there was a problem with real estate. Loans
once made would not be repaid for three decades. Banks had to hold these loans on their books. The
holding of these loans would block up precious capital and banks were wary of this.This was when the
need was felt to use some financial magic to transform a highly illiquid asset into a highly liquid one.

The Solution

The problem was that banks were forced to hold these assets on their books. Even though the returns
were lucrative the banks still wanted more. On the other hand, retail investors and pension funds
would be glad to hold these investments for years. The rate of returns provided by real estate was
more than that provided by bonds and as such it was a favorable investment. Hence, a new solution
was found out. This solution was called “securitization”.

Sale of Mortgages:

The securitization process began with the sale of loans by the banks to a third party. This meant that
if a bank made a loan of $100 and expected to be repaid $150 with interest, they would sell out the
rights to collect those loans at $130 to a third party. The bank got $130 today and the third party
would benefit from the interest that can be received over the lifetime. This third party that would
purchase these investments would usually be an investment bank.

Slicing and Dicing the Mortgages:

The investment bank would then slice and dice this mortgage. This meant that if there was one
mortgage with $100, the investment bank would create 100 different bonds that worth $1 each. This
example is an oversimplification. However, the idea is to explain that the cash flow from the mortgages
was being redirected to the bonds. In effect, the bondholders were paying the bank for making the
loans and were receiving an income in the form of interest from the mortgage holders. Thus it was
not a single bank that was making the mortgage. Rather thanks to the financial jugglery, millions of
people from across the world were pumping in money into the American mortgage market.

Tranching:

The next step in the process of creation of what was called “tranches”. This meant prioritizing the level
of default. If mortgage owners defaulted, the risk would hit the bondholders who were holding bonds
from the lowest tranche. Only after the defaults had completely wiped out that tranche would the
next tranche be affected. Doing so enabled investment bankers to sell the higher tranche bonds at a
remarkable premium. However it also led to a concentration of risk in the lower tranches. At that
moment it did not seem like a big deal since real estate was considered to be an inherently safe
investment. However, in 2008, this would pose a big problem.

Selling It on the Exchange:

The last step in the process was to list these derivative securities on the exchanges and sell them as
exchange traded derivatives. This meant that there was an active market for all of these securities.
People who purchased the bonds were not required to hold them until maturity. Instead they could
sell them off to other investors as and when the felt like. Also, since this transformation had made
risky real estate investments into safe pension fund grade investment securities, there were buyers
from as far as Europe and Japan that had huge exposure to the American mortgage markets.

The Result

Positive Effect:

What was achieved by the process of securitization was nothing sort of remarkable. It was as if the
model has been taken out from an economics textbook and could be used to define perfect markets.
All the borrowers and lenders had the opportunity to cash in and leave when they felt like. It was and
is still considered to be a perfectly liquid market. The success of these mortgage backed securities
created many imitators. Over a period of time car loans and even corporate receivables were being
securitized. It seemed like financial engineers had figured out the solution to the problem of liquidity
and exchange traded derivatives seemed to be the perfect solution.

Adverse Effect:

The process of securitization also created many adverse effects. To begin with it created a system with
no accountability. Since no one was going to hold the mortgage for long, no one exercised caution
while giving out these mortgages in the first place. A lot of bad mortgages and therefore bad bonds
made their way into the market leading to the spectacular collapse of the market which ended up
wiping out Lehman Brothers and bring the entire financial world to a standstill.

Also, since bonds were made in small denominations and were highly liquid they were purchased by
a lot of foreign governments as well foreign private investors. This created a situation that a local
mortgage market bust in the United States caused a global meltdown and recession.

The process of securitization has provided a method to created exchange traded derivatives from
illiquid assets. However, it still needs to be refined to get rid of the negative consequences.