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Derivatives: The Good, The Bad and … The Necessary

Learn about derivatives and how they are used for hedging, speculation, and arbitrage. Explore the differences between over-the-counter (OTC) derivatives and exchange-traded derivatives (ETD). Discover examples of derivative products in different asset classes.

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Derivatives: The Good, The Bad and … The Necessary

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  1. Derivatives: The Good, The Bad and … The Necessary Presented by Najib Lamhaoaur Managing Director Citigroup Global Markets The Meeting of the Africa & Middle East Depositories Association October 22, 2009

  2. The Meeting of the Africa & Middle East Depositories Association What is a derivative? • A derivative is a financial instrument that is derived from some other asset, index, event, value or condition (known as the underlying asset). Rather than trade or exchange the underlying asset itself, derivative traders enter into an agreement to exchange cash or assets over time based on the underlying asset. How are derivatives used: • Hedging: • Designed to eliminate or reduce risk in the underlying asset • Value of derivative contract is correlated to the value of the underlying position • Allows risk about price of underlying asset to be transferred from one party to another • Speculation and Arbitrage: • Speculator acquires risk to make a profit • Speculator capital provides increased market liquidity • Arbitrage opportunities arise based on price of asset versus price in the derivatives market • Derivatives are often leveraged, such that a small movement in the underlying value can cause a large difference in the value of the derivative.

  3. The Meeting of the Africa & Middle East Depositories Association • Over-the-counter (OTC)derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. There are two distinct groups of derivative contracts, distinguished by the way they are traded in the market: • The largest market for derivatives • Largely unregulated with respect to disclosure of information between the parties. • No central counterparty. • Subject to counterparty risk, since each counterparty relies on the other to perform. • Examples: • Swaps • Forward rate agreements • Exotic options • Exchange-traded derivatives (ETD) are derivatives products that are traded via specialized derivatives exchanges. • Exchange acts as an intermediary to all related transactions • Margin posted from both sides of the trade to act as a “good faith” deposit • Provide investors access to risk/reward and volatility characteristics related to an underlying commodity. • Examples: • Futures • Options on Futures • Cleared Swaps

  4. The Meeting of the Africa & Middle East Depositories Association Exchange Traded Futures vs. OTC Products

  5. The Meeting of the Africa & Middle East Depositories Association Examples of products for each of the five major classes of derivatives.

  6. The Meeting of the Africa & Middle East Depositories Association Many products and events underlie derivatives ... here are only a few of the listed derivatives that are available: Product/Event Derivative Contract (Most active) Exchange • Currencies ........................ $US – Russian ruble MICEX (Moscow) • Equities ............................... S&P500 E-mini CME (Chicago) • Money market rates ............. 28-day Interbank Interest Rate Mexder (Mexico City) • Bonds ................................. Euro Schatz Eurex (Frankfurt) • Agriculture ........................... Soymeal DCE (Dalian) • Energy ................................. Crude oil, WTI NYMEX (New York) • Industrial materials ............... Rubber SHFE (Shanghai)) • Precious metals .................. Gold COMEX (New York) • Base metals ........................ Aluminum LME (London) • Credit default ...................... iTraxx Europe 5-year index Eurex (Frankfurt) • Shipping ............................... Freight swap futures, Singapore to Japan. NYMEX (New York) • Weather ............................... U.S. wind event, $20 bin loss trigger Chicago Climate Exch. • Emissions ............................ European Union CO2 allowance ICE (London) • Housing ............................... S&P Case-Shiller housing composite CME (Chicago)

  7. The Meeting of the Africa & Middle East Depositories Association OTC Markets: Product Overview • Two parties agree on the terms of obligations. • Derivatives on unique products are suited to the OTC market. • Counterparty risk can be a significant factor in the pricing. • Function best when non-standardized agreements are needed -- that is, when delivery dates, locations, quantities or quality adjustments are necessary. • The guarantee that supports an OTC position is as good as the credit-worthiness of the weaker of the two parties. • International Swaps and Derivatives Association (ISDA) agreements or similar bilateral documents required to support trading. These are typically heavily negotiated.

  8. The Meeting of the Africa & Middle East Depositories Association Futures Markets: Product Overview • Futures are standardized contracts made today for settlement (delivery) at a future date. The contracts are linked to “cash market” products. • Futures are regulated by the CFTC and the NFA in the United States and by the FSA in the UK and similar bodies worldwide. • Futures contracts are traded on regulated Futures Exchanges (not an OTC market) as agency transactions. There is no principal trading permitted. • Each Futures Exchange is affiliated with a Clearing House. There is no single centralized clearing house and no fungibility between products. The Clearing House is the counterparty between every buyer and seller. • Futures Commission Merchants (FCM’s) provide the link between investors/hedgers and the Exchanges, accepting orders to buy/sell futures, providing execution and market expertise, and managing settlement, reporting and margins related to the futures positions • Futures are global and cross asset classes from physical commodities (e.g., gold, oil, grains) to financials.

  9. The Meeting of the Africa & Middle East Depositories Association Derivative Solutions: The Swiss Watchmaker • The business: In early June, a Swiss-based manufacturer of luxury wristwatches agrees to deliver a shipment to a major U.S. retailer in mid-September for the upcoming holiday season. The watchmaker and retailer have negotiated a payment of $10 million to be made to the watchmaker upon delivery. • The problem: The watchmaker is concerned that the U.S. dollar’s value against the Swiss franc will continue to deteriorate, reducing its profit. The exchange rate is currently 1.08 Swiss franc per dollar so the agreed payment would be worth 10.8 million Swiss francs. • The solution: The watchmaker buys a quantity of Swiss francs on a forward basis by entering a long position in 86 September Swiss franc futures. Each futures contract gives the company exposure to 125,000 Swiss francs at a futures price of $0.92 [1.08 Swiss francs per dollar]. • The result: By mid-September, the watchmaker was correct, and the value of the dollar has declined against the Swiss franc, to 1.03 Swiss francs per dollar. • The watchmaker’s $10 million payment now equals 10.34 million Swiss francs. This results in a 460,000 Swiss franc shortfall from the original expected payment back in June. • The company’s long futures position, however, is closed out at $0.97 [1.03 Swiss francs per dollar], netting nearly $445,000 or 460,000 Swiss francs. The Futures hedge protected the watchmaker from US Dollar weakness.

  10. The Meeting of the Africa & Middle East Depositories Association Derivative Solutions: The Airline • The business: A global airline, operating in 40 countries • The problem: In reviewing its cost structure, the airline observes that fuel costs, which represent just over 20% of its operating costs, are likely to rise. It determines that it will hedge a portion of its jet fuel consumption, 50,000 metric tons per month, for Fourth Quarter in 2010.. • The solution: The airline buys 50 cargo lots of fuel originating in the Amsterdam-Rotterdam-Antwerp (ARA) area forward in the OTC market at $700, $702 and $705 per metric ton for the October, November and December 2010 contracts through the Chicago Mercantile Exchange’s ClearPort platform. . • The result: The settlement prices for the October, November and December 2010 contracts end up as $698, $708 and $710 dollars, respectively, per metric ton. The contracts are financially settled, netting actual costs savings for the airline’s Q42010 fuel costs of $9 per metric ton (-$2 loss for October, +$6 savings for November and +$5 savings for December). Using Cleared Swaps, the airline was able to reduce their cost for fuel. .

  11. The Meeting of the Africa & Middle East Depositories Association Derivative Solutions: The Farm Conglomerate • The business: A large U.S. farm conglomerate. • The problem: Forecasters expect that oversupply and modest consumption growth following the current growing season will undercut corn prices, one of its major crops. • The solution: The conglomerate sells a portion of next year’s crop on a forward basis by taking a short position in 1,000 corn futures that expire in December of the following year. • The result: The conglomerate will deliver the 5,000,000 bushels of corn the following December, receiving the final futures price in exchange for the corn. Using Futures, the conglomerate sold its corn crop at a more advantageous price.

  12. The Meeting of the Africa & Middle East Depositories Association Derivative solutions: The Mortgage Investor • The business: A large U.S. bank buys mortgages for its investment portfolio. • The problem: The manager assigned to the portfolio needs to protect its value against rising interest rates. In addition, the mortgage pools will underperform if rates decline enough to induce borrowers to refinance their loans, returning principle to the lenders before their stated maturity. • The solution: After determining the current dollar sensitivity of his holdings to a basis point change in yields, the manager sells the quantity of 10-year U.S. Treasury note futures that represents an equivalent dollar sensitivity. In addition, the manager, after consulting with his research group, purchases a quantity of out-of-the money 10-year U.S. Treasury note futures calls that will increase in value if rates decline in an amount that will compensate for his mortgages’ underperformance. • The result: Six months later, rising interest rates depressed the value of the bank’s mortgage holdings. • The short U.S. Treasury futures position rose in value by a similar amount. The short U.S. Treasury futures position rose in value by a similar amount. The call options, although not exercised, provided protection against falling interest rates. Using futures and options on futures, the portfolio manager was able to reduce interest rate and repayment risk.

  13. The Meeting of the Africa & Middle East Depositories Association The Global Derivatives Markets, 1998-2008Notional Amounts Outstanding at Year-end $US trillions Exchange-Traded, $58 trillion in 2008. Over-The-Counter, $592 trillion in 2008. 600 World Economic Output, $69 trillion in 2008. 500 400 300 200 100 0 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 Source: Bank for International Settlements, International Monetary Fund.

  14. The Meeting of the Africa & Middle East Depositories Association 2008 $592 trillion notional … 2008: $33.9 trillion market value, $5 trillion net credit exposure. Over-the-Counter Derivatives Market, 2004 & 2008

  15. The Meeting of the Africa & Middle East Depositories Association Global Futures Volume, 2004 & 2008

  16. The Meeting of the Africa & Middle East Depositories Association Top Derivatives Exchange, 2008

  17. The Meeting of the Africa & Middle East Depositories Association Top Exchanges for Equity Index Futures, 2008 Top Exchanges for Interest Rate Futures & Options, 2008 Top Exchanges for Currency Products, 2008 Top Exchanges for Commodity Products, 2008

  18. The Meeting of the Africa & Middle East Depositories Association • Definition: CDS are a financial instrument for swapping the risk of debt default. Credit default swaps may be used for emerging market bonds, mortgage backed securities, corporate bonds and local government bond Credit Default Swaps (CDS) • The buyer of a credit default swap pays a premium for effectively insuring against a debt default. He receives a lump sum payment if the debt instrument is defaulted. • The seller of a credit default swap receives monthly payments from the buyer. If the debt instrument defaults they have to pay the agreed amount to the buyer of the credit default swap The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion.>

  19. The Meeting of the Africa & Middle East Depositories Association • Housing market: root of all bad? • Growth of subprime and Alt-A loans to meet investor demand. The Housing And Mortgage Markets Collide On The Way Down • Mortgage loans were not only securitized but were in many cases highly leveraged. • Portfolios that included a growing array of derivative products, notably collateralized debt obligations. • Credit default swaps were written on, and by, major participants in the mortgage market.

  20. The Meeting of the Africa & Middle East Depositories Association Regulatory Reform • In response to heightened concern, governments worldwide are acting to rationalize markets, and to rein in risks. • In the U.S., proposed legislation will address the credit risks posed by the nature of the bilateral agreement, as well as the risks posed to the financial system from fraud and market manipulation. • The “Over-the-Counter Derivatives Markets Act of 2009” drafted by the U.S. administration in August contains rules that are likely to find their way into law in the near future. • A major thrust of this draft legislation is to force OTC derivatives away from bilateral agreements and into central clearing houses. OTC derivatives, including credit default swaps, will be classified as “standardized” or “non-standardized.” • Contracts that are accepted by a clearing house would be put into the standardized category. • Standardized contracts would be required to be centrally cleared. • Standardized contracts would be required to be traded on a CFTC- or SEC-regulated exchange or on alternative swap execution facilities approved by regulators. • The CFTC and SEC would be given authority to prevent market participants from using spurious customization to avoid central clearing and exchange trading. Higher capital requirements and margin requirements will be required for non-standardized derivatives.

  21. The Meeting of the Africa & Middle East Depositories Association Growth in Derivatives: Driving Factors By the end of 2008, the global derivatives market had grown to over $600 trillion* ($592trln OTC + $58trln ETD), tracking the dramatic increase in the size and complexity of the financial industry. Driving that growth are: • Global Economy To Fuel Increased Capital Flows – (Trade & Financial) • “Global Recession is Ending” (IMF World Economic Outlook, October 2009). • World Growth +2.9% 2010 F -1.4% 2009 F +2.6% 2008 A • Risk management (Transfer & Sharing of Risk) • Price Risk • Liquidity Risk • Leverage • Capital intermediation can increase value of capital investment • Market Efficiency • Technical innovation • Liquidity • Deeper markets have made participation less costly Source: BIS and WFE

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