derivatives: the good, the bad and … the necessary presented by najib lamhaoaur managing director...

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

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

There are two distinct groups of derivative contracts, distinguished by the way they are traded in the market:


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.– 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


Exchange Traded Futures vs. OTC Products

Futures OTCRegulated Unregulated

Standardized Customized

Exchange Cleared Principal-to-principal [bi-lateral]

Standard (in-house) documentation Heavily negotiated ISDA agreement

Close out for virtually any reason Very specific termination events

Initial margin is required to be maintained Margin negotiated between counterparties

MTM Daily and Margin Calls issued, if necessary

Margin negotiated between counterparties

Margin is adjusted for volatility Margin negotiated between counterparties

Price Transparency Pricing mechanism is “market convention”

5

Contract Types

UnderlyingExchange-traded

futuresExchange-traded

optionsOTC Swap OTC Forward OTC Option

Equity S&P500 futuresOptions on

S&P500 index futures

Equity swapBack-to-back repurchase agreement

Long-dated index option

Interest rate Eurodollar futuresOption on

Eurodollar futuresInterest rate swap

Forward rate agreement

Interest rate cap or floor

Credit

Interest rate swap futures

Credit default swap index futures

Option on interest rate swap futures

Credit default swapRepurchase agreement

Credit default option

Foreign Exchange Currency futuresOption on currency

futuresCurrency swap

Currency forward agreement

Currency option

Commodity Heating oil futuresOption on heating

oil futuresCommodity total

return swap

Forward purchase agreement on

heating oil

Long-dated option on heating oil-crude oil basis

Examples of products for each of the five major classes of derivatives.


6

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)

Many products and events underlie derivatives ... here are only a few of the listed derivatives that are available:

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)


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)

7

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

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 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.

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.

Derivative Solutions: The Swiss Watchmaker

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].

10

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 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.

.

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.

.

11

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

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 Global Derivatives Markets, 1998-2008Notional Amounts Outstanding at Year-end

Exchange-Traded, $58 trillion in 2008.

World Economic Output, $69 trillion in 2008.

Source: Bank for International Settlements, International Monetary Fund.

0

100

200

300

400

500

600

'98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08

Over-The-Counter, $592 trillion in 2008.

$US trillions

14


Over-the-Counter Derivatives Market, 2004 & 2008

Foreign exchange contracts, 2004 to 2008 share: 11% to 9%Interest rate contracts, 74% to 66%Equity-linked contracts, 2% to 1%Commodity contracts, 1% to 1%Credit default swaps, 2% to 10%Other, 10% to 12%

2004$294 trillion notional


… 2008: $33.9 trillion market value,$5 trillion net credit exposure.

Source: Bank for International Settlements.


… 2008: $33.9 trillion market value,$5 trillion net credit exposure.

15

Equity Indices , 42.6% to 36.8%Interest Rate, 25.6% to 18.2%Individual Equities, 22.6% to 31.2%Ag Commodities, 3.4% to 5.0%Energy Products, 2.7% to 3.3%Foreign Currency/Index , 1.2% to 3.3%NonPrecious Metals, 1.2% to 1.0%Precious Metals, 0.7% to 1.0%Other, 0.0% to 0.3%

20048.9 billion contracts


100% increase from 2004 to 2008

Souce: Futures Industry Magazine.


Global Futures Volume, 2004 & 2008


100% increase from 2004 to 2008

Souce: Futures Industry Magazine.

16


Top Derivatives Exchange, 2008

Billions of Contracts

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

CME Group Korea Exchange Eurex CBOE NYSE Life InternationalSecuritiesExchange

BM&F/BOVESPA National StockExchange of

India

17


Milions of

0

100

200

300

400

500

600

700

800

900

CME Group Eurex National StockExchange of India

Osaka SecuritiesExchange

NYSE Life

Top Exchanges for Equity Index Futures, 2008 Top Exchanges for Interest Rate Futures & Options, 2008Milions of

0

200

400

600

800

1000

1200

1400

1600

CME Group Eurex NYSE Life BM&FBOVESPA MexDer Australian SE Tokyo FinancialExchange

NASDAQ OMXNordic

Exchange

Top Exchanges for Currency Products, 2008 Top Exchanges for Commodity Products, 2008

Milions of

0

20

40

60

80

100

120

140

160

CME Group BM&FBOVESPA Tokyo FinancialExchange

TurkishDerivativesExchange

National StockExchange of India

Korea Exchange InternationalSecurities

Exchange (ISE)

Milions of

0

20

40

60

80

100

120

140

160

CME Group DalianCommodityExchange

ZhengshoucommodityExchange

ICE FuturesEurope

ShanghaiFutures

Exchange

London MetalExchange

ICE Futures US Mercado aTérmino de

Buenos Aires

18

Credit Default Swaps (CDS)


The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion. >

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– 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

19

The Housing And Mortgage Markets Collide On The Way Down


Subprime defaults and CDS prices of U.S. banks

0

50

100

150

200

250

300

350

400

Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09

Average CDS price level of banking group

0

5

10

15

20

25

30

35

40

45Percent

Credit default swap level of major U.S. banks

Percent of subprime loans 30 days or more delinquent

Source: Bloomberg, L.P.

Housing market: root of all bad?– Growth of subprime and Alt-A loans to meet investor demand.– 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

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

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:

Growth in Derivatives: Driving Factors


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

derivatives: the good, the bad and … the necessary presented by najib lamhaoaur managing director...

Documents

derivatives market derivatives

underlying value

price of underlying

derivatives products

price of asset

exchange acts

underlying position

underlying commodity