Derivative

– Don’t expect to understand them but al least you can read about them

IFRS 9 Definition of derivative: A financial instrument or other contract within the scope of IFRS 9 with all three of the following characteristics.

1. its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract (sometimes called the ‘underlying’).
2. it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
3. it is settled at a future date.

Naming of derivatives:

Floor: An interest rate floor is a derivative contract in which the buyer receives payments at the end of each period in which the interest rate is below the agreed strike price.

A collateralised debt obligation (CDO) is a type of structured asset-backed security (ABS). An “asset-backed security” is used as an umbrella term for a type of security backed by a pool of assets—including collateralised debt obligations and mortgage-backed securities.

A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer (the creditor of the reference loan) in the event of a loan default (by the debtor) or other credit event. The buyer of the CDS makes a series of payments (the CDS “fee” or “spread”) to the seller and, in exchange, receives a payoff if the loan defaults.

Concerning derivatives, a distinction must be made in particular between:

1. Option transactions, which give to one of the parties the right, but not the obligation, to enter into a transaction. One party (the seller of the option) is irrevocably bound to perform while the other one (the purchaser of the option) is free to exercise the option or not;
2. Forward transactions, where the parties enter into a transaction which will have to be performed at a specified date in the future. In a forward transaction, parties bind themselves irrevocably to perform the transaction concluded between them at the specified date.

Transactions on such products trigger higher risks of losses and can even lead to the total loss of the invested funds. Since such transactions can lead to margin calls over the life of the product, investors must ensure that they have sufficient liquid assets before entering into such transactions.

1. Option transactions

Options are derivative financial instruments the value of which tracks the evolution of the value of the underlying asset. The purchaser of an option receives, after having paid a premium to his counterpart, the seller of the option, the right to purchase (call) or to sell (put) the underlying asset at maturity or during a certain period for a strike price determined in advance.

The characteristics of the option can be standardized or defined on a case-by-case basis between the purchaser and the seller.

1.1 Characteristics:

• Duration: the duration of the option starts from the day of the subscription until the day of the maturity of the option right;
• Link between the option and the underlying asset: this link underlines the number of units of the underlying asset that the holder of the option has the right to purchase (call) or to sell (put) by exercising his option right;
• Strike price: the strike price is equal to the price agreed upon earlier at which the holder of the option may purchase or sell the underlying asset when he exercises his option right;
• Strike date: options which can be exercised on any trading day up until the maturity date are called “American style” options. Options which can be exercised only on their maturity date are called “European style” options. The latter can nonetheless be traded on the secondary market before their maturity if the market is liquid;
• Conditions of exercise: the option can be with physical settlement, in which case the buyer of a call option can demand physical delivery of the underlying asset against payment of the strike price or the buyer of a put option can deliver to the seller of the option the underlying asset, against payment of the strike price by the seller. The option can also be with cash settlement, in which case the difference between the strike price and the market value of the underlying asset is due, provided nonetheless that the option is “in-the-money”;
• Options “in-the-money”, “out-of-the-money”, “at-the-money”:
  A call option is “in-the-money” if the market value of the underlying is higher than the strike price. Conversely, a call option is “out-of-the-money” if the current market value of the underlying asset is lower than the strike price. A put option is “in-the-money” if the market value of the underlying asset is lower than the strike price.Conversely, a put option is “out-of-the-money” if the current market value of the underlying asset is higher than the strike price. When the market value and the strike price are the same, the option is “in-the-money”;
• Price of the option: The price of an option depends on its intrinsic value as well as on a variety of factors (time value), in particular, the remaining life of the option and the volatility of the underlying asset. The time value reflects the chance that the option will be “in-the-money”. Therefore, this latter value is higher for long duration options with a very volatile underlying asset.
• Margin: over the lifetime of an option, the seller must provide as collateral, either the corresponding amount of the underlying asset or another form of collateral. The margin is determined by the bank. Stock-exchanges stipulate a minimum margin for listed options. If the margin cover provided by the investor proves to be insufficient, the bank is entitled to request additional collateral, sometimes at very short notice;
• Form:
  • Option certificates (warrants, listed options): the rights and obligations associated with the relevant option are securitised. They are sometimes listed on the stock-exchange.
  • Traded options: these are standardized options for which the rights and obligations are not securitised and which are traded on certain specific stock-exchanges.
  • Over-the-counter (OTC) options: these are options traded outside a stock-exchange or agreed directly off-exchange between the parties. Their level of standardization depends on market practices. They can also be tailor-made to meet investors’ needs. This type of option is not listed and rarely takes the form of a certificate;
• Leverage: every change in the price of the underlying asset entails a proportionally higher change in the price of the option right;
• Purchase of a call or a put: the buyer of a call option speculates on a rise of the price of the underlying over the life of the option, which causes an increase in the value of his option right. Conversely, the buyer of a put option benefits from a drop in the price of the underlying;
• Sale of a call or a put: the seller of a call option anticipates price drops of the underlying asset whereas the seller of a put profits from a rise in the value of the underlying asset.

1.2. Advantages:

Over the lifetime of the option, the beneficiary of the option is granted the right to purchase or sale certain assets.

The chances of profits are important due to the leverage effect linked to the use of an underlying asset. For the counter party, such a transaction mainly permits to increase the return on an existing position.

1.3. Risks

1.3.1. Price risk

Options may be traded on stock-exchanges or over-the-counter and follow the law of offer and demand. An important point for the determination of the price of an option consists, on the one hand in determining whether there is sufficient liquidity in the market for the relevant option, and on the other hand in determining the actual or expected evolution of the price of the corresponding underlying asset.

A call option loses value when the price of the underlying asset decreases, whereas the opposite is true for put options. The price of an option does not solely depend on the price fluctuations of the underlying asset but a series of other factors may come into play, such as for instance the duration of the option or the frequency and intensity of the fluctuations in the value of the underlying asset (volatility). Consequently, drops in the value of the option may appear although the price of the underlying asset remains unchanged.

1.3.2. Leverage risk

Due to the leverage effect, price modifications of the value of the option are generally higher than the changes in the price of the underlying asset. Thus, during the lifetime of the option, chances of gains for the holder of an option as well as risks of losses are higher. The risk attached to the purchase of an option increases with the importance of the leverage effect of the relevant option.

1.3.3. Purchase of an option

The purchase of an option represents a highly volatile investment and the likelihood that an option reaches maturity without any value is relatively high. In this case, the investor loses all the funds used for the payment of the initial premium as well as commissions. Pursuant to the purchase of an option, the investor can maintain his position till maturity, he can enter into an opposite transaction or, for “American-style” options, exercise the option before maturity.

The exercise of the option may either entail the payment in cash of a differential amount or the purchase or the delivery of the underlying asset. In case the option’s object consists in futures contracts, its exercise causes the taking of a position in futures, which supposes the acceptance of some obligations concerning security margins.

1.3.4. Sale of an option

The sale of an option entails, generally speaking, higher risk-taking than its purchase.

Indeed, even if the price obtained for an option is fixed, the losses that the seller may incur are potentially unlimited.

If market prices of the underlying asset vary in an unfavorable way, the seller of the option will have to adapt his security margins in order to maintain his position. If the sold option is an “American-style” option, the seller may be required at any moment to settle the transaction in cash or to purchase or deliver the underlying asset. If the underlying of the option consists in futures contracts, the seller will take a position in futures and will have to respect obligations concerning security margins.

The seller’s risk exposure may be reduced by keeping a position on the underlying asset (financial instruments, index or other) corresponding to the sold option.

1.3.5. Purchase of the underlying asset in case of a short sale

The seller of an uncovered call option does not have a corresponding quantity of the underlying asset at his disposal upon the conclusion of the contract (short sale).

In the case of options with a physical settlement, the potential loss for the investor amounts to the difference between the strike price paid for the delivery of the underlying assets in case the option right is exercised and the price he will have to pay to acquire the relevant underlying asset. For options with cash settlement, the risk of loss for the investor amounts to the difference between the strike price and the market value of the underlying.

Since the market value of the underlying can move well above the strike price when exercising the option, the risk of loss for the investor cannot be determined in advance and is, theoretically at least, unlimited.

This risk is more important for “American-style” options which may be exercised at any time and thus at a highly unfavorable time for the seller of the option.

Another risk for the investor selling the option is also to be unable to obtain the requested underlying when the option is exercised or to have the possibility to obtain it only at very unfavourable conditions (in particular for costs) due to the situation of the markets.

In this context, it must be reminded that the potential loss can also be greater than the value of the margin cover provided by the investor.

1.3.6. Specific risks associated to options traded over-the-counter (OTC)

A position arising from the purchase or the sale of an OTC option can only be closed with the approval of the counter party.

1.3.7. Specific risks associated to combined options

A combination consists in the conclusion of two or more option contracts based on the same underlying, which differ in the option type or the characteristics of the option.

The number of possible combinations is important. Therefore, the risks involved by any particular combination cannot be described in the present document. Consequently, the investor must inquire about the specific risks associated to the contemplated combination.

It can nonetheless be noted that for any combination, the cancellation, at a certain point, of one or more options may entail substantial changes in the risk position of the investor.

1.3.8. Specific risks associated to exotic options

These options are subject to additional conditions or agreements. Their payment structures cannot be obtained by using a combination of transactions.

They can take the form of tailor-made OTC options or warrants.

The range of exotic options is unlimited so that it is impossible to describe the risks entailed by each “exotic” option in the present document.

However, the most common “exotic” options entail the following additional risks compared to normal options.

Options depending on the overall evolution of the underlying

It is not just on expiration or exercise date of the option that the market value of the underlying is important. The investor needs to take into account potential fluctuations in the market value of the underlying during all the life of the option in order to assess the chances of gains or risks of losses.

• Barrier options
  The rights attached to such options arise (knock-in options) or expire (knock-out options) fully and irrevocably only when, during a period determined in advance, the market value of the underlying reaches a fixed threshold.

• Payout options
  Payout options grant a right to payment of a fixed amount, agreed in advance:

  • Digital option
    Payment occurs only if, upon maturity, the market value of the underlying is above (digital call) or below (digital put) the strike price. In this case, if the option is “in-the-money”, the seller of the option must pay the amount initially agreed on.

  • Lock-in option
    Payment occurs only if, during the life of the option or a specified time period during this lifetime, the market value of the underlying reaches a threshold determined in advance. Indeed, when the fixed threshold is reached, the seller of the option must pay the amount initially agreed on, irrespective of the subsequent evolution of the price of the underlying.

  • Lock-out options
    The fixed payment only occurs if during all the life of the option or a specified time period during this lifetime, the market value of the underlying never reaches a threshold or certain thresholds determined in advance. In such a case, whenever the fixed threshold or thresholds are reached, the option becomes invalid and thus loses its value, irrespective of the subsequent evolution of the price of the underlying.

• Asian options
  For these options, an average value is derived from the market value of the underlying over a specified time period. This average is used to fix the underlying’s value which must be delivered (average-rate option) or the strike price which must be paid (average-strike option). The calculation of an average value for the underlying can result in:

  • average-rate option: the value of the option on its maturity date being lower for the buyer and considerably higher for the seller than the difference between the strike price and the market value of the underlying upon maturity;
  • average-strike option: the strike price of a call option being higher than the price originally agreed or the strike price of a put option, being lower than the price originally agreed.

• Look-back options
  The market value of the underlying is recorded periodically over a specified time period.

  For a strike look-back option, the lowest value (call option) or the highest value (put option) of the underlying becomes the strike price.

  For a price look-back option, the strike price remains unchanged but the highest value (call option) or the lowest value (put option) is used in calculating the value of the underlying. Therefore, the risk is that the calculated strike price or calculated value of the underlying varies considerably from the prevailing market prices on the maturity date. Consequently, in the above mentioned cases, the seller must be aware that upon calculation or exercise of the right, the most unfavorable strike price or market value will be applied.

• Contingent options
  Buyers of such options must only pay the premium if the market value of the underlying reaches or exceeds the strike price during the life of the option (“American-style” option) or on the maturity date (“European-style” option).

The risk is thus to be compelled to pay the entire premium even if the option is only just “in-the-money” or “at-the-money”.

• Cliquet and ladder options
  • Cliquet options: the strike price is periodically modified for the following period – in general at regular intervals – to bring it in line with the market value of the underlying. An intrinsic value is then, if applicable, calculated and accumulated over the lifetime of the option.
  • Ladder options: in this case, the modifications take place periodically only when the underlying reaches specified market prices. Normally, only the higher market value is taken into account.

On the maturity date, the seller of a cliquet option is required to pay all the accumulated lock-in market values in addition to any intrinsic value of the option and the seller of a ladder option must pay the highest lock-in market value. For the seller, the amount to be paid can thus be considerably higher than the option’s intrinsic value on the maturity date.

Options on several underlyings

• Spread and out-performance options
  Both types of options are based on two underlyings.

  With a spread option, the absolute difference in movement between the value of the two underlyings forms the basis for calculating the option’s value.

  With an out-performance option, the relative difference, i.e. the percentage improvement of the value of one underlying over the other, is taken into account.

  The risk is that, despite a positive performance of the market value of both underlyings, the performance difference between the underlyings may be equal or even lower, thus having an impact on the value of the option.

• Compound options
  The underlyings of such options are options. Such products can consequently entail large leverage effects, which may trigger important financial obligations.

2. Forward transactions

Forward transactions are financial instruments. Futures are contracts traded on a stock-exchange and standardized as regards the quantity of the underlying asset and as regards the maturity date of the transaction. Over-the-counter (OTC) or forward contracts are contracts that are not traded on a stock-exchange and which may be standardized or individually negotiated between purchaser and seller.

2.1. Characteristics:

• Initial required margin: be it a future purchase or sale of an underlying asset, an initial margin is fixed when the contract is concluded. This margin is generally expressed in percentage of the value of the contract;
• Variation margin: during the entire life of the contract, a variation margin is periodically determined and required from the investor. It represents the accounting benefit or loss, derived from the modification of the contractual price or the price of the underlying asset. The variation margin may exceed the initial required margin by far. The computation method for the variation margin, be it during the life of the contract or at closing, depends on the stock-exchange rules and on the specific contractual provisions of each contract. The investor must immediately provide the bank with variation margin upon request from the latter;
• Liquidation: in general, the investor may, at any time during the life of the contract, sell off or liquidate the contract before maturity, either by selling the contract or by entering into an opposite contract as regards the delivery and reception obligations. In this latter case, the provisions of the opposite contract will be such as the delivery and reception obligations arising from both contracts cancel one another out. The liquidation puts an end to the risk positions incurred: gains and losses accumulated until liquidation are realised;
• Settlement: contracts that have not been sold off until settlement must be performed by the relevant parties. Contracts having as underlying tangible property assets may be performed by effective delivery of the assets as well as by cash settlement (although physical delivery settlement is more common) while contracts having as underlying reference rates (to the exception of currencies) cannot be performed by actual delivery of the underlying.In case of an effective delivery of the underlying, the contractual obligations need to be performed in full, whereas for cash settlement contracts, only the difference between the price agreed upon when concluding the contract and the market price upon performance of the contract is payable. Therefore, investors need more available funds for contracts providing for the actual delivery of the underlying asset than for contracts providing for cash settlement.

2.2. Advantages:

Chances of gains are important depending on the market value of the underlying upon maturity, especially because the principal amount originally invested is low. Such products may also permit to secure existing positions.

2.3. Risks:

2.3.1. Modification of the value of the contract or the underlying asset

The investor incurs a risk if the evolution of the actual value of the contract or of the underlying is not in line with the evolution forecasted by the investor when concluding the contract.

Despite a rise in the price of the contract or the underlying, the forward seller will have to deliver the underlying asset at the initially agreed upon price, which may be far lower than the current price. For the seller, the risk is equal to the difference between the price agreed upon when concluding the contract and the market value on maturity date. As the market value may theoretically rise in an unlimited manner, the loss potential for the seller is unlimited and may considerably exceed the required margins.

In case the value of the contract or the underlying asset decreases, the forward purchaser will still have to accept the underlying asset at the price agreed upon in the contract which can be potentially very much higher than the current market value. Therefore, the buyer’s risk consists in the difference between the price agreed upon when concluding the contract and the market value on the maturity date. Thus, the maximum the purchaser may lose is the initially agreed upon price. This loss may, however, exceed by far the required margins.

Transactions are regularly evaluated (mark-to-market) and the investor will need to have permanently at his disposal a sufficient margin cover. In case the margin becomes insufficient during the forward transaction, the investor will have to provide a variation margin at very short notice, failing which the transaction will be liquidated before due term, generally at loss.

2.3.2. Difficult or impossible sell-off

In order to limit excessive price fluctuations, a stock-exchange may fix price limits for certain contracts. In such a case, the investor has to keep in mind that, whenever a price limit is reached, it may be very difficult if not momentarily impossible to sell off the contract. Thus, every investor should, before entering into a forward contract, make an inquiry concerning the existence of such limits.

It will not always be possible (depending on the market and the terms and conditions of the transaction) to sell off contracts at any moment in order to avoid or to reduce the risks of a pending transaction.

Stop-loss transactions, if they are possible, may only be performed during office hours of the bank. They do not allow to limit losses to the indicated amount, but they will be performed once the threshold is reached in the market and they become at that time an order to perform such a transaction at the then current market price.

2.3.3. Purchase of the underlying in case of short sale

To sell an underlying on a forward basis without owning it when concluding the contract (short sale) entails the risk that the seller will have to buy the underlying asset at an extremely unfavorable market price in order to be able, upon maturity, to perform his obligation to deliver effectively the underlying.

2.3.4. Specific risks associated to over-the-counter transactions (OTC)

For standardized OTC transactions, the market is in general transparent and liquid. Therefore, the selling off of contracts can normally be done. However, no market exists for OTC transactions agreed individually between the purchaser and the seller. That is why the closing-out is only possible with the agreement of the other party.

2.3.5. Specific risks associated to forward exchange products

A forward exchange transaction allows the selling or the purchase of a currency at a future date and at a price fixed when the contract is concluded.

This type of investment permits to eliminate the exchange risk. Moreover, no premium has to be paid upon conclusion of the contract.

The main risk for the investor is the loss of profit in the event the evolution of market rates is more favorable than the evolution of exchange rates anticipated when concluding the contract.

2.3.6. Specific risks associated to combined transactions

The number of possible combinations is important. Therefore, the risks involved by any particular combination cannot be described in the present document. Consequently, the investor must inquire about the specific risks associated to the contemplated combination.

It can nonetheless be noted that, generally, the risks associated to such combined transactions may vary when elements of this combination are sold off.

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