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INTRODUCTION
One can easily be overwhelmed by the apparently countless types of
derivative contract traded in the marketplace. The pages of the Wall
Street Journal list the prices of tens of thousands of standardised,
exchange-traded futures, options and future options contracts on hundreds
of underlying assets. And this only begins to scratch the surface. The
Wall Street Journal reports only trading summaries for U.S. derivative
exchanges. Other exchanges worldwide have derivatives trading volume
roughly equal to that in the United States. Moreover, the notional amount
of exchange-traded derivatives worldwide represents only about 16% of all
derivatives outstanding and about 84% of derivatives are private contracts
arranged with banks and various financial houses (Whaley 2006). Further
according to Whaley (2006), many of these contracts are plain-vanilla
forwards, swaps, caps, collars, or floors, as well as inverse floaters,
protected equity notes, ration swaps, time swaps, knockout options, spread
locks, wedding-band swaps, and the like.
Much of the business of the derivatives market is transacted
in the UK and the USA. As presented by Swan (2000), the largest share of
the business (26.9 percent) was being transacted in the UK as of April
1995, the daily transaction turnover is reported to be $590 billion and
the trade is approximately earning $5.9 billion in revenue for UK.
Derivative products are perceived as a high risk investment. When using
futures to hedge, the risk stems not from potential loss of capital, but
rather from potential loss of opportunity (Fouque, Papanicolaou & Sircar 2000).
There are two main futures markets for cocoa – the London International
Financial Futures and Options Exchange (Euronext.liffe), and the Coffee,
Sugar, and Cocoa Exchange (CSCE) in New York. The two contracts
demonstrate a strong correlation but still offer arbitrage possibilities
(Taylor 2006). Both the LIFFE and CSCE contracts are long established and
represent a high proportion of worldwide trade. This paper, however, will
be focusing only on LIFFE as the futures market for cocoa in the UK.
FUTURES CONTRACT
Futures have been around in various guises for around 100 years according
to Taylor (2006) and are originally based on agricultural commodities but
are now of many different types. It was in the early 1970’s that futures
became respectable, with the opening of ‘regulated exchanges’ around the
world. McDonald (2005) noted that the two oldest changes are both American
and both based in Chicago: the Chicago Mercantile Exchange (CME) and the
Chicago Board of Trade (CBOT). In the 1980’s other countries followed suit
and opened their own exchanges, the London International Financial Futures
Exchange (LIFFE) opened in 1982, followed four years later by the Marchè à
Terme International Francais (MATIF) in 1986, and there now seems to be at
least one new exchange opened every year (Fouque, Papanicolaou & Sircar
2000). There are now over forty exchanges worldwide, with each trading a
particular selection of contracts. The financial future is the building
block for interest rate exposure management technique (derivatives).
Futures are primarily used by banks, other financial institutions and
large multinational companies to hedge and trade interest rate positions.
A futures contract is identical to a forward contract. The
only difference is that the gains and/or losses on a future position are
posted each day (Whaley 2006). The price associated with this commitment
is the trade entry level. The essence of a futures market is in its name:
Trading involves a commodity or financial instrument for a future delivery
date, as opposed to the present time (Schwager 1984). Thus, if a cocoa
farmer wished to make a current sale, he would sell his crop in the local
cash market. However, if the same farmer wanted to lock in a price for an
anticipated future sale, he could locate an interested buyer and negotiate
a contract specifying the price and other details, or, he could sell
futures. Until the early 1970’s, futures markets were restricted to
commodities but since that time, the futures are has expanded to
incorporate three additional market sectors, namely: currencies, interest
rate instruments and stock indexes (Schwager 1984).
FORWARD CONTRACT
As defined by Whaley (2006), a forward is a contract to buy or sell an
underlying asset at some pre-specified future date at a price agreed upon
today. No money changes hands until the expiration date, at which time the
buyer pays the amount of cash specified in the contract and the seller
delivers the underlying asset. Forward currency markets reduce the risk
associated with foreign trade to the extent that importers’ demand for and
exporters’ supply of foreign currency are matched in the market at a given
exchange rate, or the risk is shifted to agents whoa re wiling to assume
it (Quirk 1988). It is well known by now, and formalised in various
capital asset pricing theories, that the required return on any
transaction is positively related to its level of risk. A reduction in
exchange risk should therefore reduce the profit margins required to
conduct foreign and should lower the costs of imports and exports. The
nature of the distribution of price risks among contracting parties is not
the same for all kinds of derivatives. For forwards, it is symmetric: the
risk of loss for the one mirrors the chance of profit for the other
(McDonald 2005). Interesting examples of forward contracts are the
benchmark contracts for base metals on the London Metal Exchange (LME).
Although these are contracts traded on an exchange with some degree of
transparency, the contracts are for 3 moths where market players can take
positions for any business day out to 3 months forward (UK Reuters Ltd.
1999). This is a similar situation to that found in the over-the-counter
(OTC) Forward FX markets.
OPTIONS/SWAP
An option, like the forward, is a contract to buy or sell an
underlying asset at some pre-specified future date at a price agrees upon
today. Unlike a forward, however, the buyer of the option has the right
but not the obligation to buy or sell the underlying asset at the option’s
expiration (Whaley 2006). The seller’s obligation depends on whether or
not the buyer chooses to exercise the option. The model most widely used
in options pricing is the Black-Scholes approach. It is based on the
following assumptions: it is possible to trade continuously in the market;
there are no price jumps; there is a risk-free rate of interest for
borrowing and lending which is constant over the whole life of the option;
there are neither transaction costs nor taxes; the price of the underlying
asset is log-normally distributed (Walmsley 1996). Under these
assumptions, the option price is determined by a formula containing the
current price of the underlying instrument, the options exercise price,
its remaining life time, the level of interest rates and the projected
volatility of the underlying instrument. Those five factors combine in a
way that, in contrast to most other financial instruments, the
relationship between the position value and the market rate becomes
non-linear, and expected changes in value can no longer simply be
calculated by multiplying estimated changes in rates by a given constant
sensitivity of the position to changing rates as in traditional risk
analyses (Morgan 1995).
A swap,
on the other hand, is an agreement between tow parties to exchange
sequences of cash flows over a period in the future, and the parties that
agree to the swap are known as counterparties (Kolb 2003). The cash flows
that the counterparties make are generally tied to the value of debt
instruments or to the value of foreign currencies (Taylor 2006). According
to Kolb (2003), in large part, the swap market has emerged because swaps
escape many of the limitations inherent in futures and exchange-traded
options markets. Swaps are custom-tailored
to the needs of the counterparties (Hull 2005). If they wish, the
potential counterparties can start with a blank sheet of paper
and
develop a contract that is completely dedicated to meeting their
particular needs, thus, swap agreements are more likely to meet the
specific needs of the counterparties than exchange-traded instruments. |
