Every financial market involves risk for the market user, but there are some markets whose main function is the redistribution of risk. On the one hand, they are the riskiest markets of all. On the other, they are markets in which risks can be reduced or eliminated. These are the options and futures markets, which come under the general heading of markets in derivative products or derivatives. These markets are not the only places where derivative products are bought and sold. We saw earlier that the banks undertake large volumes of ‘over-the-counter’ derivatives business direct with their customers in products such as swaps and interest rate caps (see Chapters 14, 15 and 17). But it is the public derivatives markets that are most frequently reported in the press.
The customers who use these markets fall into two main categories: those who want to hedge (guard against) a risk to which they are exposed in the normal course of their business. And those who are prepared to accept a high risk in return for the possibility of large rewards: the traders or speculators.
Following the collapse in February 1995 of the City of London’s oldest merchant bank, Barings, as a result of losses in the derivatives markets, awareness of derivatives has spread far beyond the readers of the financial pages. But judging from much of the press and television reporting at the time, there is considerable confusion as to what derivatives are. Yet the principle behind derivative products is a very old one. All that is new is the recent explosive growth in the derivative markets and in the range of products that are dealt in them. So let us start from basic principles.
First, why the term ‘derivatives’? Answer: because they are financial products derived from some other existing product. Shares, bonds, currencies and commodities such as cocoa or zinc are all existing products. There are markets in which they can be bought and sold. It is not too difficult to understand what they are.
And today there are derivatives based on these existing products. The derivatives give the right (and perhaps the obligation) to buy or sell a quantity of one of these existing products at some point in the future. Or to benefit in some other way from a rise or fall in the price of one of these existing products.
Perhaps the best approach is to look at derivatives in terms of a bet (and there are, in fact, bookmakers who will offer you a bet on the movement in a market index). Suppose you think that share prices are going to rise. You could, of course, buy shares to make a profit from the rise that you think is coming. But you would need quite a lot of cash for a worthwhile investment. Alternatively, you could find somebody who is prepared to bet against your view of the market: somebody who does not think that the market will rise as fast as you do or who thinks it is going to fall. So you agree with this person that he will pay you £1 for every percentage point by which the generally accepted stockmarket index rises above an agreed starting point within, say, three months. The other side of the coin is that you agree to pay him £1 for every percentage point by which the stockmarket index might fall below an agreed starting point. In practice of course, you would probably be betting much larger amounts: perhaps £10,000 for every percentage point by which the index rises or falls. But the attraction of the system is that you do not have to put up much cash at the outset when you make your bet. You will be required to pay a small deposit or margin for safety. However, if the bet goes against you and the market starts moving in the opposite way to that you had expected, you might be required to provide considerably more cash or else cancel your bet and accept your losses to date. Equally, if the bet is going your way you could decide to take your profits at any time within the three months by cancelling it.
What we have described here is not the way the futures markets work in practice. The mechanics are rather different. But the principle and the effect are much as described in our example. There is an opportunity to make or lose very large sums of money very quickly for a relatively modest initial cash outlay. The same principle underlies many of the over-the-counter or OTC derivative products that are sold by banks rather than traded in a market.
Now take a different approach. Again, you want to take a bet on your belief that share prices will rise. You think that there is a good chance that the stockmarket index will rise by 10 per cent within three months. Suppose the present level of the index is 100. You bet somebody £1 that the index will rise above 104 within three months. For every percentage point that it rises above 104, he will pay you 50p. So if it rises to 110 as you expect, you will collect £3 (50p multiplied by 6) in return for your £1 stake: a £2 profit or a 200 per cent return on your £1 outlay. If you are wrong and the index does not rise above 104, you will have lost your £1 stake money. But that is all that you will have lost.
What we have just described is the principle behind an option. Again, the mechanics of a real options market are a little different and the sums involved are usually much larger. But there is an important difference to note between futures and options. In a futures market you can end up losing a great deal more than your original cash stake, as merchant bank Barings found out. But in an options market a buyer of options knows that his loss is limited to his original stake. In our example, the maximum loss is £1 (the potential losses for the person who creates or writes the option that you buy can, of course, be much larger).
We have also talked throughout in terms of a ‘bet’, and the options and futures markets can indeed be used for wild betting. But in many circumstances it would be more accurate to talk of our ‘bet’ as an ‘insurance policy’. Suppose our investor is an institution that knows that it will have £5m to invest in shares in three months’ time. It thinks that the market is going to rise and there is a risk that it will have to pay a lot more for the shares by the time it has the money available. For a relatively modest outlay today it could buy options on the stockmarket index. If share prices do rise, it will have to pay more for its shares when the £5m is available. But it will have made a profit on its options that it can offset against this higher cost. The stake money spent on buying the options has served as an insurance premium. The futures markets can be used to insure against future price movements in the same way.
If the principles behind futures and options are relatively simple, the mechanics are inevitably more complex. Our best starting point is the forward commodity markets where the techniques evolved.
To focus on the essential elements rather than the detail of any particular derivative, we will invent a physical product – call it ‘commoditum’ – and imagine it is a relatively common metal used in many manufacturing processes.
There is a free market in which commoditum can be bought and sold. In the usual way, the price of commoditum will rise or fall depending on the balance between buyers and sellers in this market, and it can fluctuate quite widely. The mining companies that produce commoditum obviously want as high a price as possible for their product. Conversely, the manufacturers who use commoditum in their products want to buy it as cheaply as possible. But both producers and users of commoditum may have one clear interest in common: there are times when both of them will want to reduce the uncertainty as to price. The producer cannot plan his production of commoditum efficiently if he does not know whether he will get £500 or £1,500 per ton when he has stocks ready to sell in six months. The manufacturers who use commoditum in their products cannot budget efficiently if they do not know whether they will have to pay £500 or £1,500 per ton when they next need to restock on commoditum in six months.
So it could pay both sides to reduce or eliminate the uncertainty. How can they do this? One way would be for the producer and the manufacturer to agree today the price at which the one will supply and the other will buy commoditum in six months’ time. Suppose today’s price for commoditum for immediate delivery (technically, the spot price) is £1,000 per ton. Both sides think that the price is more likely to rise than to fall over the coming six months, though the possibility of a fall cannot be discounted. And after much haggling, they eventually compromise on a price of £1,100 per ton for the commoditum to be delivered in six months. The producer commits himself to selling 20 tons at £1,100 per ton in six months and the manufacturer commits himself to buying 20 tons at £1,100 per ton in six months.
Who wins and who loses from this arrangement depends on what actually happens to the price of commoditum in the market over this six months. If the price for immediate delivery has fallen to £900 per ton by the end of six months, the manufacturer will find himself paying £1,100 per ton for something he could have bought in the market at £900 and he will have lost. The producer, on the other hand will have gained. If the spot commoditum price is £1,400 per ton after six months, the producer will have lost by agreeing in advance to deliver at only £1,100 per ton and the manufacturer will have saved himself a lot of money.
However, both sides to the transaction will have removed uncertainty. They will have had a known price on which to base their planning. And it was to provide this certainty that the forward markets evolved. A forward market is one where buyers and sellers can establish a price for a product to be delivered at a specific date in the future. We took as our example a transaction in commoditum to be delivered in six months. But it could equally well have been commoditum for delivery in three months or nine months. Thus, in these forward markets, a range of prices will be quoted. We might talk of the price for ‘three months’ commoditum’ (commoditum for delivery in three months), ‘six months’ commoditum’, ‘nine months’ commoditum’, and so on. And we also assumed a single transaction between one commoditum producer and one buyer. In practice, there will be a number of people prepared to offer commoditum for delivery in six months and a number of potential buyers of commoditum for delivery in six months. The price of ‘six months’ commoditum’ will reflect the views of all these potential sellers and buyers.
This principle of buying and selling for future delivery has characterized the markets in physical commodities – mainly metals and staple foodstuffs – for generations. It has also been a feature of the foreign exchange market, where prices can be agreed today for foreign currencies that are to be delivered in the future (effectively the parties thus ‘lock into’ a known exchange rate). But all of this still seems some way removed from the forces that destroyed the Barings merchant bank in 1995.
To understand this, we have to follow the evolution of the markets a stage further. If forward markets are a very old concept, futures markets are a somewhat more recent one, though the underlying principles are very similar. In the forward markets, buyers and sellers can agree the price for a product to be delivered at any point in the future. It could be for delivery in two-and-a-half months or for delivery in 30 weeks. In futures markets, the agreements are standardized. Suppose we are looking at a market in commoditum futures from the standpoint of a date early in April. We might see that you can buy or sell a contract for delivery of commoditum in May, July, September, November or in January of the following year.
Not only the delivery dates are standardized; so are the terms and conditions of the contract. The standard contracts are, let us suppose, for delivery of ten tons of commoditum on one of the dates we have mentioned. The contracts relate to commoditum of a standard quality and purity. Thus, somebody who buys one commoditum contract for September delivery is, in theory, agreeing to take delivery of ten tons of commoditum on a specified date in September. The seller of a September commoditum contract is, again in theory, agreeing to deliver ten tons of the standard grade commoditum on the specified date in September.
How is the price established? Again, it is by the interplay of buyers and sellers in the market, but the mechanics are a little different from the simple forward market. In our hypothetical futures market, participants can buy and sell the September commoditum contract (and, of course, the May commoditum contract, the July contract and all the rest). The price of a September commoditum contract at any given time will thus reflect the balance between buyers and sellers of that particular contract at the time. If, subsequently, more buyers emerge, the price is likely to go up. If more sellers emerge, it will probably go down.
Let us suppose, as with our forward market example, that we are looking at the position from a standpoint at the beginning of April and that the spot price of commoditum at that point is again £1,000 per ton. A contract for immediate delivery of ten tons of commoditum would thus have a value of £10,000 at that point. And let us assume that a contract for delivery in September stands in the market at a price of £11,000. Anybody who buys the September commoditum contract is thus in theory agreeing a price of £11,000 for ten tons of commoditum to be delivered in September. Anybody who sells the September commoditum contract is in theory agreeing to supply ten tons of commoditum in September at a price of £11,000.
The important point to remember is that the September commoditum contract is itself a form of security that can be bought and sold in a market. It is not the same thing as the commoditum metal itself. But it is a derivative of commoditum whose market price at any given time will be largely influenced by buyers’ and sellers’ views of the outlook for the commoditum price. Once you grasp this fact, you can see how the principle can be extended to other types of product. Why not have a futures contract for delivery of a nominal £100,000-worth of a standard type of government bond in September? Or a basket of shares in companies? Or a standard amount of a foreign currency: US dollars, for example?
In practice, this is what has happened. Financial futures markets in a whole range of financial products have sprung up and expanded enormously in recent years. They are markets which the participants can use effectively to fix the price they will pay or receive for bonds, shares and currencies in the future. As such, they can be used to offset many of the financial risks that crop up inevitably in the course of business. But they can also be used for gambling on a massive scale. We are getting closer to the events that brought down the Barings merchant bank in 1995. But before turning to financial futures, there are a few further fundamental concepts that we can illustrate more easily with our example of commoditum futures.
First, why should a market in derivatives be any more dangerous than a market in the underlying products? Why should it be more dangerous to buy commoditum futures than the commoditum metal itself? Or government bond futures rather than investing in government bonds? The answer is that it need not be more dangerous, but that it very often is. And the main reason is gearing (or leverage in the American terminology) built into futures markets.
Let us go back to our September commoditum futures contract. The contract, remember, is for ten tons of commoditum to be delivered in September. And, as of the beginning of April, the price of this contract in the market is £11,000. The vital point, however, is that a buyer of this contract does not have to put up £11,000 when he purchases it. At that stage he only has to put up a relatively small deposit or margin. It might be 10 per cent of the value of the contract. In financial futures markets it might be as low as 1 per cent (sellers of contracts, incidentally, will also have to provide a margin).
For our example we will stick with 10 per cent. The bulk of the contract price does not become due until the contract matures (in September, in our example). So our buyer of one contract has to put up £1,100 of initial margin. In return, he is exposed to the profit or loss on £11,000-worth of commoditum. Suppose by September the price of commoditum for immediate delivery has risen to £1,400 per ton. The contract for September delivery of ten tons of the metal is now worth £14,000. Our buyer of the contract has made a profit of £3,000 (the £14,000 current value of the contract less the £11,000 he originally agreed to pay for it). But the startling point is that he has made this profit on a cash outlay of only £1,100: the initial margin that he had to provide. His return on this cash outlay is thus about 273 per cent.
In this case everything went well. But what if the commoditum price began falling shortly after he bought the September contract for £11,000 in April? Suppose the price of the September contract was down to £9,900 by early June. On paper, he has a loss of £1,100. This has completely wiped out the initial £1,100 deposit or margin that he provided, and he will have been required to provide further margin – another £1,000, say – to top up his margin after the paper losses. If he could not or did not meet this margin call (provide the further cash margin), the exchange would simply have closed him out. In other words, his contract would effectively have been cancelled by the exchange and his paper losses would have become real ones. This is why exchanges always insist on a margin and insist that it is kept topped up. It is to ensure that the investor or speculator has always provided a sufficient safety cushion to cover any losses.
In our example, the purchaser of the September commoditum contract might have taken the view that the price fall in June was just a temporary blip and that the price would rise again by September to give him his expected profit. In this case he would have wanted to provide the further margin to ‘stay in the game’. But note that futures markets have an element of a poker game. You may be pretty confident that you have a winning hand. But unless you have a big enough cash stake to be able to stay in the game, you could still lose.
Now, our example so far has assumed that the buyer of the September commoditum contract had intended to hold it until it became due in September. But there is no reason why this should necessarily be the case. If the price of the commoditum contract for September delivery had risen to £13,000 by late July, he might well have decided to take his profit at this point. How would he take his profit? By selling an identical September commoditum contract for £13,000 in late July. His profit then (less expenses, of course) is the £13,000 he receives from selling a contract less the £11,000 he had agreed to pay originally to buy one. But in reality, as we saw, he had never had to put up the full price in cash. What happens in practice is that he simply receives a cheque for his profit and the return of his margin.
Thus, no commoditum has changed hands. There has been no transfer of the physical metal from a seller to a buyer. And this is an aspect that newcomers to the futures markets often find difficult to grasp. In practice, futures markets very rarely result in physical delivery of the underlying product (the London Metal Exchange is a little different in this respect). They are a mechanism for determining the price of a product at various delivery dates. They are a mechanism for allowing participants to benefit (or lose) from the rise or fall in the price of an underlying product. But they are not generally markets for distribution of a physical product. Gains or losses are settled in cash.
And the markets can be used equally well to profit from a fall in the value of a product as from a rise. Somebody betting on a fall in the value of commoditum (or a rise less than the market was expecting) would sell a contract rather than buying one. Suppose that in April he sold a September commoditum contract at £11,000. And suppose that the price of this contract then duly fell to £9,000 by, say, July. He could then buy a contract at £9,000 and collect a profit of £2,000.
The point to remember is that the contract is the same, whether you are buying it or selling it. In theory, if you buy you are agreeing to take delivery of ten tons of commoditum in September. If you sell, you are agreeing in theory to deliver ten tons of commoditum in September. In practice, you realize your profit or loss by closing your position: doing the opposite of what you had done at the outset. If you had originally bought a contract, you close the position by selling an identical contract. Thus in theory you had originally agreed to take delivery of ten tons of commoditum and by selling a contract later you agree in theory to deliver ten tons of commoditum. The two obligations cancel each other, so no commoditum needs to change hands. Likewise, if you had sold a contract at the outset, you close the position later by buying a contract.
The extension of the futures principle to purely financial products was, perhaps, inevitable. It enables participants to take bets on (or protect themselves against) rises or falls in the value of the underlying products. These products might be government bonds, interest rates, currencies or shares. If the principle of an interest rate future sounds a bit odd, do not worry too much about the detail. In effect, a hypothetical futures contract is constructed, whose spot value rises or falls according to whether the interest rate in question moves down or up (the market price of a contract for future delivery is, of course, determined by buyers and sellers in the normal way).
You will often notice in the financial press that commentators report on what is happening in the futures market as a prelude to what might happen in the cash market. Suppose there is some news that might be judged good for gilt-edged stocks (UK government bonds). Speculators who want to profit from a rise in gilt-edged stocks might be inclined to buy gilt-edged futures in the first instance, because they will get a bigger percentage profit from any given price movement than they would by buying the gilt-edged stocks themselves in the stock market (the cash market). Thus the price of the gilt-edged futures contract might begin moving up and suggest that the prices of gilt-edged stocks themselves in the cash market might shortly follow suit.
The workings of options are probably easier to understand at the outset than those of futures, though in both cases the trading strategies followed by professionals in the market may be very complex. Start with a traditional option on shares. An option in this case is the right to buy or the right to sell a share within a stipulated time period at a price that is fixed when the option is bought. Technically, this is an American option, but it is the most common kind in Britain. The so-called European option is different in that it may only be exercised on a specific date, rather than at any point up to expiry.
Say that you decide at the beginning of April that the shares of XYZ Holdings are likely to rise sharply within the next month or so. The current price is 100p and you think it might well rise to 130p by the end of June. You could, of course, buy 10,000 of the shares for £10,000, and if you are right your 10,000 shares will be worth £13,000 within three months: a profit of £3,000, or 30 per cent on your outlay. But you need to have £10,000 to do it, and though the value of the XYZ shares is unlikely to fall to nothing, you are in theory putting the whole £10,000 at risk.
Instead, you might consider it was worth paying, say, 10p per share for an option that gave you the right to buy a share in XYZ for 105p at any time over the next three months. If the XYZ share price stays at 100p, the option has no value and you lose the 10p premium you paid. But this is the most you can lose. If the share price does rise to 130p, then your option clearly has a value and is worth exercising: you have the right to buy for 105p a share that you could resell for 130p.
Suppose you had bought options on 10,000 XYZ shares. The total cost at 10p per share would have been £1,000. If, once the price has risen, you exercise your option to buy the 10,000 shares at 105p and immediately resell them at 130p, your profit is £13,000 less £10,500. So you make £2,500 but against this you have to offset the £1,000 cost of your options. But this still leaves a profit of £1,500 (before expenses) on an outlay of only £1,000, or a profit of 150 per cent: considerably better than if you had simply bought the shares. The point to note is that options are a very highly geared investment. A comparatively small movement in the share price results in a proportionately far larger movement in the value of the option.
But there is another side to the bargain. Who was prepared to agree to sell XYZ shares at 105p if you exercised your option? It was probably an owner of XYZ shares who took a different view from you of what the price was likely to do. He took the view that XYZ shares were pretty fully valued at 100p and that he would be prepared to sell at this price or a little above. But instead of selling at 100p today, he could create or write an option and charge 10p for it: the option you bought.
If the price of the shares failed to reach 105p, the option would not be exercised and he would hang on to his shares; but he would have an extra 10p per share in the kitty to set against any fall in the share price. If the price rose above 105p and the option was exercised, he would be obliged to part with his XYZ shares at 105p. But he would really be getting 115p, because he has the 10p premium as well. So by getting 10p for the option he has reduced by 10p his possible paper loss if the XYZ share price falls. He has also limited his possible profit if the XYZ price rises, because the maximum he gets is 115p: 105p for the share and 10p for the option. He has written options as a way of hedging his risk: limiting his possible loss but also restricting his possible profit.
Remember that in futures you buy a contract if you are betting on a price rise and you sell a contract if you are betting on a fall. The contract itself is the same in either case. With options, too, you can bet on rising or on falling prices. But in both cases you buy an option: it is the option itself that is different. If you are bullish you buy a call option (we assumed a call option in the example above) which gives you the right to buy shares at a pre-determined price. If you are bearish, you buy a put option which gives you the right to sell shares at a pre-determined price.
The traditional options to buy or sell shares that we have been describing so far are arranged with one of the stockbrokers specializing in this business. You can take out call or put options, or double options which give you the right to buy or sell.
More prominent today is the London market in traded options, now operated by Liffe (see below). The principle of traded options is clear enough if we go back to the example of XYZ Co. You paid 10p for the right to buy an XYZ share at 105p within the next three months. You exercised the option if the XYZ price rose above 105p. If it did not rise, the option expired valueless and you lost the whole of your money.
A traded option differs from the traditional type in that you can buy and sell the option itself, much as if it were a share. Again, it has become a tradable derivative product. Suppose after a month the XYZ share price rose from 100p to 110p. The call option for which you paid 10p now has intrinsic value, because it gives you the right to buy a share at a price (105p) below its current value (110p). So the option itself is now almost certainly worth more than the 10p you paid for it. Reflecting the rise in the share price, it might now be worth, say, 15p. So you could sell it at this point and take your profit without needing to exercise it. If the XYZ share price had fallen, the value of the option would also have fallen, but you would have had the chance of selling the option and recouping some of your outlay.
The 10p you paid originally for your XYZ traded option was all hope value or time value. There was no intrinsic value initially in an option giving the right to buy a share at 105p (the exercise price) when the share price was 100p. In the market jargon, the option was out of the money. If, on the other hand, it had been a call option to buy an XYZ share at 105p when the share price was 110p, it would have been in the money – it would already have had intrinsic value. An option to buy a share at 105p when the share price is 105p is at the money – exercise price and market price of the shares are the same. With put options this works the other way round; the option is in the money when the market price is below the exercise price.
Example 18.1 Traded options on shares of UK companies, traded on Liffe in London. Source: Financial Times.
The time value in an option erodes throughout its life. It may be worth paying 10p for the chance that a share price will rise by the required amount some time in the next three months. It would probably not be worth paying the same if the option only had a week to run. So the market price of an option will usually drop gradually with the passage of time unless the market price of the underlying share moves the right way (up for a call option and down for a put).
While we have seen that the buyer of an option on shares – unlike the buyer of a futures contract – at least knows what his maximum loss will be, even this market can offer massive losses for the writer or creator of options. Again, selling options on shares that you own can be a conservative hedging strategy. But naked option writing – selling options when you do not have an existing position to hedge – is a very different matter. Perhaps the most dangerous technique of all is naked writing of put options.
Towards the end of London’s stockmarket boom of the 1980s, many small investors were wrongly advised that they could make risk-free money by writing deep out-of-the-money put options on UK shares. In other words, for a premium of a few pence per share they contracted to buy, if required to do so, the underlying shares at a price fixed at a level 25 per cent or more below market prices at the time. The possibility that the market would fall that far was judged so remote as to be negligible. Then came the crash of October 1987 (see Chapter 7b) with shares in Britain falling more than 36 per cent from their peak. The option writers were thus obliged to buy shares at a price way above their market value, landing many of them with losses that far outran their total financial resources. Lesson: unless you are a financial institution with very deep pockets, do not write naked options.
There is little doubt that our naked option writers were speculating –though they may not have realized it until too late. However, the examples that are usually quoted of futures and options market techniques will tend to stress the hedging nature of the operation: using these markets to protect against an existing business risk. But where should we draw the dividing line between hedgers and speculators?
Let us look at the distinction in the context of the futures markets. In our example of commoditum futures, both parties to the transaction had a position to hedge. The producer was going to have commoditum to sell and wanted to lock into a known price. The manufacturer was going to have to buy commoditum and wanted to lock into a known price. Both were hedging a known risk. If the commoditum price rose, the manufacturer would pay more for his product but he would have a profit on the futures contract he had bought to compensate him. If it fell, the producer would be offsetting a profit from the futures contract he had sold against the lower price he received from selling his physical commoditum.
But our manufacturer could equally well have bought his commoditum futures contract from a speculator rather than a producer. This speculator might never have handled commoditum in his life. He might not even know what it looked like. No matter; he follows the movements of the commoditum market and, because he thinks the price is going to fall, he sells a contract. Since he has no commoditum to sell, his position is unhedged. If he loses on the futures contract, he will not have profits on the physical metal to offset against his losses. In practice, there are various ways he might hedge his position to some degree in the futures market, but we will ignore these. He is taking a very big risk.
If he sold the September contract at £11,000 and the price fell to £9,000 by September, well and good. He has made £2,000 profit on a small outlay. But what if an explosion puts the world’s biggest commoditum mine out of action and serious shortages of the metal threaten? The price could rocket. Suppose the price of the September contract more than doubles to £24,000. He will have to buy a contract at £24,000 to satisfy his obligation to deliver at £11,000: a £13,000 loss. And he has no protection from ownership of stocks of physical commoditum, which would have risen massively in value.
Straight bets of this kind – though in the financial futures market – appear to have been behind the collapse of the Barings merchant bank in early 1995. In this case the bank’s trading operation in Singapore was betting on a rise, not on a fall. So it was buying contracts rather than selling them. It was taking the bets on its own account: so-called proprietary (or own-account) trading. And the main ‘product’ on which it was betting was a Tokyo stockmarket index. It bought futures contracts whose value would rise if the Nikkei index of Japanese shares rose. Instead, pushed partly by the Kobe earthquake, it dropped like a stone. The bets were not taken to hedge an existing holding of Japanese shares. Since the value of the shares represented by the futures contracts was many billions of pounds, it was unlikely that they could have been. Estimates of the bank’s losses on futures contracts ranged from £800m upwards and Barings was wiped out as an independent entity.
Financial derivatives are traded in two main ways. There are the over-the-counter or OTC derivative products that are created and sold mainly by banks (see Chapter 14) and may be tailored to a client’s individual requirements. And there are the standardized derivative products that are traded in specific futures markets. It is the latter that we are concerned with here and in the UK the futures market most closely related to the securities markets is the London International Financial Futures and Options Exchange or Liffe (pronounced ‘life’). It is one of the largest in the world, though has always ranked after the Chicago Board of Trade and the Chicago Mercantile Exchange in the United States. Financial futures are a fast-moving business in every sense. New contracts are introduced quite frequently and dropped if they do not attract the requisite interest. Likewise, the different futures exchanges compete strongly with each other and swings in their relative status can take place rapidly. In the late 1990s Liffe found itself under competitive pressure from the European Eurex market, a joint venture of the German and Swiss stock exchanges but with trading links to other futures markets. This promoted a revamp of Liffe and a move from its traditional ‘open outcry’ trading system to a more modern electronic system (see below). At the end of the century Liffe’s products spanned five different currencies and it offered derivative products based on bonds, short-term interest rates, swaps, equities and equity indices and commodities. It had taken over the Traded Options Market (offering options on shares in leading companies), which was originally part of the London Stock Exchange, and had also acquired the London Commodity Exchange, dealing in futures on soft (foodstuff) commodities such as cocoa, coffee, white sugar and others. Liffe also operated the BIFFEX market in freight futures, originally the province of the Baltic Exchange.
The members of Liffe are mainly subsidiaries of financial institutions – banks, discount houses, stockbrokers – but also include individual traders or locals who trade on their own account. Liffe now uses an electronic trading system called Liffe Connect for most of its financial products, which may have brought efficiency gains but has done away with one of the more colourful spectacles for visitors to London’s financial markets. The old ‘open outcry’ system involved traders in garish jackets (the different colours and patterns identifying their parent firm) yelling and signalling to each across the various pitches on the trading floor. At busy periods the appearance was that of bedlam.
Just as commodity futures can be used to hedge an existing risk or to take a straightforward bet, so can financial futures. Each contract is structured differently from the others, but the long gilt contract on Liffe will illustrate the principle.
The size of this contract is a nominal £100,000 and the price is expressed in terms of a nominal £100-worth of a notional 7 per cent long-dated government stock. The minimum step by which the price can move (a tick) is 0.01 per cent and 0.01 per cent of £100,000 is £10. The buyer of a contract is theoretically buying a nominal £100,000 of gilt-edged stock for delivery in the future: let us say June.
If long-term interest rates fall, the market value of the June contract is likely to rise because gilt-edged stocks will rise in value. Suppose an investor had bought the contract at 110.31. If the price later rose to 113.22, he could sell a contract at 113.22 to close his position. He would have a profit of 291 ticks which, at £10 per tick, represents a gain of £2,910. The initial margin on the long gilt contract is – at the time of writing – £1,500, so anyone who had bought a contract would have a profit of 94 per cent. Financial futures contracts very rarely result in physical delivery. The purchaser of a contract simply closes his position by selling an identical contract and taking his profit or his loss.
The same principle applies to the contracts in interest rates or the FTSE equity index. By using futures it is possible to hedge against a rise in interest rates: the value of an interest rate contract falls if interest rates move up, much as with a gilts contract. So you buy a contract if you are betting on a fall in interest rates and sell if you expect a rise. The techniques available to the futures trader can be highly complex. But the most important point in terms of press comment is that price movements in the futures market will sometimes give advance warning of likely price trends in the stockmarket itself (the cash market) or in interest rates.
The market in traded options offers options on the shares of some 75 leading companies, including the major privatization stocks. It also offers options as well as futures on the FTSE 100 Index (the Footsie Index) and a range of other UK and international equity indices. The Footsie is the index of 100 leading UK shares and the option is thus a way of betting on the movement of the market as a whole.
Example 18.2 Futures contracts and options on government bonds in various markets. Source: Financial Times.
For each individual company there are options with different exercise prices. The Financial Times carries a table of them headed Liffe equity options. The exercise price is shown in the column immediately following the company name, and prices are given for call and put options at each price. The idea is to have at least one out of the money and one in the money option for each company. And at each price there are options with differing lives. They normally run initially for three, six or nine months. Once the life of the three-month option has expired, the six-month option will only have three months’ life left, the previous nine-month option will only have six months’ and a new nine-month option will be created. Options in British Telecom, say, have expiry dates in February, May, August and November – only three being available at one time. Others follow a different cycle to prevent all options having the same expiry dates.
Example 18.3 Prices of ‘soft’ commodities for future delivery. Source: Financial Times.
The price quoted is the middle price for an option on a single share, but deals are in contracts which normally consist of options on 1,000 shares. Under the name of the company is shown the previous day’s price for the shares themselves.
Because of the gearing, price swings in traded options can be very large and can happen very fast. There are theoretical models for calculating what the price of an option should be relative to the underlying share price, and professionals deal actively to take advantage of small anomalies. Activity is sometimes very heavy in options of companies in the news – particularly takeover candidates.
London’s main commodity markets divide between the metals and the soft commodities. Metals are traded on the London Metal Exchange (LME) and, as we saw, the soft commodities are now part of Liffe.
Copper, lead, zinc, nickel, tin, silver, aluminium and aluminium alloy, are traded on the LME, which is the centre of world trading in the non-ferrous metals. Trading is carried out by the ring-dealing members who transact their own or their clients’ orders on an open outcry basis in trading sessions that last five minutes for each metal and take place four times a day. The official price for the metal for the day is the price ruling at the end of the morning session. After the metals have been traded individually, there is a kerb trading session in which any of the metals can be traded. But, as well as ring trading, there is also extensive dealing on the telephone by ring-dealing members and brokers before and after the official sessions, effectively giving 24-hour trading coverage.
In addition to the ring-dealing members, there are commission houses which offer a brokerage service to would-be investors or speculators in commodities. They channel their business through a ring-dealing member.
Example 18.4 Cash and three-months’ prices for some of the metals traded on the London Metal Exchange. Source: Financial Times.
Trading on the LME is a mix of physical and forward or futures business. A price is established for each metal for immediate delivery (the cash price or spot price) and also a price for delivery in three months. Prices may also be agreed for any period between, and nowadays it is also possible to deal up to 27 months ahead in some metals. The futures price is for a standard contract (25 tonnes in the case of copper) of metal of a defined grade. There are also official LME traded options on futures contracts, which have been a growth area in recent years. The Financial Times shows both the cash and three-months’ prices for the LME metals and the movement on the day. Usually the three-months’ price is higher than the cash price (contango) because the buyer is avoiding financing costs for three months. Backwardation is the situation where the cash price exceeds the three-months’ price.
London also houses Europe’s leading energy exchange. The International Petroleum Exchange (IPE) offers futures contracts and, in some cases, options on a range of petroleum products: Brent crude, gas oil, natural gas and fuel oil.
The Baltic Exchange is the traditional market for negotiation of shipping freight, though the freight futures contract has, as we saw, now moved to Liffe.
Liffe has an informative website at www.liffe.com/ and Eurex, the European derivatives exchange, is at www.eurexchange.com/. The International Petroleum Exchange has a site at www.ipe.uk.com/. The Chicago Board of Trade is at www.cbot.com/ and Chicago Board Options Exchange at www.cboe.com/. Information on the London Metal Exchange may be found at www.lme.co.uk/, on the International Petroleum Exchange at www.ipe.uk.com and the world’s largest commodity exchange, the New York Mercantile Exchange, is at www.nymex.com/. Many brokerages and similar firms use the Internet to offer their trading services in futures and options – on currencies, financial products and commodities – to the private investor. Remember that the gearing built into derivative products makes dealing a high-risk operation and commission charges can be very heavy.
