Derivatives market
Derivatives include futures, options and swaps. Stock indices are also a kind of derivative, although not necessarily classified as such. Maturities vary between a day and a decade. Both futures and forwards are promises to buy or sell the underlying instrument at maturity. The difference between them is that futures contracts are standardized in their structure and traded at organized exchanges, whereas forwards are tailored to customer need and are traded only over-the-counter (OTC). They are less liquid than futures when trades remain small, but when the amounts climb to 0m and beyond, they may be the only alternative (Davis 2004). Options give the right to buy or sell the underlying instrument at a certain price and time, or during an agreed period. They give protection in the form of a price limit like futures/forwards but allow, in addition, the option holder to reap the fruits of a favorable price development. Logically, they are comparatively expensive products. Standardized options are traded at exchanges, unstandardized at OTC. Swaps are agreements to barter the payment streams of the underlying instruments or/and the instruments themselves. As the barter objects may be of unequal value, side payments are possible. Swaps are difficult to standardize and therefore over-the-counter (Laulajainen 2003).
Derivatives are a reasonably coherent group but organizationally divided between exchanges and over-the-counter (OTC). Exchanges are part of financial markets but, because of their formal organization and transparency. Payment is a particularly thorny issue, because it is an integral part of every financial transaction whether at exchanges or OTC, and consequently fits in almost everywhere. As derivatives do not give ownership until exercised, they avoid some taxes. They entail less administrative work than equities and bonds, which gives lower trading fees. And a contract is bought for a modest down payment which also encourages their use. It is still more attractive when the underlying instruments like equities can be replaced by an index which reflects their movements. Therefore, derivatives are welcomed by investors who wish to change their exposure often, rapidly and at low cost. The speed makes derivatives react more rapidly at times to market news and change in sentiment than the underlying securities (Ben-Ami 2001). Foreign exchange markets are the glue which keeps the world economy together and it allows for communication between countries. The spot market is very large, about 0tr in annual trading value or twenty-one times the global exports of goods. The derivatives market is almost twice its size. Most of the trading is simply the balancing of positions, however. Spreads are very narrow and balancing consequently inexpensive. Customer trades thus have a substantial multiplier effect. Whether tracking or hedging, the need to use derivatives depends on the volatility of the underlying instruments, and they in turn on external economic and political developments beyond the influence of the exchange. What the exchange can do is to select the most heavily traded and volatile stocks as the underlying building blocks. It follows that the derivatives market and the cash market locate in the same time zone. When the underlying instrument is a bond, its homogeneity and low probability of default are also relevant (Dubofsky & Miller Jr., 2003). The derivative market of Italy is facing similar problems as Greece wherein there is a derivative time bomb which will lead to cuts to prevent losses and court cases. Italy is doing the best it can to prevent more problems or minimize the effect of the problem.
Future swap forward
Nowadays, the users of financial statements are making demands that preparers of financial statements feel themselves incapable of meeting. Financial statements are regarded as an information system. They are intended to provide information. But in order to provide information one needs to have access to the information required. And in order to obtain this information one needs to carry out measurements. The growth of the different market segments of a country has put pressure on governments with restrictions on foreign exchange transactions to drop restrictions, which the swap market can easily frustrate. Accordingly considerable growth in non-dollar currency swaps has occurred in recent years. Swaps in virtually all major currencies are now available. Since many financial products, such as note issuance facilities, swaps, and financial futures transactions involve contingent obligations, they are not included on balance sheets. The rapid growth in off-balance-sheet items, however, has been a cause of concern to regulators, which has led to an effort to capitalize off-balance-sheet items so as to include them in the overall grasp of bank supervisory regulations (Blake 2000). The rapid growth in bank holdings of interest-sensitive instruments such as government bonds at a time of declining rates in addition to the enormous growth in over-the-counter and exchange-traded derivative instruments such as swaps, futures, options, and various types of structured financial instruments raised the issue of position risk. This is the risk that financial instruments of contingent obligations held by banks on or off the balance sheet could change dramatically in value as a result of changes in interest rates, for example, raising the danger of substantial losses once the positions are unwound or replaced. Historical values may not be a good guide to actual values, especially in times of volatile interest rates and exchange rates. The volume of financial derivatives has grown rapidly in recent years in response to prevailing patterns of interest-rate and exchange-rate volatility, equity market developments, and the gains inherent in arbitraging investment and financing opportunities across currencies and fixed/floating debt pricing (Smith & Walter 2004).
Financial statements for given periods consist of a great number of different items. Traditionally, these items are divided into different types according to what is known as a chart of accounts, which simply means a list in which each account is named, described and organized in a specific order. The chart of accounts controls the systematic order used. Items that are logically connected in terms of type are placed in the same section of the system, itemized in the same account. Derivatives and the kinds of synthetic securities they make possible are at once linked to trading in the underlying cash securities and to a degree substitute for them as investment vehicles. It is clear that the U.S. and international markets are already very closely linked, not just in terms of the relationship between domestic and Eurodollar interest rates, but also through the newer forms of linkage that the interest-rate and currency-swap markets provide. During the past few years a system for swapping interest rate and foreign currency obligations among debt obligors around the world developed. It is now possible for a company that owes floating-rate debt to swap the interest portion of the debt with another company that has a fixed-rate obligation. Thus without actually doing a financing a company can switch its future interest-rate exposure from fixed to floating or vice versa. This is a very useful tool for managing financial liabilities. It is also a useful tool for managing assets-a pension fund investor can swap fixed-interest payments from a bond for a contract to receive a floating rate of interest (Dunbar 2000). Some use swaps more aggressively than that. A sizable market for swaps of all kinds and classification now exists, and arranging the transactions is not difficult. With the difference in techniques, companies and countries can alter the whole structure of their liabilities on very short notice, or they can use them to lower their costs of funds. Swaps can also be used to exchange foreign currency obligations, sometimes in very unusual ways. Derivatives packaged together with cash market securities can create synthetic securities with characteristics that differ substantially from those of the original cash market instrument. Thus derivatives are used to alter the investment characteristics of a security without requiring the security to be sold and the proceeds reinvested (Anthony 2003).
Maintenance of capital adequacy of financial intermediaries is as vital to protect against losses on personal debt as on corporate debt. But even if capital adequacy is maintained, it is arguable that defaults would be fewer if financial intermediaries were more restrained in their pursuit of market share especially since such episodes often culminate in an over tightening of credit standards in reaction. Even if lenders adequately cover their risks during such episodes, the risk to households and the macro economy could justify restraint. Derivatives traded in over-the-counter markets include interest-rate swaps, currency swaps, other swap-related derivatives, and a variety of small-volume, customized instruments used to hedge interest-rate, equity, and foreign exchange risks. Swaps are over-the-counter instruments involving the exchange of one stream of payment liabilities for another. Before 1980 swaps scarcely existed. By 1985 they were seen to offer great advantage to issuers of debt securities because, with them, a party could lower the cost of financing in bond markets, or raise the yield on bond investments, through arbitrage and by exploiting comparative advantages (Hira & Parfitt 2004). Indeed, swaps had become so much a part of the international financial scene that activities like Eurobond transactions involving swaps were responsible at times for more than half of all new issues. Also, since about 1987 banks and other financial intermediaries have found swaps extremely beneficial in managing the special risks of interest-rate and currency exposures from loan or investment portfolios. Swaps are enormously accommodating since the different kind of instruments enable parties to change their financial assets and liabilities at will and at low cost, for example, to change a fixed-interest payment obligation into a variable one, or to change a dollar-payment obligation into a deutsche mark one. Swaps constitute valid and binding agreements between individuals and participants to exchange one stream of future interest and sometimes principal payments for another. Swaps, however, represent contingent values and therefore do not appear on balance sheets, except in footnotes. The growth of interest-rate and currency swaps has been exceptional since their origin. Swaps are now the preferred instrument for hedging foreign exchange exposure beyond a year (Khoury 2004).
Options market
The options market in Italy centers on different aspects of making business. The options market in Italy would ensure that there would be fairness and equality. The options market serves as a good financial instrument for Italy. Every corporation using financial instruments must use a back office to conduct trade reconciliation, bookkeeping, accounting and marking to market, and audits of risk management and trading. Firms active in capital markets activity might choose to spread these back office functions over several areas in the firm, including existing administration, finance, treasury, legal, and audit areas. Smaller institutions often integrate the back office into a single business area. It is increasingly common for firms to in source or outsources some or all of their back office functions, such as cash management and securities operations. Providers of these services include independent financial institution. Probably the easiest forward-like exposures to identify are those exposures arising from financial instruments that were issued or acquired through a formal trading market, whether on an exchange or through the OTC derivatives dealing marketplace. In simple terms, spot and forward-like exposures arising from traded instruments include cash market transactions, forwards, swaps, and futures. Options and option-like payoffs also often appear in other traded or listed financial instruments, including derivatives and securities. These embedded options may include options that are otherwise available as stand-alone products or implicit options created by virtue of the contract design process. A basic and extremely common example of an asset with an embedded option that can be virtually perfectly replicated with a stand-alone purchase or sale is a bond with call and/or put provisions (Chorafas 2000).
A callable bond is a bond in which the issuer has the right to call the bond away from the investor in certain circumstances. The bond thus includes an embedded call option on interest rates (Chorafas 2000). The underlying of the option depends on how the call provision is structured. If the issuer can call the bond at any time over the bond’s life if interest rates fall by more than 100 basis points, for example, then the bond includes an option on interest rates with a tenor equal to the tenor of the bond that the holder has written to the issuer with a strike rate 100 basis points below the current interest rate. Bonds can also contain numerous other types of embedded options. A putable bond is a bond whose holder has the right to redeem the bond for face value prior to maturity in the event certain triggers are hit in the market, such as rate declines that might prompt the investor to want to rebalance her portfolio toward higher-yield securities. Similarly, a convertible bond is similar to a straight bond plus the issuance to the bond holder of warrants. Some bonds even contain options on commodity prices, exchange rates, or equity prices of companies other than the bond issuer. Apart from bonds, other fixed income assets also often contain various types of embedded options, not all of which have traded or OTC analogues. Mortgages and other loans with prepayment provisions, for example, contain valuable options held by the borrowers to prepay their loans. When interest rates decline, the holder of a fixed-rate mortgage may prepay the mortgage so that she can refinance at a more favorable interest rate. This means that the holder of the mortgage holds a type of option on interest rates written by the lender (Blake 2004).
The reason the embedded prepayment option in a mortgage does not have traded option analogue traces to the imperfect correlation between any given individual’s prepayment behavior and some interest rate (Blake 2004).The quality option and the geographical option are sometimes collectively called the cheapest to deliver option embedded in futures contracts because together they give the right to the short to select for delivery the cheapest possible physical inventory that still satisfies the contract’s minimum requirements for delivery. Note that these options arise because of the need to standardize the futures contract for exchange listing. A fully customized contract could specify pricing based on an exact quality and exact location, but in order to generate sufficient liquidity to support an exchange listing a futures contract must be standardized along dimensions like quality and allowed delivery points. Such standardization features inevitably lead to at least some embedded optionality. Some options are option-like in every way, down to being written on a financial asset price, except that they cannot be freely traded, bought, or sold. Stock options are a very common example of such non-traded financial options. Employee stock options can neither be traded nor transferred but are nevertheless contracts in which employees or managers or a firm are compensated with a kind of option-like equity component that allows them to buy some number of shares on or before some specified date at a pre agreed price (Healey 2003).
The restrictions on trading products like stock options often also imply that such options cannot be viewed as simple calls and puts. Two common features of stock options, for example, are vesting and barriers. A vesting period is a period of time in which the employee must remain at the company before the option can be exercised, whether or not it is in-the-money. From a risk management perspective, this means that the stock option product is better viewed as a forward-starting option and not merely as an option (Healey 2003).Employee stock options also may contain barrier provisions, especially when granted by high technology or start-up venture firms. Until the stock price of the firm has, say, doubled, the employee options are worthless, even if they are struck at-the-money. If an at-the-money option contains a knocking feature that says the option conveys no rights until the stock price doubles, then the minimum payoff on the option will be the value of the stock grant on the date of issue. This feature transforms the simple employee option into an up-and-in option. The use of down-and-out provisions in employee stock options is not as common for obvious incentive reasons. Although some companies do not mind rewarding employees for better performance even when that performance is due entirely to correlations of the company’ stock price to the broad market, companies are reluctant to punish employees for broad market corrections that might also pull down their stock prices below the out-strike at which the option grant ceases to exist (Atkinson 2004). A significant number of financial contracts have option-like features even if they are not themselves called options. One of the analogues to financial options is the traditional insurance contract. In exchange for paying a premium to an insurance company, the company agrees to make a payment proportional to the damage incurred. If this insurance covers damage from floods, then the insurance policy can be viewed as a type of put option with an underlying of the value of the insured property less any deductible. The difference between the current value of the insured property and the payment guaranteed by the insurer is equal to the deductible, which means the option is out-of-the-money. Options are like forwards except that the buyer has the right but not the obligation to execute the deal. This is a privilege for which he pays a premium to the seller of the option. The option may be a call, giving the buyer the right to buy a certain asset; or a put (Atkinson 2004).
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