Derivatives Market Operations for ACCA AFM Students

Here’s what you need to know:

• 1. Exchange-Traded vs. OTC Agreements (Advantages and Disadvantages):

  • Exchange-Traded Derivatives: Standardised contracts bought and sold on public exchanges.
  • Advantages:
    1. Easy to trade.
    2. Highly regulated.
    3. Transparent prices.
  • Disadvantages:
    1. No flexibility—contracts are fixed, so you can’t customise them.
  • OTC (Over-the-Counter) Derivatives: Custom agreements made directly between two parties, not on an exchange.
  • Advantages:
    1. You can customise the deal (e.g., size, terms) to fit your needs perfectly.
  • Disadvantages:
    1. Riskier (no exchange oversight).
    2. Harder to trade.
    3. Prices aren’t as clear.
  • Example: A company uses exchange-traded futures for oil prices (standard, safe) or OTC swaps for a unique currency risk (custom, riskier).

• 2. Key Features of Derivatives:

  • Standard Contracts: Fixed, pre-set terms (e.g., size, expiration) set by the exchange—easy to understand but not flexible.
  • Tick Sizes: The smallest price move a contract can make (e.g., $0.01 for some futures)—keeps trading precise.
  • Margin Requirements: Money you deposit upfront as a safety net to cover potential losses—ensures you can pay if the trade goes bad.
  • Margin Trading: Borrowing money to trade bigger than your deposit—can make big profits but also big losses.
  • Example: Trading oil futures on an exchange with a $5,000 margin, where each contract moves in $0.01 ticks—standard, safe, but limited flexibility.

• 3. Source of Basis Risk and How to Minimise It:

  • What it is: Basis risk happens when the price of a derivative (e.g., futures) doesn’t move exactly like the thing you’re hedging (e.g., actual oil prices)—causing unexpected losses or gains.
  • Source:
    1. Differences between the futures price and the spot (real) price.
    2. Timing mismatches (e.g., futures expire before you need them).
  • How to Minimise:
    1. Match the derivative to the asset closely (e.g., use futures with the same expiration and commodity).
    2. Use scenario analysis to predict price differences and adjust your hedge.
  • Example: A farmer hedges wheat prices with futures, but if the futures price doesn’t match the local wheat price, there’s basis risk—fix it by choosing better-matched contracts.

• 4. Risks and How to Manage Them:

  • Delta Risk: Measures how much a derivative’s price changes when the underlying asset’s price changes (e.g., if oil goes up $1, how much does your option change?).
  • Manage It:
    1. Adjust your position (e.g., buy or sell more derivatives) to balance the risk.
    2. Use hedging strategies.
  • Gamma Risk: Measures how much delta changes if the underlying price changes—basically, how unstable delta is.
  • Manage It:
    1. Use options with lower gamma.
    2. Rebalance your portfolio to stabilise changes.
  • Theta Risk: Measures how much a derivative’s value drops over time (time decay), especially for options as they near expiration.
  • Manage It:
    1. Choose options with longer expiration dates.
    2. Trade actively to offset time decay.
  • Example: You buy an oil option; if oil prices jump, delta shows the profit/loss, gamma shows how that changes if prices keep moving, and theta shows the value loss as time passes—manage by adjusting trades or hedging with other derivatives.

• Key Takeaway for AFM:

  • The derivatives market is like a toolbox for managing financial risks—use exchange-traded or OTC wisely, understand key features like standard contracts, tick sizes, margin requirements, and margin trading, watch out for basis risk, and manage delta, gamma, and theta risks to protect your investments.