Financial Markets Operations Management (8 page)

Equity trades are priced in units of currency per share. For example, the price of ABC Corporation shares might be EUR 5.50 per share. The one exception to this rule occurs in the UK where shares are priced in pence per share (not pounds sterling per share), so shares in Barclays Bank might be priced at 250p per share.

In order to make the correct calculation, we need to know the local market convention regarding brokerage fees and any local stock exchange/tax charges. Let us pretend that a trade has been executed in an imaginary market where the brokerage fee is charged at 25 basis points on the market value and that a local tax of 50 basis points is also charged on the market value of any purchase.

How much, then, would we have to pay if we were to buy 10,000 XYZ Corporation shares at 3.25 per share? To calculate the market value of this transaction, we multiply the number of shares traded by the price per share. In addition, we need to calculate the brokerage fees and, separately, any local taxes. The results are shown in
Table 2.25
.

There are different tax regimes in each country, as the examples show. It is usual that the local clearing house collects the tax and periodically remits it to the appropriate government agency.
Table 2.27
shows some examples of these taxes.

As ownership of shares with voting rights represents an actual interest in the issuing company, it is important for the company to know which investors have substantial shareholdings. An investor with an interest of over 50% of the voting rights has control of the issuing company; a situation that the issuing company may not be comfortable with. There are, therefore, disclosure rules that oblige any shareholder with more than a predefined percentage interest to disclose that fact to the issuing company and possibly the local stock exchange and regulator. The requirements do vary from market to market, but typically shareholdings below a 3% threshold are not required to be disclosed (see
Table 2.28
).

Not only is disclosure required when investors acquire shares that cross the specified thresholds, but also when investors dispose of shares that likewise cross the threshold.

In Chapter 3: Data Management, you will notice that one of the data fields contains information on the total number of shares in issue. It is this figure against which the investor's holding is compared in order to calculate the percentage interest. Failure to disclose as and when required can lead to fines and holdings being frozen in terms of deliveries and benefits.

So far in Chapter 2 we have seen the three main types of cash market instruments, including both the money markets and the capital markets. These financial instruments cover a time horizon from short term to long term; from certificates of deposit to long-term debt and equities.

The issuers of these financial instruments range from corporate issuers to government treasuries.

One further common factor is that these instruments are issued because the issuer requires cash/capital for whatever purpose. Investors can purchase these instruments and become either a holder of an issuer's debt and/or a stakeholder in the issuer company.

We will now continue our look at financial instruments by turning our attention to the derivatives market.

Whilst issuers are directly involved in the issuance of cash market instruments, they have no such role with derivatives. So what, you might ask, are derivatives? There are many different types of derivatives and we can define the whole class as follows:

If you are comfortable with this definition, here is another from the Office of the Comptroller of the Currency (a department of the US Treasury):

What can we learn from the OCC's definition? There are two learning outcomes:

1. The underlying covers a very broad range of asset types, e.g. interest rates, stock market indices, commodities, share prices, etc.
   
2. Derivative transactions fall into four types:
   
   • Forwards
     
   • Futures
     
   • Options
     
   • Swaps.
     

We can also differentiate derivatives in further ways. Firstly, there are types of derivative product that are constructed by an exchange, traded on the exchange and cleared by a central clearing system. We refer to these as
exchange-traded derivatives
.

Secondly, there are other types of derivative product that are constructed by financial entities such as banks and traded away from an exchange between the buyer and the seller. We refer to these as
Over-The-Counter (OTC) derivatives
.

Not only are OTC derivatives traded between buyer and seller, but all the post-trade activities also take place between the buyer and the seller, i.e. no central clearing system is involved. This situation is changing, with many of the more straightforward OTC contracts being cleared centrally and the more exotic OTC contracts yet to be decided.

It is not possible in this book to look at every single derivative product; we will, however, look at one or two examples of ETDs and OTCs. It is sufficient for you to be able to define the four main types of derivatives and understand the prime reasons for using them.

This derivative type is ETD.

Notice how the definition of a future is similar to that of a forward. The key difference is that the terms of a futures contract are much more standardised with regards to the:

• Standard quantity/amount;
  
• Standard (underlying) asset/commodity;
  
• Specific delivery date.
  

This derivative type can be either ETD or OTC.

Call options and put options can also be sold; the seller is known as the
writer
of the contract.

This derivative type is OTC.

• Hedging:
  A broad range of market participants use derivatives to hedge or reduce their exposure to future market conditions, for example, an airline will ask its bank to design a combination of option contracts against rising jet fuel prices. If the fuel price increases to a predetermined amount, then the bank, in effect, refunds the difference between the cash price of the fuel and the strike price of the option contract. We will look at an example later in this chapter. As a further example, a fund manager can hedge a portfolio of bonds against a decrease in value by selling an appropriate number of futures contracts. If the portfolio does, in fact, decrease in value, then the fund manager will receive benefit from an increase in the value of the futures contract. A perfect hedge would therefore be a decrease in the portfolio value of X, mirrored by an increase in the value of the futures contracts also of X.
  
• Dealing:
  Both ETD and OTC contracts are traded by dealers who work for banks and securities houses. Their role is to trade on behalf of their employer companies and to advise and trade on behalf of their clients. They will have expertise in a wide variety of derivative products ranging from standard ETDs to complex combinations of OTC contracts.
  

• Speculation:
  It can be time-consuming and expensive to buy or sell the underlying assets such as equities and bonds. For a speculator it can be a lot more straightforward to purchase a derivative contract and benefit by selling it when the price increases. It may not be possible to sell the underlying asset “short”; by contrast, it is just as easy to sell the derivative short as it is to buy long. Furthermore, these transactions can be executed much more quickly and more cheaply.
  

  A common variant of speculative trading is
  spread trading,
  whereby there is a combination of buys and sells in the same product but with two different aspects, for example:
  

  • Two different delivery months (e.g. March and June);
    
  • Two different stock market indices (e.g. DAX and CAC);
    
  • Two different commodities (e.g. West Texas Intermediate and Brent crude).
    
• Arbitrage:
  Arbitrageurs attempt to exploit the price differences between two similar products traded in two different markets. By way of comparison, in
  Table 2.29
  we can see how an arbitrageur might benefit from the price differences on an interest-rate future and an underlying government bond.
  

• The arbitrageur has made a profit by benefiting from price differences that might only remain for a short period of time. Note that the arbitrageur has closed out both positions at the conclusion of this transaction.
  

• Asset allocation:
  An institutional client such as an insurance company might be holding a portfolio of securities in one particular market. It might wish to reduce its exposure to that market and increase exposure in another market. There are two ways that the insurance company can achieve this:
  
  1. The insurance company can sell securities in the first market and with the cash buy securities in the second. This can be expensive in terms of transaction costs, time-consuming in selecting appropriate securities and uncertain in terms of pricing. Furthermore, it may not be part of the insurance company's investment strategy to reallocate funds for a long-term time horizon. In other words, this might be a short-term strategy.
     
  2. The insurance company can reduce exposure in the first market by selling an appropriate number of futures contracts and can increase exposure in the second by buying an appropriate number of futures contracts. This can be achieved by two transactions and can be quick to execute with low transaction charges. If the insurance company wishes to revert to the original allocation, then it simply needs to close out the two futures contracts.
     
• Changing risk:
  A corporation might be borrowing money at a variable rate of interest and may be concerned that interest rates will increase. It could enter into an interest rate swap, in which it would swap its variable interest payments with, for example, a fixed rate of interest. In this way, if interest rates do increase as feared, the corporation is protected by paying interest at a fixed rate.
  

In April 2009, the International Swaps and Derivatives Association (ISDA) announced the results of its Derivatives Usage Survey of the world's biggest 500 companies. It found that 94% of these companies were users of derivative products.
Table 2.30
shows the usage by industry sector and the type of derivative used and
Table 2.31
shows the usage by country.

These are the main uses and users of derivative products. From an operational point of view, the reasons for using derivatives tend to be of secondary importance, however interesting these reasons might be. We are more concerned by what needs to happen once a derivatives transaction has taken place. The best way to approach this is to consider exchange-traded derivative transactions separately from OTC transactions, remembering that more and more of the latter are being cleared centrally rather than bilaterally between the buyer and seller.