What is derivatives
A derivative is a contract between two or more parties whose value is depends on the value of underlying asset. A derivative is to transfer risks in the economy. By owning a derivatives contract, contract’s holder is protected from price changes in the market, as the contract locked the price as in the contract.
History of derivative markets in Asia
Ever since the crisis in Asia, there has been an enormous growth in Asian bond markets which has not been matched with equal growth in products of derivative. Markets that grown out of the financial sector recapitalisation before the mid of 2003, experienced a precious little bearish movement in bond market , but the use of hedge instruments are lacking at that time (Hohensee & Lee, n.d.). After the world’s financial crisis in year 2008, the Asia OTC market declined instead of growing in 2019. However, It started to grow in 2010 and shooted up over 25% in 2012. Study shows that, annual turnover of 2012 in the Asian OTC derivatives markets were about $186 trillion spiked from 2009 & 2010. In Asia, the OTC derivatives markets was a 80% of the 2008-2012 growth in turnover, with interest rate derivatives a distant second at 18%. Equity derivative has thrived in some markets of Asia, it was witnessed as the most fast growing product among the traded derivative products. Exchange-traded volumes had flourished from $16.9 million to $54.2 trillion in 2002 till 2006 which currently represent 31% and 38.9% global equity derivatives turnover by notional value and number of trades respectively. The most widely traded types of equity derivatives are the index derivatives in Asia at 82.4% and 15.9%. Recently, OTC derivatives have picked up momentum. The high growth of equity derivatives trading in the region is due in part to the Korean derivatives market, where the trading on the Kospi equity index almost doubled over the last two years (Jobst, 2007).
History of derivative markets in China
In 1980s, China reform it's financial structures. From that, spot and futures markets introduced to financial market by offering seven types of financial instruments which are A, B shares, Treasury bonds, Treasury bond repurchases, corporate bonds, convertible bonds and securities investment funds. While the stock exchanges traded bond futures with high volumes, at the same time, the must-have laws, regulation and administrative to monitor framework had been established. In between the establishment of financial derivatives market it has four stages which is the theoretical stage from 1987 to 1990 , the stage of developing of future market from 1990 to 1993, the period of rectification and regulation adjusted period from 1994 to 1999 and lastly from year 2000 until now, finance derivatives market is in the process of recovering and growing.
In between the developing stage, an unforeseeable loss was incurred as the risk management procedures was showed to be inadequate. From examples, it was the cases that margins decreased to as small as only one percent of contract price in early 1995. To overcome this, the government decided to close the bond futures markets and take back their trading activities involving commodity futures. It was then continued to have no single financial derivatives were legalized until the stage of financial reformation,trading activities is traded again.(Lim, Gan, & Lim, 2012). Besides, China joined a significant organisation named World Trade Organisation(WTO) in 2001 to recognised its position in international market. Follow by that, the China Financial Futures Exchange was established in Shanghai by Shanghai Futures Exchange, Zhengzhou Commodity Exchange, Dalian Commodity Exchange and Shanghai Stock Exchange, approved by the State Council and China Securities Regulatory. From experts, they say the organisation stated above was a significant platform for financial derivatives trading activities in China followed by it exist strategic meaning to enhance their market. It purposely is to strengthen the capital market reform, complete capital market system and expand capital market functions. Inter-bank market is the primary behaviour of OTC derivatives trading in China. It combines the invisible market to look at non-identical exchanges among the financial institutions but it focuses to large commercial banks sometimes (Zhou, 2016). Moreover, a central counterparty called Shanghai Clearing House, to bear on the counterparty credit risk in between the transactions as well as provide efficiency and stability to China’s financial markets was established in Shanghai at November 2009 in China’s OTC derivatives ("Central Counterparty Clearing House – CCP", 2018).
Current and potential products in China
(A) Commodity-based financial derivatives
Commodity derivatives are financial instruments which values are based on the underlying commodities such as minerals, oil, gas, agricultural products and metals(Parker & Perzanowski, 2010). It is the most oldest form of financial derivative (Lim, Lim, & Gan, 2012). Commodity prices may have significant variation, through the usage of commodity derivative, the price variations can be controlled. China has the world’s largest consumption of raw materials from agriculture to energy products (Chan, 2018). Chinese are highly rely on imported commodities to meet high demands. Based on statistics, China imports almost 60 percent of oil and about 90 percent of soybeans. However, China is still remain as the price takers in the commodities market. Based on the China Securities Regulatory Commission (CSRC), China’s trading volume for commodity futures has been in the top of the lists in the world for these five years. In year 2014, strong US dollar and the decline in prices of international crude oil had affected commodity futures badly. Moreover, other commodities such as energy, rubber, steel and others hit the lowest point as well. A commodity futures is a contract, which buyer and seller agree to buy or sell a mutually accepted amount of a commodity at a certain price in a specific date (Staff, 2018). In 1990, China’s first futures contract was introduced and until 1993, there was more than 300 futures companies. A significant value after that, China’s futures market was increased by 35 times in its trading value, as well as trading volume increased by 7.5 times in between the year 2002 to 2011.
Figure 1
Referring to the figure 1 above, it proved that ZCE, DCE and SHFE in China have ranked top places in global ranking futures and options in field of agriculture and metal which the top agricultural futures was ranked first by DCE, having about 44 million transaction volume and the top metal futures was ranked first by SHFE, about 123 million volume of transaction (Acworth, 2018).
(B) Exchange rate derivatives
Exchange rate derivatives are financial derivatives where the payoff is depending on the foreign exchange rate or two or more other currencies. China is a growing market which have a significant contributions to the global economy. This has resulted Renminbi (RMB), the Chinese exchange rate has captured large amount of attentions around the world. Here are the types of exchange rate derivatives:
(i) Renminbi (RMB) futures
Foreign exchange futures refers to an agreement between two parties to exchange currencies at a foreign exchange rate during a specified delivery month. It is easily convertible and standardized globally(Harvey, 2011). China’s futures market was began in 1990 that China International Futures Corporation Limited was founded by the end of year 1993. In between the year 2002 to 2011, China’s futures market developed fast which its trading volume increased by 35 times and trading volume expanded by 7.5 times. In today’s futures exchanges market, there are ZhengZhou Commodity Exchange (ZCE), Dalian Commodity Exchange (DCE), Shanghai Futures Exchange (SHFE), and China Financial Futures Exchange (CFFEX). Among them, ZCE and DCE mostly focuses on the agricultural products, SHFE focuses on metal futures while CFFEX only occupied a stock index product, which launched in April 2010 (Zhen, 2013, p.76-79).
(ii) Renminbi (RMB) exchange swaps
Foreign exchange swap refers to currently purchasing one currency and selling another currency with two different value date while forward re-selling the bought currency and buying another one currency (Vanguard, 2018). The foreign exchange swap has two principal amounts for each of the both currency. It is important for both counterparties to agree to exchange principal amounts at time to maturity. In addition, it provides flexibility for entities to utilize their comparative benefit in their market respectively (Zhang, 2004). On May 2018, a currency swap agreement had finally executed between People’s Bank of China and the Central Bank of Nigeria which worth over RMB 16 billion. The aim of this proposal is to provide sufficient amount of local currency liquidity to Chinese and Nigerian Industries to carry out in their business. The current swap would help other local business by reducing the obstacles that they encounter in the search of currencies in their business transactions. Despite that, China Government utilise the funds to provide loan at concessional interest rate to attract more Chinese business involve in Nigeria to enable them carry out their contractual and commitments. With the China controlling about 35 percent market share of Nigeria, China has become the largest trading partner of Nigeria at the moment (Udo, 2018).
(iii) Renminbi (RMB) forwards
In all developed countries included China, foreign exchange forwards as a fundamental instruments of foreign exchange is purposely for hedging as well as speculation. It is a tool used by non-local importers and other parties to minimise their foreign exchange risk. Similar with other foreign exchange businesses, China expanded to its state-owned banks after being originally monopolized by Bank of China( BOC) for few years (Zhang, 2004). According to Harvey, 2011, currency forwards is not identical to other hedging methods as it do not require any deposit when involved large corporations and banks. It consist not very much flexibility and amounts a binding obligation which means the contract buyer and seller cannot escape from law if the “locked in” rate proves to be having conflict. Hence, a financial institution is always needed as they can require a deposit from retail investor to compensate their risk through non-delivery or non-settlement transactions(Harvey, 2011).
(iv) Renminbi (RMB) non-deliverable forwards and options
Non-deliverable forwards can define as financial derivative of foreign currency which is differ with the forward contract that we normally see and used in a number of different markets such as foreign exchange and commodities. In China, a specific name has created for non-deliverable forwards which call Chinese Yuan Non-deliverable Forward (“CNY NDF”), it is a contract with Bank of China that we are able trade with Chinese Yuan (CNY) at a certain rate that is set by the bank to avoid the risks of foreign exchange or speculate on the movement of currency to grasp market opportunities (Bank of China, 2018).
Under CNY NDF, the Bank of China would determine the settlement currency amount by notional amount on valuation date in US dollars (USD) and compare to the forward rate and settlement rate that has agreed, which would settled in USD on settlement date. The settled currency amount can be calculate by the formula of Notional amount × [1 – (forward rate ÷ settlement rate)]. When the settled currency amount is greater than 0, the person who bought USD should receive the amount of settled currency amount from seller of USD while the settled currency amount is less than 0, the seller of USD should receive the settlement currency from the person who bought USD. (Bochk.com, 2018).
Chinese Yuan Non-deliverable Forward is respect to CNY and usually traded as US dollars in onshore or offshore market and it is similar as conventional forwards that may affect by the decision of investors and policymakers. There are many banks in China developing non-deliverable forwards which is related to wealth management product. RMB/dollar NDF market does not contain complete source of data due to the privately negotiated deals but it is estimated an average daily amounts between 3 billion and 5 billion USD (Zhen. 2013, p.93).
Potential products in China
Derivatives in China has developed rapidly which attracts creative traders to invest in their market. New derivative products are introduced to assist these investors to hedge risk (Chatterjee & Clare, 2018). The potential product that can boost the Chinese market is the commodity-futures. The growth of the commodities futures market has allowed the foreign players access which bring benefits to the derivatives-trading volume. Palm oil, soybeans and pure terephthalic acid (PTA) can be potentially make a market access to the international futures market (Wong, Lu , Lee, Zhu, & Bowry, 2018).
Figure 2
International market access potentially can be obtained on palm oil, pure terephthalic acid and soybeans. According to the China’s securities officials, plastics and soybeans are the next largest imports in China after the iron ore and crude oil. According to figure 2, the most active futures contracts are traded in the year 2017 is the Steel Rebar Futures. Besides, the Soybean and PTA futures are climbing up the ranking so there is potential for both of the futures to become internationalised in the near future.
How to price derivative products
Pricing Model for Renminbi (RMB) Options
In China, the method for Renminbi (RMB) option pricing is the Black-Scholes Model (Zhang, 2004) .It is used to determine the theoretical value of an option based on the volatility, type of option, underlying stock price, time to maturity, strike price and risk-free rate.
There are few assumptions need to be made:
The volatility is constant.
There are no transactions costs or taxes.
No payment for dividend during the life of the derivative.
Security trading is continuous.
The risk-free interest rate is constant and same for all maturities.
Black-Scholes Model Formula
C=SN(d1)-KerTN(d2)
P = KerTN(-d2)-SN(-d1)
where , d1=ln(SK)+(r+s22)ts*t d2=d1-s*t
C = Call premium
P = Put Premium
N(x) = Cumulative probability of standard normal distribution,
S = Current stock price
K = The option’s strike price,
t = Time to maturity,
r = Risk-free rate of interest,
s = the stock price’s standard deviation,
As shown, the two parts in the equation which represent receipt of stocks and payment of exercise price respectively. The first part is the multiplication between the stock price and the change in the call premium in relation to a change in the underlying price. d1 is the factor by which the discounted expected value of contingent receipt of the stock exceeds the stock’s current value. The second part is the present value of paying the strike price at maturity. d2 is the probability, which is adjust according to risk, that the option will exercise. d1 is will always be greater than d2as d1 is also considered the fact that the gain from stock on exercise is dependent on the conditional future values that the stock price takes on the expiry date (Farid, 2011). The call premium or put premium, which is the value of the option, is the difference between two parts.
Computed Renminbi Option price
All the data is collected from the Thomson Reuters datastream and Investing.com as shown as below.
Current currency price, S = 6.94
Strike price, K = 6.94
Risk-free interest rate, r = 3.01%
Standard deviation, s = 0.02375
Time to maturity, t = 0.0833
First, we need to calculate,
d1=ln(6.946.94)+(0.0301+0.0237522)(0.0833)0.02375(0.0833)
=0.37
d2=0.37-0.023750.0833
=0.363524
N(d1) = 0.64431
N(d2)= 0.64189
The value of European call option :
C = (6.94)(0.64431)-6.94e-(0.0301)*(0.0833)(0.64189)
=0.027988
As for European put option,
P = 6.94e-(0.0301)*(0.0833)(0.35811)-(6.94)(0.35569)
= 0.01055
The value of call option obtained from Black-Scholes Model(BS) is 0.027988 and value of put option is 0.01055 while the market value of call option is 0.04547 and put option is 0.03477 with the strike price of 6.94. By comparison, the intrinsic value calculated through the BS Model is lower than the market value. This result shows that both call and put option are overvalued in the market. This is highly due to implied volatility. In this example, the 30-day implied volatility used in BS model is higher than the statistical volatility. This means that there is an assumption from the market that there is an increase in future volatility of the stock. There will be uncertainty in the market. Besides, the interest rate that is used to compute is riskless interest rate which do not consider any risks. But in real world, there will be risk. Moreover, there is a premium on the option price. As for the difference in prices, it represents arbitrage opportunity.
Implied Volatility of USD/CNY from Eikon Thomson Reuter.
Figure 3
Strike price and market value of call and put option of USD/CNH from Investing.com (USD/CNH Options, n.d.)
Figure 4
Pricing Model for Renminbi (RMB) Forward:
There are few assumptions on market participants such as they are exposed to no costs of transaction but to the same tax rate on every net trading profit, can take loan or borrow money at the same risk free interest rate as well as take advantage of arbitrage opportunities as they occur.
Formula for Renminbi (RMB) Forward that provides no income:
F0= S0erT
*Current price grow exponentially along with the time.
Assumptions:
The investors are subject to no transaction costs.
The investment assets that provide no income.
The investors are subject to no storage costs.
Notation:
T = Time until delivery date in a forward or futures contract (in years)
S0= Price of the asset underlying the forward or futures contract today
F0= Forward or futures price today
r = Zero-coupon risk-free interest rate p.a. (continuous compounding) for an investment maturing at the delivery date
Arbitrage Opportunities
F0>S0erT
Investors can:
Borrow S0at risk-free rate of interest for T years.
Purchase one unit of the investment asset.
Enter into a short forward contract on one unit of investment assets.
At time T, the asset is sold for F0. The amount of S0erT is to repay the loan that the investors have borrowed and the investors will earn a profit of F0-S0erT.
When,
F0<S0erT
Investors can:
Sell the investment assets for S0.
Invest the proceeds form the risk-free rate of interest for time T.
Enter into a long forward contract on one unit of investment assets.
At time T, the cash will be grown to S0erT. The asset is repurchased for F0 and the investors will earn a profit of S0erT-F0 .
Computed Renminbi (RMB) Forward
From Thomson Reuters Datastream, the CME – Standard and Poor’s (S&P) the forward ask price on 23 Oct 2018 was $7 with time to maturity of 6 months and the current spot price was $6.9444. The risk free rate derived from the China government bond yield is 3.63%.
Figure 4
S0= 6.9444
r =0.0362
T =6/12
F0= S0erT
= 6.9444e0.0362612
= 7.07
Analysis
The market forward price is at $7 while the theoretical forward price is $7.07. The difference between market price and expected forward price happens all the time in the real world. The main reason the theoretical price is differ with market price is because the theoretical format doesn’t include market risk, while in real life there are systematic risk and undiversifiable risk. The market value is undeniable and it reflects the actual, real profit and loss. On the other hand, the theoretical value reflects the expected price of the forward.