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Chapter 1
Introduction
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© 2002 South-Western Publishing
Outline
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Introduction
Objectives of the text
Types of derivatives
Participants in the derivatives world
Uses of derivatives
Effective study of derivatives
Introduction
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There is no universally satisfactory answer
to the question of what a derivative is,
however one explanation ......
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A financial derivative is a ‘financial instrument
or security whose payoff depends on another
financial instrument or security’ ......the payoff
or the value is derived from that underlying
security
derivatives are agreements or contracts
between two parties
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Introduction (cont’d)
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Futures, options and swap markets are very
useful, perhaps even essential, parts of the
financial system
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hedging or risk management
speculate or strive for enhanced returns
price discovery - insight into future prices of
commodities
Futures and options markets, and more
recently swap markets have a long history
of being misunderstood -
Introduction (cont’d)
How many have heard of the following:
 Nick Leeson and Barings Bank
 Orange County - California
 Sumitomo Copper
....market type losses have often been attributed to the
use of ‘derivatives’ - in many of these situations this
has been the case i.e a speculative application of
derivatives that has gone against the user
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Introduction (cont’d)
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“What many critics of equity derivatives fail
to realize is that the markets for these
instruments have become so large not
because of slick sales campaigns, but
because they are providing economic value
to their users”
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Alan Greenspan, 1988
Derivatives & Risk
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Derivative markets neither create nor destroy
wealth - they provide a means to transfer risk
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zero sum game in that one party’s gains are equal
to another party’s losses
participants can choose the level of risk they wish to
take on using derivatives
with this efficient allocation of risk, investors are
willing to supply more funds to the financial markets,
enables firms to raise capital at reasonable costs
Derivatives & Risk
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Derivatives are powerful instruments - they
typically contain a high degree of leverage,
meaning that small price changes can lead to
large gains and losses
this high degree of leverage makes them
effective but also ‘dangerous’ when misused.
Objectives of the Course
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To illustrate the economic function/
application of derivatives
To understand their application in both risk
management and speculative situations
To inform the potential user so that an
intelligent decision might be made
regarding the role of derivatives in a
particular situation
Types of Derivatives
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Options
Futures contracts
Swaps
Hybrids
Options
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An option is the right to either buy or sell
something at a set price, within a set period
of time
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The right to buy is a call option
The right to sell is a put option
You can exercise an option if you wish, but
you do not have to do so
Futures Contracts
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Futures contracts involve a promise to
exchange a product for cash by a set
delivery date - and are traded on a futures
exchange
Futures contracts deal with transactions
that will be made in the future
contracts traded on a wide range of
financial instruments and commodities
Futures Contracts
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Are different from options in that:
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The buyer of an option can abandon the option if
he or she wishes - option premium is the
maximum $$ exposure
The buyer of a futures contract cannot abandon
the contract - theoretically unlimited exposure
Futures Contracts (cont’d)
Futures Contracts Example
The futures market deals with transactions that will
be made in the future. A person who buys a
December U.S. Treasury bond futures contract
promises to pay a certain price for treasury bonds
in December. If you buy the T-bonds today, you
purchase them in the cash, or spot market.
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Futures Contracts (cont’d)
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A futures contract involves a process
known as marking to market
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A forward contract is functionally similar to
a futures contract, however:
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Money actually moves between accounts each
day as prices move up and down
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it is an arrangement between two parties as
opposed to an exchange traded contract
There is no marking to market
Forward contracts are not marketable
Futures/Forward Contracts History
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Forward contracts on agricultural products
began in the 1840’s
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producer made agreements to sell a commodity to a
buyer at a price set today for delivery on a date
following the harvest
arrangments between indiviudal producers and
buyers - contracts not traded
by 1870’s these forward contracts had become
standardized (grade, quantity and time of delivery)
and began to be traded according to the rules
established by the Chicago Board of Trade (CBT)
Futures/Forward Contracts History Cont’d
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1891 the Minneapolis Grain Exchange
organized the first complete clearinghouse
system
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the clearinghouse acts as the third party to all
transactions on the exchange
designed to ensure contract integrity
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buyers/sellers required to post margins with the
clearinghouse
daily settlement of open positions - became known as the
mark-market system
Futures/Forward Contracts History Cont’d
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Key point is that commodity futures (evolving from
forward contracts) developed in response to an
economic need by suppliers and users of various
agricultural goods initially and later other
goods/commodities - e.g metals and energy
contracts
Financial futures - fixed income, stock index and
currency futures markets were established in the
70’s and 80’s - facilitated the sale of financial
instruments and risk (of price uncertainty) in
financial markets
Option Contracts - History
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Chicago Board Options Exchange (CBOE)
opened in April of 1973
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call options on 16 common stocks
The widespread acceptance of exchange
traded options is commonly regarded as one of
the more significant and successful investment
innovations of the 1970’s
Today we have option exchanges around the
world trading contracts on various financial
instruments and commodities
Options Contracts
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Chicago Board of Trade
Chicago Mercantile Exchange
New York Mercantile Exchange
Montreal Exchange
Philadelphia exchange - currency options
London International Financial Futures
Exchange (LIFFE)
London Traded Options Market (LTOM)
Others- Australia, Switzerland, etc.
Swaps
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Introduction
Interest rate swap
Foreign currency swap
Introduction
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Swaps are arrangements in which one party
trades something with another party
The swap market is very large, with trillions
of dollars outstanding in swap agreements
Currency swaps
Interest rate swaps
Commodity & other swaps - e.g. Natural gas
pricing
Swap Market - History
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Similar theme to the evolution of the other
derivative products - swaps evolved in
response to an economic/financial requirement
Two major events in the 1970’s created this
financial need....
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Transition of the principal world currencies from
fixed to floating exchange rates - began with the
initial devaluation of the U.S. Dollar in 1971
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Exchange rate volatility and associated risk has been with
us since
Swap Market - History
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The second major event was the change in policy of
the U.S. Federal Reserve Board to target its money
managment operations based on money supply vs
the actual level of rates
U.S interest rates became much more volatile hence
created interest rate risk
 With the prominance of U.S dollar fixed income instruments
and dollar denominated trade, this created interest rate or
coupon risk for financial managers around the world .
The swap agreement is a ‘creature’ of the 80’s and emerged
via the banking community - again in response to the above
noted need
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Interest Rate Swap
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In an interest rate swap, one firm pays a
fixed interest rate on a sum of money and
receives from some other firm a floating
interest rate on the same sum
Foreign Currency Swap
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In a foreign currency swap, two firms
initially trade one currency for another
Subsequently, the two firms exchange
interest payments, one based on a foreign
interest rate and the other based on a U.S.
interest rate
Finally, the two firms re-exchange the two
currencies
Commodity Swap
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Similar to an interest rate swap in that one
party agrees to pay a fixed price for a notional
quantity of the commodity while the other party
agrees to pay a floating price or market price
on the payment date(s)
Product Characteristics
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Both options and futures contracts exist on
a wide variety of assets
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Options trade on individual stocks, on market
indexes, on metals, interest rates, or on futures
contracts
Futures contracts trade on products such as
wheat, live cattle, gold, heating oil, foreign
currency, U.S. Treasury bonds, and stock market
indexes
Product Characteristics (cont’d)
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The underlying asset is that which you have
the right to buy or sell (with options) or to
buy or deliver (with futures)
Product Characteristics (cont’d)
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Listed derivatives trade on an organized
exchange such as the Chicago Board
Options Exchange or the Chicago Board of
Trade
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OTC derivatives are customized products
that trade off the exchange and are
individually negotiated between two parties
Product Characteristics (cont’d)
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Options are securities and are regulated by
the Securities and Exchange Commission
(SEC) in the U.S and by the ‘Commission
des Valeurs Mobilieres du Quebec’ or the
Commission Responsible for Regulating
Financial Markets in Quebec for the
Montreal Options Exchange
Futures contracts are regulated by the
Commodity Futures Trading Commission
(CFTC) in the U.S.
Participants in the Derivatives
World
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Include those who use derivatives for:
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Hedging
Speculation/investment
Arbitrage
Hedging
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If someone bears an economic risk and
uses the futures market to reduce that risk,
the person is a hedger
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Hedging is a prudent business practice;
today a prudent manager has an obligation
to understand and apply risk management
techniques including the use of derivatives
Speculation
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A person or firm who accepts the risk the
hedger does not want to take is a
speculator
Speculators believe the potential return
outweighs the risk
The primary purpose of derivatives markets
is not speculation. Rather, they permit the
transfer of risk between market participants
as they desire
Arbitrage
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Arbitrage is the existence of a riskless
profit
Arbitrage opportunities are quickly
exploited and eliminated in efficient
markets
Arbitrage (cont’d)
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Persons actively engaged in seeking out
minor pricing discrepancies are called
arbitrageurs
Arbitrageurs keep prices in the marketplace
efficient
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An efficient market is one in which securities are
priced in accordance with their perceived level
of risk and their potential return
The pricing of options incorporates this
concept of arbitrage
Uses of Derivatives
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Risk management
Income generation
Financial engineering
Risk Management
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The hedger’s primary motivation is risk
management
Someone who is bullish believes prices are
going to rise
Someone who is bearish believes prices are
going to fall
We can tailor our risk exposure to any points
we wish along a bullish/bearish continuum
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A Framework for Integrated Risk Management
Organization wide
Strategic
-technology & information
- knowledge management
-industry value chain transformation
Crisis Management
-environmental disasters
-brand crisis/computer system failure
Operating Risks
-distribution networks
-manufacturing
Commercial Risks
- new competitor(s)
- customer service expectations
- new pricing models
- supply chain management
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Market & Credit Risk
-price - interest & fx. rate
-commodity price
Risk
Identification Impact
Response
Risk Management (cont’d)
FALLING PRICES
EXPECTED
BEARISH
FLAT MARKET
EXPECTED
NEUTRAL
Increasing bearishness
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RISING PRICES
EXPECTED
BULLISH
Increasing bullishness
Income Generation
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Writing a covered call is a way to generate
income
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Involves giving someone the right to purchase
your stock at a set price in exchange for an upfront fee (the option premium) that is yours to
keep no matter what happens
Writing calls is especially popular during a
flat period in the market or when prices are
trending downward
Financial Engineering
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Financial engineering refers to the practice
of using derivatives as building blocks in
the creation of some specialized product
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e.g linking the interest due on on a bond issue
to the price of oil (for an oil producer)
Financial Engineering (cont’d)
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Financial engineers:
Select from a wide array of puts, calls futures,
and other derivatives
– Know that derivatives are neutral products
(neither inherently risky nor safe)
.....’derivatives are something like electricity:
dangerous if mishandled, but bearing the
potential to do good’
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Arthur Leavitt
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Chairman, SEC - 1995
Effective Study of Derivatives
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The study of derivatives involves a
vocabulary that essentially becomes a new
language
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Implied volatility
Delta hedging
Short straddle
Near-the-money
Gamma neutrality
Etc.
Effective Study of Derivatives
(cont’d)
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A broad range of institutions can make
productive use of derivative assets:
financial institutions
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Investment houses
Asset-liability managers at banks
Bank trust officers
Mortgage officers
Pension fund managers
Corporations - oil & gas, metals, forestry
etc.
Individual investors