Chapter 1

Introduction

1 © 2002 South-Western Publishing

 Outline

 Intro– what are derivative securities?

 Overview and different perspectives
 Course Objectives
 Types of derivatives
 Participants in the derivatives world
 Uses of derivatives

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 Introduction

 Thereis no universally satisfactory answer to

the question of what a derivative is, however
one explanation ......

– 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)
 Futures,
options and swap markets are very useful,
perhaps even essential, parts of the financial system
– 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 -

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 Introduction (cont’d)

How many have heard of the following:

 Nick Leeson and Barings Bank $1.3B (1995)
 Orange County – California - $1.7B (1994)
 Sumitomo Copper $2.6 B (1996)
 Proctor & Gamble – $102 M (1994)
 Govt. of Belgium - $1.2B (1997)
....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)

“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”
– Alan Greenspan, 1988

‘In our view, however, derivatives are financial weapons of mass

destruction, carrying dangers that, while latent now, are potentially
lethal’
– Warren Buffett 2002 Berkshire Hathaway annual report

’derivatives are something like electricity: dangerous if mishandled, but

bearing the potential to do good’
– Arthur Leavitt- Chairman SEC 1995

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 Objectives of the Course

 To illustrate the economic function/ application of derivatives

 To understand their application in both risk management and
speculative situations
 To provide sufficient understanding such that the user can
make an informed and intelligent decision regarding the role
of derivatives in a particular situation and to identify the need
for better understanding before proceeding

…working introductory level knowledge of derivative securities

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 Derivatives & Risk

 Derivative markets neither create nor destroy

wealth - they provide a means to transfer risk
– 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

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 Derivatives & Risk

 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.

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 Types of Derivatives

 Options
 Futures contracts
 Swaps
 Hybrids

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 Options

 An option is the right to either buy or sell

something at a set price, within a set period
of time
– The right to buy is a call option
– The right to sell is a put option

 Youcan exercise an option if you wish, but

you do not have to do so

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 Futures Contracts

 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

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 Futures Contracts

 Are different from options in that:

– 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

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 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)

Afutures contract involves a process known as

marking to market
– Money actually moves between accounts each day as
prices move up and down

A forward contract is functionally similar to a futures

contract, however:
– 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

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 Futures/Forward Contracts -
History
 Forward contracts on agricultural products began in the
1840’s
– producer made agreements to sell a commodity to a buyer at a
price set today for delivery on a date following the harvest
– arrangements between individual 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)

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 Futures/Forward Contracts -
History Cont’d

 1891 the Minneapolis Grain Exchange organized

the first complete clearinghouse system
– the clearinghouse acts as the third party to all
transactions on the exchange
– designed to ensure contract integrity
 buyers/sellers required to post margins with the clearinghouse
 daily settlement of open positions - became known as the mark-
market system

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 Futures/Forward Contracts -
History Cont’d

 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

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 Option Contracts - History

 Chicago Board Options Exchange (CBOE) opened in April

of 1973
– 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

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 Options Contracts

 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.

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 Swaps

 Introduction
 Interestrate swap
 Foreign currency swap

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 Introduction

 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

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 Swap Market - History

 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....
– Transition of the principal world currencies from fixed to
floating exchange rates - began with the initial devaluation
of the U.S. Dollar in 1971
 Exchange rate volatility and associated risk has been with us since

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 Swap Market - History

– The second major event was the change in policy of the U.S.
Federal Reserve Board to target its money management
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 prominence 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

 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

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 Foreign Currency Swap

 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

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 Commodity Swap

 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)

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 Product Characteristics

 Both options and futures contracts exist on a wide

variety of assets
– Options trade on individual stocks, on market indexes, on
metals, interest rates, or on futures contracts
– Futures contracts trade on agricultural commodities such
as wheat, live cattle, precious metals such as gold and
silver and energy such as crude oil, gas and heating oil,
foreign currencies, U.S. Treasury bonds, and stock market
indexes

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 Product Characteristics (cont’d)

 The underlying asset is that which you have

the right to buy or sell (with options) or to
buy or deliver (with futures)

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 Product Characteristics (cont’d)

 Listedderivatives trade on an organized

exchange such as the Chicago Board
Options Exchange or the Chicago Board of
Trade, the NYMEX or the Montreal
Exchange

 OTC derivatives are customized products

that trade off the exchange and are
individually negotiated between two parties

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 Product Characteristics (cont’d)

 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.

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 Participants in the Derivatives
World
 Include those who use derivatives for:
– Hedging
– Speculation/investment
– Arbitrage

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 Hedging

 Ifsomeone bears an economic risk and

uses the futures market or other derivatives
to reduce that risk, the person is a hedger

 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

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 Speculation

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 or enable
the transfer of risk between market participants
as they desire

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 Arbitrage

 Arbitrage is the existence of a riskless

profit
 Arbitrage opportunities are quickly
exploited and eliminated in efficient
markets
– Arbitrage then contributes to the efficiency of
markets

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 Arbitrage (cont’d)

 Persons actively engaged in seeking out minor

pricing discrepancies are called arbitrageurs
 Arbitrageurs keep prices in the marketplace efficient
– 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

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 Uses of Derivatives

 Risk management
 Income generation
 Financial engineering

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 Risk Management

 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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39
 A Framework for Integrated Risk Management
Organization wide

Strategic
-technology & information/knowledge Risk
- business model
-industry value chain transformation

Regulatory Risk
Identification Impact Response
-environmental
Connectivity

-competition

Operating Risks
-distribution networks
-manufacturing

Commercial Risks
- new competitor (s)
- customer service expectations
- new pricing models
- supply chain management

Market & Credit Risk

-price - interest & fx. rate
40 -commodity price
 Risk Management (cont’d)

FALLING PRICES FLAT MARKET RISING PRICES

EXPECTED EXPECTED EXPECTED

BEARISH NEUTRAL BULLISH

Increasing bearishness Increasing bullishness

….for a producer
…the consumer has the opposite view

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 Income Generation

 Writing a covered call is a way to generate income

– Involves giving someone the right to purchase your
stock at a set price in exchange for an up-front fee (the
option premium) that is yours to keep no matter what
happens
 Writingcalls is especially popular during a flat
period in the market or when prices are trending
downward

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 Financial Engineering

 Financialengineering refers to the practice

of using derivatives as building blocks in
the creation of some specialized product
– e.g linking the interest due on a bond issue to
the price of oil (for an oil producer)

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 Financial Engineering (cont’d)

 ‘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’
Arthur Leavitt

Chairman, SEC - 1995

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 Effective Study of Derivatives

 Thestudy of derivatives involves a

vocabulary that essentially becomes a new
language
– Implied volatility
– Delta hedging
– Short straddle
– Near-the-money
– Gamma neutrality
– Etc.

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 Effective Study of Derivatives
(cont’d)

A broad range of institutions can make productive

use of derivative assets:
 Financial institutions
– Investment houses
– Asset-liability managers at banks
– Bank trust officers
– Mortgage officers
– Pension fund managers
 Corporations - oil & gas, metals, forestry etc.
 Individual investors/speculators

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