Derivatives Chapter1

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2002 South-Western Publishing1

Chapter 1

Introduction


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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

There is no universally satisfactory answerto the question of what a derivative is,however one explanation ......

A financial derivative is a financial instrumentor security whose payoff depends on anotherfinancial instrument or security ......the payoffor the value is derivedfrom that underlyingsecurity

derivatives are agreements or contracts

between two parties


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Introduction (contd)

Futures, options and swap markets are very

useful, perhaps even essential, parts of thefinancial system

hedging or risk management

speculate or strive for enhanced returns

price discovery - insight into future prices ofcommodities

Futures and options markets, and morerecently swap markets have a long history

of being misunderstood -


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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 ofderivatives - in many of these situations this has been the

case i.e a speculative application of derivatives that has goneagainst the user


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What many critics of equity derivatives fail to realize is that themarkets fo r these inst ruments have become so large not because ofsl ick sales campaigns, but because they are provid ing econom ic

value to their users Alan Greenspan, 1988

In our view, however, derivatives are f inancia l weapon s of massdestruc t ion, carrying d angers that, wh i le latent now , are po tent ially

lethal Warren Buffett 2002 Berkshire Hathaway annual report

derivatives are something like electricity: dangerous if mishandled, butbearing 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 roleof derivatives in a particular situation and to identify the needfor better understanding before proceeding

working introductory level knowledge of derivative securities


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Derivatives & Risk

Derivative markets neither create nor destroywealth - they provide a means to transfer risk

zero sum game in that one partys gains are equal to

another partys losses

participants can choose the level of risk they wish to takeon using derivatives

with this efficient allocation of risk, investors are willing tosupply more funds to the financial markets, enables firmsto 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 leadto large gains and losses

this high degree of leverage makes them

effective but also dangerous whenmisused.


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Types of Derivatives

Options

Futures contracts Swaps

Hybrids


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Options

An opt ionis the right to either buy or sell

something at a set price, within a set periodof time

The right to buy is a cal l opt ion

The right to sell is a put opt ion

You can exercise an option if you wish, butyou do not have to do so


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Futures Contracts

Futures con tractsinvolve a promise to

exchange a product for cash by a setdelivery date - and are traded on a futuresexchange

Futures con tractsdeal 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 ifhe or she wishes - option premium is themaximum $$ exposure

The buyer of a futures contract cannot abandonthe contract - theoretically unlimited exposure


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Futures Contracts (contd)

Futures Contracts Example

The futures market deals with transactions that willbe made in the future. A person who buys aDecember U.S. Treasury bond futures contract

promises to pay a certain price for treasury bondsin December. If you buy the T-bonds today, youpurchase them in the cash, orspot market.


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Futures Contracts (contd)

A futures contract involves a processknown as mark ing to market Money actually moves between accounts each

day as prices move up and down

A forward con tractis functionally similar toa 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 1840s 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 andbuyers - contracts not traded

by 1870s 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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History Contd

1891 the Minneapolis Grain Exchange

organized the first complete clearinghousesystem

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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History Contd

Key point is that commodity futures (evolving fromforward contracts) developed in response to an

economic need by suppliers and users of variousagricultural goods initially and later othergoods/commodities - e.g metals and energycontracts

Financial futures - fixed income, stock index andcurrency futures markets were established in the70s and 80s - facilitated the sale of financialinstruments 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 investmentinnovations of the 1970s

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

Interest rate swap Foreign currency swap


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Introduction

Swapsare 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 gaspricing


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Swap Market - History

Similar theme to the evolution of the other

derivative products - swaps evolved inresponse to an economic/financial requirement

Two major events in the 1970s created this

financial need....

Transition of the principal world currencies fromfixed to floating exchange rates - began with the

initial devaluation of the U.S. Dollar in 1971

Exchange rate volatility and associated risk has been withus 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 vsthe 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 instrumentsand dollar denominated trade, this created interest rate or

coupon risk for financial managers around the world .

The swap agreement is a creature of the 80s 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 afixed interest rate on a sum of money andreceives from some other firm a floatinginterest rate on the same sum


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Foreign Currency Swap

In a foreign cu rrency swap, two firmsinitially trade one currency for another

Subsequently, the two firms exchangeinterest payments, one based on a foreigninterest 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 widevariety of assets

Options trade on individual stocks, on market indexes, onmetals, interest rates, or on futures contracts

Futures contracts trade on agricultural commodities suchas wheat, live cattle, precious metals such as gold andsilver and energy such as crude oil, gas and heating oil,

foreign currencies, U.S. Treasury bonds, and stock marketindexes


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Product Characteristics (contd)

The underly ing assetis that which you havethe right to buy or sell (with options) or tobuy or deliver (with futures)


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Lis ted derivat ivestrade on an organizedexchange such as the Chicago Board

Options Exchange or the Chicago Board ofTrade, the NYMEX or the MontrealExchange

OTC derivat ivesare customized productsthat trade off the exchange and areindividually negotiated between two parties


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Options are securities and are regulated bythe 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 theMontreal Options Exchange

Futures contracts are regulated by theCommodity 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

If someone bears an economic risk anduses the futures market or other derivativesto reduce that risk, the person is a hedger

Hedging is a prudent business practice;

today a prudent manager has an obligationto understand and apply risk managementtechniques including the use of derivatives


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Speculation

A person or firm who accepts the risk thehedger does not want to take is aspeculator

Speculators believe the potential returnoutweighs the risk

The primary purpose of derivatives marketsis not speculation. Rather, they permit orenable the trans fer o f r isk between marketpart ic ipants as they desire


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Arbitrage

Arbi t rageis the existence of a risklessprofit

Arbitrage opportunities are quicklyexploited and eliminated in efficientmarkets

Arbitrage then contributes to the efficiency ofmarkets


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Arbitrage (contd)

Persons actively engaged in seeking outminor pricing discrepancies are calledarbitrageurs

Arbitrageurs keep prices in the marketplaceefficient

An efficient market is one in which securities arepriced in accordance with their perceived levelof 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 hedgers primary motivation is risk

management

Someone who is bul l ishbelieves prices aregoing to rise

Someone who is bearishbelieves 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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Strategic

-technology & information/knowledge

- business model

-industry value chain transformation

Regulatory Risk

-environmental

-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

-commodity price

Organization wide

Risk

Identification Impact Response

A Framework for Integrated Risk Management


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Risk Management (contd)

FALLING PRICES FLAT MARKET RISING PRICESEXPECTED 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 cal lis a way to generateincome

Involves giving someone the right to purchaseyour stock at a set price in exchange for an up-front fee (the option premium) that is yours tokeep no matter what happens

Writing calls is especially popular during aflat period in the market or when prices aretrending downward


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Financial Engineering

Financial eng ineeringrefers to the practiceof using derivatives as building blocks inthe creation of some specialized product

e.g linking the interest due on a bond issue tothe price of oil (for an oil producer)


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Financial Engineering (contd)

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 thepotential to do good

Arthur Leavitt

Chairman, SEC - 1995


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Effective Study of Derivatives

The study of derivatives involves avocabulary 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(contd)

A broad range of institutions can makeproductive 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, forestryetc.

Documents

Derivatives Chapter1