1. Bates College Investment Club
Derivatives
February 2018

2. Derivative markets
Derivatives: transactions negotiated by two private parties (counterparties) outside of an financial exchange. One counterparty is called a dealer (investment bank) and the other is called a user (investment fund, government agency). These contracts “derive” their value from an underlying asset.
Fastest growing component of financial markets from 2010s–present have been over the counter derivatives.
Two main branches of derivatives:
Options: contracts that allow participations certain benefits under certain conditions
Forwards: contracts that set a price for something to be delivered in the future
Derivatives are customizable and flexible depending on the size and expiration of the contract and underlying asset.
p. 253

3. Historical overview of derivatives
During the 1980s, the market for such financial products barely existed
During the 1990s, when investors found out they could both manage and increase risk
They have drawn considerable controversy as they are difficult to explain and they allow banks to take risks that can be difficult to put down on financial reports
All throughout the 2000s–even in the 2008 financial crisis–the usage of derivatives have ballooned
Specifically, derivatives played a critical role in the collapse of the subprime mortgage market during the 2008 financial crisis
Many people don’t understand what they are, how they work, and how risk is distributed p

4. Risks of derivatives
Counterparty risk: the main difference between derivative contracts and stocks is that these contracts are dependent on two parties who could, at one point, become insolvent. There is particular emphasis on the creditworthiness of each counterparty as it is essential to gauge the risk of the derivative.
Price risk: stocks are standardized, there is no expiration date and their price is literally reflected on its value. With derivatives, the price of a contract may increase or decrease either at or promptly after the expiration date. The more customized the derivative, the more present price risk is.
Legal risk: Stocks, which are traded on exchanges, abide by a clear set of rules and customs that clearly outline how they are traded. The complexity of derivatives make them harder to legally manage.
Settlement risk: “Netting” occurs when one side of the trade is executed and the other is delayed. p

5. Forwards
The most simple derivative contract: an agreement to set a price now for something to be delivered in the future. e.g.: price of grain to a baker
Forwards, on the average, can be customized to mature further and further into the future, making it an attractive option for long-term investors.
Forwards are traded on a stock exchange and are usually executed as an insurance policy again adverse price movements.
Hedge fund managers use forwards in order to hedge against asset price volatility
Note that forward contracts and futures contracts serve the same function. They are differentiated by their specifics. p

6. Futures
One of the most common forward is called a “futures contract”: an agreement to buy or sell an asset (especially commodities or stocks) at a fixed price in the future.
Unlike forwards, they are not traded on a stock exchange and are privately undertaken by two counterparties. They are not used as insurance against adverse movements.
Futures are usually entered with commodities (i.e. a bag of grain) if an investor believes that price will fluctuate
In order to be traded on a future’s market a commodity must meet certain quality standards and fall into a structured contract. After the two requirements are satisfied, then the delivery date is set. On this date, the commodity must be delivered in exchange for the set price. p

7. Swaps
A swap is a contract where on party “swaps” an asset or cash flow for another asset or cash flow. Tom agrees to swap 1 apple with Pierre who gives him 1 banana. They engage in a contract that stipulates the swap. There are players and receivers.
Interest rate swaps: two parties to exchange interest payment obligations. Interest payments are a cash flow. Take for example a mortgage. Tom wants to buy a house, he takes out a mortgage (a loan) from a bank and then pays it back over time. Bank of America receives a stream of payments from Tom. Bank of America then “swaps” their mortgage with J.P. Morgan Chase who gives them Pierre’s mortgage. They are swapping cash flows. Swaps are often utilized if a company can borrow money easily at one type of interest rate but prefers a different type.
Currency swaps: Like interest rate swaps, currency swaps rely on the exchange streams of two different currencies. If interest rates are lower in the Eurozone than the United States, an investor might buy the U.S. dollar and swap it for the Euro.
p. 258

8. Options
They are financial contracts that stipulate certain benefits at certain times. When investors enter into an option they are given the right to buy or sell an asset at a determined price.
When you take out an option to buy an asset its called a “call”. When you want to sell it, its called “put”.
You compare and contrast the price of the option (strike price) and current market price (spot price) to figure out when to sell/buy.
Next we will look at an example of an option being exercised to fully explain what this is.
Swaption: a combination of an option and a swap. It gives a holder the right to enter a swap with another party at a given time in the future. Parties usually agree on a swaption when there are uncertainties about the price movements in the future.
p. 258

9. Equity derivatives
Equity options: Pierre believes that a share of Amazon.com will increase from $10 to $50. He buys (with a premium) a call-option from Michel who agrees to a strike price of $25. This contract is for one week. On day four, the share increases to $50! Michel has to sell it to Pierre for the strike price for $25 and Pierre sells it for the spot price of $50. If it went down from its strike price, Pierre would do nothing for the remainder of the week and Michel would keep the premium.
A European option is where an investor can only exercise his option on or after a specific date
An Asian option is where an investor can exercise his option at its maturity at the average of all the prices during the period of the option
An American option is where the investor has complete freedom to do whatever they want until its maturity date
A Bermudian option: American + European = set of dates to exercise option
A tick is a measure of the price movement of a security. It is used to gauge the volatility of an asset. If it goes above a specified tick amount, then the trading of that security is halted to the participants specifications.
pp. 153–171

10. Credit derivatives
Credit derivatives were financially engineered to transfer and distribute credit risk. Credit risk is the risk that the debtor will not repay the issuer. The main instrument in credit derivatives is called the credit default swap. A CDS is a contract where to parties agree to exchange risk. Pierre is a financially stable guy who takes out a loan from Michel. Michel doesn’t think Pierre is financially stable so he talks to Marc. Marc agrees to pay the entire debt of Pierre if he defaults. In exchange for this promise, Michel pays him a premium for the guarantee. This effectively swaps the risk from Pierre to Marc. Marc wants to do this because he gets a nice premium and because Pierre is financially stable will never have to pay for it. Although it has nothing to do with derivatives a collateralized debt obligation is a similar financial instrument. A CDO occurs when Michel collateralizes his debt by combining all the loans into one component (i.e. an obligation). If one person doesn’t pay, Michel can just switch to another loan’s cash flow. e.g. CDOs during the financial crisis.
pp. 153–171

11. Synthetic securities
Here is where it gets super complicated. A “synthetic” security mimics the returns of an actual security. It simulates the return of an actual investment, but the return is actually created by using a combination of financial instruments, such as options contracts. Although they are artificial they distribute risk, increase returns, and diversify portfolios.
Synthetic long position: when an investor enters into a contract that follows a stock upward (long call) and sells it when it drops below a certain price point (short put).
Synthetic short position: when an investor enters into a contract that follows a stock downward (long put) and sells it when it increases above a certain price point (short call).
Note the difference between normal short selling and going long. What is artificial about it is that you’re not actually buying/selling any real stocks. Contrast this with “naked short-selling”: selling stocks that you don’t have.
pp. 153–171

12. Derivatives in Review:
The form and function of financial derivatives
A brief history of their usage in the financial world
The systemic risks of derivative contracts
Differences between forwards, futures, swaps, and options
The notions of strike and spot prices as well as call and put options
Equity-linked and credit-linked derivatives
European, Asian, American, and Bermudian options and ticks
Synthetic derivatives and investments
pp. 153–171

13. References
Levinson, Marc. “The Economist’s Guide to Financial Market: Why the Exist and How They Work”. The Economist. Print. pp. 254–271.