1. Maclachlan, Money & Banking Spring 2006 1 Financial Derivatives Chapter 13 Week 2

2. Maclachlan, Money & Banking Spring 2006 2 Definition A derivative is a financial instrument whose value depends on (or derives from) the value of another instrument (the underlying). Example: the value of a stock option depends on the value of the underlying stock.

3. Maclachlan, Money & Banking Spring 2006 3 Three Basic Types of Derivatives 1.Futures/Forwards 2.Options 3.Swaps Derivatives can be created through combining the basic types, e.g., swaptions, futures options.

4. Maclachlan, Money & Banking Spring 2006 4 Forward Contracts Began as a way for farmers to hedge risk. Suppose price of wheat could be $10 a bushel or $20 a bushel, depending on the weather. How could farmer hedge? Currency and interest rate forward contracts.

5. Maclachlan, Money & Banking Spring 2006 5 Futures Contracts Standardized. Exchange traded and insured. Marked to market, margin requirements. Highly liquid. Open outcry http://www.nymex.com/media/sounds1.wav http://www.nymex.com/media/sounds1.wav

6. Maclachlan, Money & Banking Spring 2006 6 http://www.nymex.com/lsco_pre_agree.aspx

7. Maclachlan, Money & Banking Spring 2006 7 Comparison Forward Contracts Customized Arranged by bankers. Subject to counterparty risk Illiquid Futures Standardized Exchange traded Insured, margin requirements Liquid Marked to market

8. Maclachlan, Money & Banking Spring 2006 8 Hillary Clinton’s 1979 Investment in Cattle Futures "It's a mockery of the profession to say you took a thousand dollars and made a hundred thousand," says Joe Gressel, a 19-year veteran of the Merc's trading pits. "Around here," he adds, in a sentiment echoed by some of his colleagues, "we're flabbergasted that she's bamboozled the people of New York state."

9. Maclachlan, Money & Banking Spring 2006 9 Options Right but not the obligation to buy (sell) an underlying instrument at a prespecified price. Call vs. put. Strike (or exercise) price. Price of underlying vs. price of option. Hockey stick diagrams.

10. Maclachlan, Money & Banking Spring 2006 10 Swaps Swaps originated in the early 1980’s to hedge interest rate risk. The notional principal outstanding of swaps and other over-the-counter (OTC) derivatives, stood at $197 trillion at the end of December 2003.

11. Maclachlan, Money & Banking Spring 2006 11 Swaps Allows a floating rate borrower to get a fixed rate obligation. Longshore Construction can only get a loan from the bank at a floating rate. Sallie Mae can issue long-term bonds to investors at a fixed rate. How can they both benefit through trade?