1. Chapter 1
Introduction
© 2002 South-Western Publishing

2. Outline Intro – what are derivative securities?
Overview and different perspectives
Course Objectives
Types of derivatives
Participants in the derivatives world
Uses of derivatives

3. Introduction
There is 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

4. 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 -

5. 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

6. 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

7. 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

8. 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

9. 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.

10. Types of Derivatives
Options
Futures contracts
Swaps
Hybrids

11. 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
You can exercise an option if you wish, but you do not have to do so

12. 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

13. 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

14. 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.

15. Futures Contracts (cont’d)
A futures 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

16. 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)

17. 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

18. 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

19. 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

20. 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.

21. Swaps
Introduction
Interest rate swap
Foreign currency swap

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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)

28. 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

29. 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)

30. Product Characteristics (cont’d)
Listed derivatives 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

31. 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.

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

33. Hedging
If someone 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

34. 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

35. 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

36. 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

37. Uses of Derivatives Risk management Income generation
Financial engineering

38. 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

40. A Framework for Integrated Risk Management
Organization wide
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
Risk
Identification Impact Response
Connectivity

41. 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

42. 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
Writing calls is especially popular during a flat period in the market or when prices are trending downward

43. Financial Engineering
Financial engineering 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)

44. 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

45. Effective Study of Derivatives
The study of derivatives involves a vocabulary that essentially becomes a new language
Implied volatility
Delta hedging
Short straddle
Near-the-money
Gamma neutrality
Etc.

46. 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