Derivatives Model

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Chapter 1

Chapter 1

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Outline

Outline

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 IntroIntro – – what are derivative securities? what are derivative securities?

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 Overview and different perspectivesOverview and different perspectives

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 Course ObjectivesCourse Objectives

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 Types of derivativesTypes of derivatives

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 Participants in the derivatives worldParticipants in the derivatives world

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Introduction

Introduction

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 There is no universally satisfactory There is no universally satisfactory answeranswer

to the question of what

to the question of what a derivative is,a derivative is,

however one explanation ...

however one explanation ...

 –

 – A financial derivative is a ‘fiA financial derivative is a ‘financial instrumentnancial instrument or security whose payoff depends on another

or security whose payoff depends on another

financial

financial instrument instrument or sor security’ ecurity’ ...the ...the payoffpayoff

or the value is

or the value is deriv ed deriv ed  from that underlying from that underlying

security

security

 –

 – derivatives are agreements or contractsderivatives are agreements or contracts between two parties

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Introduction (cont’d)

Introduction (cont’d)

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 Futures, options and swap markets are veryFutures, options and swap markets are very

useful, perhaps even essential, parts of the

useful, perhaps even essential, parts of the

financial system

financial system

 –

 – hedging or risk managementhedging or risk management

 –

 – speculate or strive for enhanced returnsspeculate or strive for enhanced returns

 –

 – price discovery - insight into future prices ofprice discovery - insight into future prices of

commodities

commodities



 Futures and options markets, and moreFutures and options markets, and more

recently swap markets have a l

recently swap markets have a long historyong 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

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Introduction (cont’d)

“What many critics of equity derivatives fail to realize is that the

m a r k e ts f o r t h e s e in s t r u m e n t s h a v e b e c o m e s o la r g e n o t b e c a u s e o f s l i c k s a l es c a m p a ig n s , b u t b e c au s e t h e y a r e p r o v i d i n g e c o n o m i c v a l u e t o t h e i r u s e r s  ” 

 – Alan Greenspan, 1988

„In our view, however, derivatives are f i n an c i a l w e ap o n s o f m a s s

d e s t r u c t i o n , c a r r y i n g d a n g e r s t h a t , w h i l e la t en t n o w , a r e p o t e n t i a ll y

lethal‟ 

 – Warren Buffett 2002 Berkshire Hathaway annual report

’derivatives are something like electricity: dangerous if mishandled, but bearing the potential to do good’

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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

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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

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Options

 An o p t i o n   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 c a l l o p t i o n  – The right to sell is a p u t o p t i o n

 You can exercise an option if you wish, but

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Futures Contracts

 F u t u r e s c o n t r ac t s   involve a promise to

exchange a product for cash by a set

delivery date - and are traded on a futures exchange

 F u t u r e s c o n t r ac t s   deal with transactions

that will be made in the future

 contracts traded on a wide range of

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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

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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 s p o t m a r k et  .

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Futures Contracts (cont’d)

 A futures contract involves a process

known as m ar k i n g t o m ar k e t

 – Money actually moves between accounts each

day as prices move up and down

 A f o r w a r d c o n t r ac t   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

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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

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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

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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

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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)

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Swaps

 Introduction

 Interest rate swap

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Introduction

 S w a p s   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

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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

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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 f o r ei g n c u r r en c y s w ap  , 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

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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 u n d e r l y i n g as s e t   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)

 Lis ted 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 d erivatives  are customized products

that trade off the exchange and are

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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

 If someone bears an economic risk and

uses the futures market or other derivatives to reduce that risk, the person is a h e d g e r

 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 s p e c u l a t o r

 Speculators believe the potential return

outweighs the risk

 The primary purpose of derivatives markets

is not speculation. Rather, they permit or enable t h e t r an s f er o f r i s k b e t w e en m ar k e t p a r t i c i p an t s a s t h e y d e s i r e

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Arbitrage

 A r b i t r a g e   is the existence of a riskless

profit

 Arbitrage opportunities are quickly

exploited and eliminated in efficient markets

 – Arbitrage then contributes to the efficiency of

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Arbitrage (cont’d)

 Persons actively engaged in seeking out

minor pricing discrepancies are called a r b i t r a g e u r s

 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

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Uses of Derivatives

 Income generation

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Risk Management

 The hedger’s primary motivation is risk

management

 Someone who is b u l l i s h   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

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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

Organization wide

Risk

Identification Impact Response

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Risk Management (cont’d)

FALLING PRICES FLAT MARKET RISING PRICES

EXPECTED EXPECTED EXPECTED

BEARISH NEUTRAL BULLISH

Increasing bearishness Increasing bullishness

….for a producer

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Income Generation

 Writing a c o v e r ed c a l l   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

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Financial Engineering

 Financial eng ineering  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

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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

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Effective Study of Derivatives

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