© 2002 South-Western Publishing 1

Chapter 1

Introduction

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Outline

Introduction Types of derivatives Participants in the derivatives world Uses of derivatives Effective study of derivatives

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Introduction (cont’d)

How many have heard of the following: Nick Leeson and Barings Bank - Orange County - California Sumitomo Copper Proctor & Gamble Government of Belgium

....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

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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

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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 -

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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

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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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Objectives of the Course

To illustrate the economic function/ application of derivatives

To understand their application in both risk management and speculative situations

To inform the potential user so that an intelligent decision might be made regarding the role of derivatives in a particular situation

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Types of Derivatives

Options Futures contracts Swaps Hybrids

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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

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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

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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 the contract - theoretically unlimited exposure

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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 spot market.

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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

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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 established by the Chicago Board of Trade (CBT)

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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 mark-market system

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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 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

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

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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 us 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 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 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 local/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 wide variety of assets– Options trade on individual stocks, on market

indexes, on metals, interest rates, or on futures contracts

– Futures contracts trade on products such commodities e.g. wheat, live cattle, gold, crude oil, heating oil, natural gas, foreign currency, U.S. Treasury bonds, and stock market indexes

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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)

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Product Characteristics (cont’d)

Listed derivatives trade on an organized exchange such as the Chicago Board Options Exchange or the Chicago Board of Trade

OTC derivatives are customized products that trade off the exchange and are individually negotiated between two parties

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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 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

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Speculation

A person or firm who accepts the risk the hedger does not want to take is a speculator(or a firm hedging the opposite position)

Speculators believe the potential return outweighs the risk

The primary purpose of derivatives markets is not speculation. Rather, they permit the transfer of risk between market participants as they desire

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Arbitrage

Arbitrage is the existence of a riskless profit

Arbitrage opportunities are quickly exploited and eliminated in efficient markets

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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

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Uses of Derivatives

Risk management Income generation Financial engineering

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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

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Strategic -technology & information - knowledge management -industry value chain transformation Crisis Management -environmental disasters -brand crisis/computer system failure

Operating Risks -distribution networks -manufacturing

Commercial Risks - new competiter(s) - customer service expectations - new pricing models - supply chain management

Market & Credit Risk -price - interest & fx. rate -commodity price

Organization wide

Con

nect

ivity

Risk

Identification Impact Response

A Framework for Integrated Risk Management

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Risk Management (cont’d)

FALLING PRICES FLAT MARKET RISING PRICES

EXPECTED EXPECTED EXPECTED

BEARISH NEUTRAL BULLISH

Increasing bearishness Increasing bullishness

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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

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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)

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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

Chairman, SEC - 1995

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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.

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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