1

Derivatives- Introduction

The speed of money is faster than it’s ever been.

Loleen Doerrer

Time, April 11, 1994, p. 33

2

Business risk Vs. Financial Risk

Risks related to the underlying nature of the business and deal with such matters as the uncertainty of the future sales or the cost of inputs – Business Risk

Risks dealing with uncertainty of such factors as interest rates, exchange rates, stock prices and commodity prices – Financial Risk

3

Managing risk

Most businesses are accustomed to accepting business risks.

Indeed acceptance of business risks and the potential rewards that can come with it are the foundations of capitalism

Financial risks are a different matter and although our financial system is replete with risk, it also provides a means of dealing with risk, in the form of derivatives

4

Derivatives– A derivative is a financial instrument whose

return is derived from the return on another instrument.

Size of the derivatives market at seems to be continuously growing

Real vs. financial assets (Real assets are physical assets and include agricultural commodities, metals and sources of energy; financial assets are stocks, bonds/loans, and currencies)

Operational Definition

A derivative is a risk-shifting agreement, the value of which is derived from the value of an underlying asset. The underlying asset could be a physical commodity, an interest rate, a company’s stock, a stock index, a currency, or virtually any other tradable instrument upon which two parties can agree.

5

An interesting observation…

"We view them as time bombs both for the parties that deal in them and the economic system .. In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

- Warren Buffett, the Chairman of Berkshire Hathaway and his critique of the derivatives market. (March 2003)

6

7

Growth of derivatives marketsDerivative products initially emerged as hedging

devices against fluctuations in commodity prices, and commodity-linked derivatives remained the sole form of such products for almost three hundred years.

Financial derivatives came into spotlight in the post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products.

In recent years, the market for financial derivatives has grown tremendously in terms of variety of instruments available, their complexity and also turnover.

8

Growth of derivatives marketsIn the class of equity derivatives the world

over, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives.

Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use. The lower costs associated with index derivatives vis–a–vis derivative products based on individual securities is another reason for their growing use.

9

Factors driving the growth of derivative products1.Increased volatility in asset prices in financial markets,2. Increased integration of national financial markets

with the international markets,3. Marked improvement in communication facilities and

sharp decline in their costs,4. Development of more sophisticated risk management

tools, providing economic agents a wider choice of risk management strategies, and

5. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets.

10

Economic functions of derivatives

First, prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level.

The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices.

11

Derivatives – Economic Function

Second, the derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them.

12

Derivatives – Economic Function

Third, derivatives, due to their inherent nature, are linked to the underlying cash markets.

With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.

13

Derivatives – Economic Function

Fourth, speculative trades shift to a more controlled environment of derivatives market.

In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets.

14

Derivatives – Economic Function

Fifth, an important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity.

The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense.

15

Derivatives – Economic Function

Finally, derivatives markets help increase savings and investment in the long run.

Transfer of risk enables market participants to expand their volume of activity.

Hedging

Hedging using derivatives is commonly used by parties who seek to offset their existing risks by entering into a derivatives transaction.

The existing risks could be an investment portfolio, price changes in oil for a petroleum mining company or perhaps investments in a foreign country.

16

Speculating

Speculation is more commonly used by hedge funds or traders who aim to generate profits with only a marginal investment, essentially placing a bet on the movement of an asset.

Although speculation can produce a high return on investment, the downside risks are equally as prominent

Because of the high degree of leverage one can take in speculative contracts, an adverse change in prices could result in rapidly increasing debt and a portfolio worth millions could fall to almost zero with the space of a few hours.

17

Arbitrage

Opportunities to arbitrage take place throughout the world markets, and derivatives are sometimes used to exploit these.

Practitioners working within risk finance or quantitative finance often develop models to price various assets being traded across the markets, and upon finding price discrepancies, one can make use of a specific combination of derivatives in order make a riskless profit.

18

Major derivative categories

Derivatives fall into two categories. One consists of customized, privately negotiated derivatives, which are known generically as over-the-counter (OTC) derivatives or, even more generically, as swaps.

The other category consists of standardized, exchange-traded derivatives, known generically as futures

19

Forward contract

A forward is a customized, privately negotiated agreement between two parties to exchange an asset or cash flows at a specified future date at a price agreed on the trade date.

Entering a forward contract typically does not require the payment of a fee.

20

Forward Rate Agreement (FRA)

A forward rate agreement is a forward contact on a short-term interest rate, usually Libor, in which cash flow obligations at maturity are calculated on a notional amount and based on the difference between a predetermined forward rate and the market rate prevailing on that date.

The settlement date of an FRA is the date on which cash flow obligations are determined.

21

Swap

A swap is a privately negotiated agreement between two parties to exchange cash flows at specified intervals (payment dates) during the agreed-upon life of the contract (maturity or tenor).

Entering a swap typically does not require the payment of a fee.

22

Interest rate swapThe value of an interest rate swap to a

counterparty is the net difference between the present value of the payments the counterparty expects to receive and the present value of the payments the counterparty expect to make.

At the inception of the swap, the value is generally zero to both parties, and becomes positive to one and negative to the other depending on the movement of interest rates.

Present value is the value of a quantity to be received in the future, adjusted for the time value of money (interest foregone while waiting for the quantity).

23

Cross-currency swapA cross-currency swap is an interest rate swap

in which the cash flows are in different currencies.

Upon initiation of a cross-currency swap, the counterparties make an initial exchange of notional principals in the two currencies.

During the life of the swap, each party pays interest (in the currency of the principal received) to the other.

And at the maturity of the swap, the parties make a final exchange of the initial principal amounts, reversing the initial exchange at the same spot rate.

24

Cross Currency Swap

A cross-currency swap is sometimes confused with a traditional FX swap, which is simply a spot currency transaction that will be reversed at a predetermined date with an offsetting forward transaction; the two are arranged as a single transaction.

25

26

Derivative Markets and Instruments

Options– Definition: a contract between two parties

that gives one party, the buyer, the right to buy or sell something from or to the other party, the seller, at a later date at a price agreed upon today

– Option terminology• price/premium• call/put• exchange-listed vs. over-the-counter options

27

Use of options in 17th Century!Options made their first major mark in financial

history during the tulip-bulb mania in seventeenth century Holland. It was one of the most spectacular get rich quick binges in history. The first tulip was brought into Holland by a botany professor from Vienna. Over a decade, the tulip became the most popular and expensive item in Dutch gardens. The more popular they became, the more Tulip bulb prices began rising.

That was when options came into the picture. They were initially used for hedging. By purchasing a call option on tulip bulbs, a dealer who was committed to a sales contract could be assured of obtaining a fixed number of bulbs for a set price. Similarly, tulip-bulb growers could assure themselves of selling their bulbs at a set price by purchasing put options.

28

Use of options in 17th Century!Later, however, options were increasingly used by

speculators who found that call options were an effective vehicle for obtaining maximum possible gains on investment. As long as tulip prices continued to skyrocket, a call buyer would realize returns far in excess of those that could be obtained by purchasing tulip bulbs themselves.

The writers of the put options also prospered as bulb prices spiralled since writers were able to keep the premiums and the options were never exercised. The tulip-bulb market collapsed in 1636 and a lot of speculators lost huge sums of money. Hardest hit were put writers who were unable to meet their commitments to purchase Tulip bulbs.

29

Forward Contracts– Definition: a contract between two

parties for one party to buy something from the other at a later date at a price agreed upon today

– Exclusively over-the-counter

Derivative Markets and Instruments (continued)

30

Futures Contracts– Definition: a contract between two

parties for one party to buy something from the other at a later date at a price agreed upon today; subject to a daily settlement of gains and losses and guaranteed against the risk that either party might default

– Exclusively traded on a futures exchange

Derivative Markets and Instruments (continued)

31

Options on Futures (also known as commodity options or futures options)– Definition: a contract between two

parties giving one party the right to buy or sell a futures contract from the other at a later date at a price agreed upon today

– Exclusively traded on a futures exchange

Derivative Markets and Instruments (continued)

32

Swaps and Other Derivatives– Definition of a swap: a contract in which two

parties agree to exchange a series of cash flows

– Exclusively over-the-counter– Other types of derivatives include swaptions

and hybrids. Their creation is a process called financial engineering.

The Underlying Asset– Called the underlying– A derivative derives its value from the

underlying.

Derivative Markets and Instruments (continued)

33

Features of OTC Markets1. The management of counter-party (credit) risk is

decentralized and located within individual institutions,2. There are no formal centralized limits on individual

positions, leverage, or margining,3. There are no formal rules for risk and burden-sharing,4. There are no formal rules or mechanisms for ensuring

market stability and integrity, and for safeguarding the collective interests of market participants, and

5. The OTC contracts are generally not regulated by a regulatory authority and the exchange’s self regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance.

34

Some Important Concepts in Financial and Derivative Markets

Risk Preference– Risk aversion vs. risk neutrality– Risk premium

Short SellingReturn and Risk

– Risk defined– The Risk-Return tradeoff (see

Figure 1.1, p. 7)

35

Market Efficiency and Theoretical Fair Value– Definition of an efficient market– The concept of theoretical fair value

Some Important Concepts in Financial and Derivative Markets (continued)

36

Fundamental Linkages Between Spot and Derivative Markets

Arbitrage and the Law of One Price– Arbitrage defined– Example: See Figure 1.2, p. 10

• The concept of states of the world

– The Law of One Price

The Storage Mechanism: Spreading Consumption across Time

Delivery and Settlement

37

The Role of Derivative Markets

Risk Management– Hedging vs. speculation– Setting risk to an acceptable level

Price DiscoveryOperational Advantages

– Transaction costs– Liquidity– Ease of short selling

Market efficiency

38

Criticisms of Derivative Markets

SpeculationComparison to gambling

39

Misuses of Derivatives

High leverageInappropriate use

40

Derivatives and Your Career

Financial management in a businessSmall businesses ownershipInvestment managementPublic service

41

(Return to text slide)

42

(Return to text slide)