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Hot Topics in Financial Markets

Lecture 3 – The Great Casino

Hot Topics in Financial Markets


Lecture 3: Derivatives – the Great Casino

• A brief history of financial institutions

• Derivative instruments and their origins

• Facts and figures on derivatives markets

• Why and how should derivatives trading be curbed?

A Brief History
of financial institutions

17th Century London


• Royal Exchange used for trading commodities →
• Brokers traded on behalf of friends/clients
• Stockbrokers ‘too rowdy’ – traded in coffee houses
• Broker John Castaing was first to list prices of stocks and
commodities on walls of Jonathan's Coffee House, Change Alley
o First example of exchange listing
o  London Stock Exchange (LSE)
o 1801: LSE formally incorporated
o 1802: Moved to building, Capel Court

2 7 November, 2012

Carol Alexander
University of Sussex, 7 November 2012
Hot Topics in Financial Markets
Lecture 3 – The Great Casino

Big Bang
1986: the London market

• A unique system of specialists evolved on the LSE. By 1986:


• Only 5 jobbers (market makers) left
o Buy and sell on own account, making money on the spread
• Only brokers were allowed to deal with jobbers
o On their clients behalf
• No foreigners allowed
o Big banks were kept out of both market-making and broking
• As financial markets trading increased globally, so did pressure
to bring more capital to London
o Deregulation of financial markets trading in UK established
London as (arguably) the global financial centre
3 7 November, 2012

Open-Outcry
…and electronic trading platforms

• This is when brokers shout and


use hand signals to transfer buy
and sell orders

• Still used in some exchanges

- LME, CBOT, CME, NYMEX

• Most exchanges now use


electronic platforms

- 1986: LSE
- 1994: Boursa Italia
- 1997: Toronto stock exchange
4 7 November, 2012
- After 2000: most exchanges

Carol Alexander
University of Sussex, 7 November 2012
Hot Topics in Financial Markets
Lecture 3 – The Great Casino

Glass-Steagall Act
Banking Act of 1933

• US senators Glass and Steagall argued that “integrated


financial services firms” helped create the Great Depression
and collapse of the US banking system in the 1930s
• 1933: Act passed to limit commercial and retail bank securities
activities
o Created marked distinction between commercial & retail
banks and investment banks
• 1999: Act was repealed, after much debate (led by, among
others, Alan Greenspan) that distinction between commercial
and investment banking activities had been blurred by “market
developments” since the 1960s
5 7 November, 2012

Glossary of Financial Instruments


On balance sheet

• IAS 39 defines a financial instrument as follows:


o “Any contract that gives rise to a financial asset of one entity
and a financial liability (or equity instrument) of another entity”
• Distinguish two types of cash financial instruments:
• Real assets:
• Property, machinery etc.
• Cash (including foreign currencies)
• Commodities
• Financial assets:
• Claims on real assets (e.g. a loan is a claim on cash)
• Securities (i.e. bonds and shares)

• Cash instrument values are recorded on a firms balance sheet


6 7 November, 2012

Carol Alexander
University of Sussex, 7 November 2012
Hot Topics in Financial Markets
Lecture 3 – The Great Casino

Glossary of Financial Instruments


Off balance sheet

• Derivative instruments are bets on:


o Real or financial assets
o Anything else that is measureable by an index, e.g.
• Temperature
• Inflation
• Volatility
• Derivatives values are not recorded on a firms balance sheet
• Three main types of derivatives:
o Swaps
o Forwards and Futures
o Options
7 7 November, 2012

Origins of Derivatives
Forwards

• Since the middle ages, farmers could sell a crop forward at a


price agreed today
o A hedge against uncertainty in future spot price fluctuations
• A forward contract is an over-the-counter (OTC) instrument, i.e.
o Not traded on an exchange
o Subject to credit risk of the issuer

• Around 1630, the Royal Exchange in London allowed forwards


on tulip bulbs to be traded
o Dutch tulip bulb mania, 1636-37
“Extraordinary Popular Delusions and the Madness of Crowds”
8 7 November, 2012

Carol Alexander
University of Sussex, 7 November 2012
Hot Topics in Financial Markets
Lecture 3 – The Great Casino

Origins of Derivatives
Futures

• Futures are like forwards, but they are


o Exchange traded, standardized contracts
• No credit risk
• Leveraged, i.e. traded on margin (see next slide)

• First recorded on Chicago Board of Trade, formed in 1848


o Lack of storage facilities in Chicago for all grain to be delivered at once
o ‘To Arrive’ contract allowed farmers to sell grain at a price fixed now, for
future delivery (meanwhile storing it themselves)
o Contracts standardized in 1865

• 1925: First clearing house for CBOT futures


o Buy and sell order matched, settlement ensured
9 7 November, 2012

Origins of the Margin

• In 17th century London, brokers used to lend money


(on interest) to their clients to help them buy stocks
and commodities
• Similarly, modern futures exchanges require only a
fraction of the cost of the futures to be transferred
into the margin account
• Futures are marked-to-market at the end of each day
o If the price fall exceeds the margin, it must be
topped up (a margin call)
o If the price rises, then money can be taken out of
the margin account
10 7 November, 2012

Carol Alexander
University of Sussex, 7 November 2012
Hot Topics in Financial Markets
Lecture 3 – The Great Casino

Origins of Derivatives
Options

• Options are like futures, but the holder has no obligation to buy
(or sell) at the price that is fixed now (the strike price)
• First active trading of options was on the Bourse de Paris
• In 1900, more than 800 French shares and bonds, and nearly
300 foreign stocks were quoted daily by the agents de change
• About 10% of the shares were sold at a premium because they
included a 3-month at-the-money put option
o After 3 months, the holder has the right to sell the share back
at the price he originally paid
• A put option is an insurance against a price fall

11 7 November, 2012

Vanilla Options
Pay-offs and types

• The other type of ‘vanilla’ option is a call


o The right to buy at a fixed price, called the strike price, K
• European options give this right on a specified day, called the
expiry date: denoted time T

• If ST denotes the market price of the share (or more generally,


the underlying) on the expiry date
Call: pay-off = max {ST – K, 0}
Put: pay-off = max {K – ST, 0}

• American options can be exercised on or before the expiry date

12 7 November, 2012

Carol Alexander
University of Sussex, 7 November 2012
Hot Topics in Financial Markets
Lecture 3 – The Great Casino

Market vs Theoretical Prices


…of futures and options

• Most exchange-traded futures and options are actively traded


after their first listing (i.e. there is a liquid secondary market)
• Therefore, their market prices before expiry are determined by
demand and supply
• Theoretical prices are given by a model which is based on the
principle of no-arbitrage
o Futures have a unique no-arbitrage model price – like the
forward interest rates of Lecture 1
o Options have no unique no-arbitrage price because their
value depends on the volatility of the underlying
Different volatility models give different theoretical option prices
13 7 November, 2012

Black-Scholes-Merton Model
1986
• Merton (1973) and Black & Scholes (1973)
o First simple no-arbitrage model for pricing a vanilla option
o Based on a constant volatility assumption
• Marked the beginning of ….
o Massive growth in trading volumes for options on exchanges
o Development of stochastic volatility option pricing models
• Parameters calibrated to market prices of vanilla option
• Used to find no-arbitrage prices of OTC exotic options

• Black died in 1995, but Scholes and Merton won the Nobel
Prize in 1997

14 7 November, 2012

Carol Alexander
University of Sussex, 7 November 2012
Hot Topics in Financial Markets
Lecture 3 – The Great Casino

Facts and Figures


From BIS Quarterly Review

OTC Derivatives (in $ trillion)

15 7 November, 2012

OTC Trading by Derivative Type


Notional outstanding in December 2011

Futures/Swaps ($577 trillion)

Options ($71 trillion)

Forwards and Swaps Options


Dealers ($178 Dealers ($41
trillion) trillion)

Financial
Financial
Institutions
Institutions
($24 trillion)
($351 trillion)
Non-Financial
Non-Financial Institutions ($5
Institutions trillion)
($46 trillion)
16 7 November, 2012

Carol Alexander
University of Sussex, 7 November 2012
Hot Topics in Financial Markets
Lecture 3 – The Great Casino

Exchange Trading by Derivative Type


Notional outstanding in December 2011

Futures ($23 trillion)

Options ($34 trillion)

Futures Options
Interest Rate Interest Rate
($22 trillion) ($32 trillion)

Currency
Currency ($0.2
($0.08 trillion)
trillion)

Equity Index
Equity Index ($2 trillion)
($1 trillion)

17 7 November, 2012

Why Curtail Derivatives Trading?


Gambling with public money

• Alan Greenspan (US Federal Reserve) held interest rates too


low for too long during the last decade
o Retail and commercial banks, starved of yield on usual
business (loans),
o Released from Glass-Steagall act, they looked to derivatives
markets to make money
• Credit default swap boom and bust created the banking crisis in
2008, and the on-going sovereign debt crisis
o Of five major investment banks, only Goldman Sachs and
Merrill Lynch survived
o And, after the Lehman Brothers collapse, these too now have
status of ordinary banks
18 7 November, 2012

Carol Alexander
University of Sussex, 7 November 2012
Hot Topics in Financial Markets
Lecture 3 – The Great Casino

Why Curtail Derivatives Trading?


Speculation is rife and dangerous

• Exchange-traded instruments are commonly traded for pure


speculation
o For example, average holding time of SP500 futures is now
about 10 seconds
o Algorithmic trading has changed the landscape of financial
markets during the last few years
• Investment in companies used to help the economy, but now
speculation spills over even into company shares!
o Flash crashes – Dow Jones fell 1000 points in May 2010
o Market lost more than $1 trillion in 15 minutes (then regained)
o Average holding time for US share is now 22 seconds
19 7 November, 2012

How to Curtail Derivatives Trading?


Dodd-Frank Act

• Dodd–Frank Wall Street Reform and Consumer Protection Act


o Comprehensive regulation of financial markets, new
consumer protection agency, uniform standards for products
o Increased transparency for OTC derivatives trades: must now
be put through clearing houses of exchanges
• Important part of Dodd-Frank Act: Volker Rule
o Ban on proprietary trading where deposits are used to trade
on the bank's own accounts
o Investment bank separated from commercial/retail activities
• Signed by President Obama in 2010
o Implementation depends on outcome of US election
20 7 November, 2012

Carol Alexander
University of Sussex, 7 November 2012
Hot Topics in Financial Markets
Lecture 3 – The Great Casino

How to Curtail Derivatives Trading


…and speculative trading in general

• Add a very small transaction tax (Tobin tax) to every trade


• This has just been implemented in France (August 2012)
o 10 basis points (bps) per transaction
• UK is currently opposed to such a tax
o Most trading in Europe is on London markets
o Europe-wide Tobin tax would not benefit UK economy
• But UK might implement a very small local tax (e.g. 2 bps)
o Indeed, UK already has stamp duty of 50 basis points, but
only on share transactions (market-makers exempt)
• However, Tobin tax requires global financial policy coordination

21 7 November, 2012

Carol Alexander
University of Sussex, 7 November 2012

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