2002 South-Western Publishing

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Chapter 1
Introduction
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Outline
Intro what are derivative securities?
Overview and different perspectives
Course Objectives
Types of derivatives
Participants in the derivatives world
Uses of derivatives

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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 (contd)
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 (contd)
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





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Introduction (contd)
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
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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

working introductory level knowledge of derivative securities
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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 partys gains are equal to
another partys 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
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 (contd)
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 (contd)
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 1840s
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 1870s 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 Contd
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 Contd
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
70s and 80s - 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 1970s
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 1970s 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 80s 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 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 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 (contd)
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 (contd)
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
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Product Characteristics (contd)
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 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
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
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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
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Arbitrage (contd)
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 hedgers 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
- 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














Organization wide
Risk

Identification Impact Response

A Framework for Integrated Risk Management
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Risk Management (contd)

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
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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 (contd)
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
(contd)
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