Transcript CHAPTER 1: INTRODUCTION

Derivatives- Introduction
The speed of money is faster than
it’s ever been.
Loleen Doerrer
Time, April 11, 1994, p. 33
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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
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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
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 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)
4
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.
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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)
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Growth of derivatives markets
 Derivative 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.
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Growth of derivatives markets
 In 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.
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Factors driving the growth of
derivative products
 1.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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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Interest rate swap
 The 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).
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Cross-currency swap
 A 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.
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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.
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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
options
vs.
over-the-counter
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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.
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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.
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Derivative Markets and Instruments
(continued)
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
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Derivative Markets and Instruments
(continued)
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
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Derivative Markets and Instruments
(continued)
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
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Derivative Markets and
Instruments (continued)
 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.
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Features of OTC Markets
 1. 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.
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Some Important Concepts in Financial and
Derivative Markets
Risk Preference
– Risk aversion vs. risk neutrality
– Risk premium
Short Selling
Return and Risk
– Risk defined
– The Risk-Return tradeoff (see Figure
1.1, p. 7)
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Some Important Concepts in Financial
and Derivative Markets (continued)
Market Efficiency and Theoretical
Fair Value
– Definition of an efficient market
– The concept of theoretical fair value
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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
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The Role of Derivative Markets
Risk Management
– Hedging vs. speculation
– Setting risk to an acceptable level
Price Discovery
Operational Advantages
– Transaction costs
– Liquidity
– Ease of short selling
Market efficiency
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Criticisms of Derivative Markets
Speculation
Comparison to gambling
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Misuses of Derivatives
High leverage
Inappropriate use
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Derivatives and Your Career
Financial management in a business
Small businesses ownership
Investment management
Public service
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