001 Financial Derivatives

SKOOL COMPUTER EDUCATION

The DerivativesFinancial & Commodity



INTRODUCTION

• By now the headlines are familiar: “Gibson Greetings Loses $19.7 Million in Derivatives” . . .

• “Procter and Gamble Takes $157 Million Hit on Derivatives” . . .

• “Derivatives Losses Bankrupt Barings.” • Such popular press accounts could easily lead us to

conclude that derivatives were not only involved in these losses, but were responsible for them as well.

• Over the past few years, derivatives have become inviting targets for criticism.

• What are they?


INTRODUCTION

• It is not an easy to define. • Economists, accountants, lawyers, and government

regulators have all struggled to develop a precise definition.

• Imprecision in the use of the term, moreover, is more than just a semantic problem.

• It also is a real problem for firms that must operate in a regulatory environment where the meaning of the term often depends on which regulator is using it.


The Size of Derivatives Bubble = $190K Per Person on Planet

• The Invisible One Quadrillion Dollar Equation -- Asymmetric Leverage and Systemic Risk .

• According to various distinguished sources including the Bank for International Settlements (BIS) in Basel, Switzerland -- the central bankers' bank -- the amount of outstanding derivatives worldwide as of December 2007 crossed USD 1.144 Quadrillion, ie, USD 1,144 Trillion.


The Size of Derivatives Bubble = $190K Per Person on Planet

• The main categories of the USD 1.144 Quadrillion derivatives market were the following:1. Listed credit derivatives stood at USD 548 trillion;2. The Over-The-Counter (OTC) derivatives stood in

notional or face value at USD 596 trillion and included:

a. Interest Rate Derivatives at about USD 393+ trillion;

b. Credit Default Swaps at about USD 58+ trillion;c. Foreign Exchange Derivatives at about USD 56+

trillion;d. Commodity Derivatives at about USD 9 trillion;e. Equity Linked Derivatives at about USD 8.5 trillion;

andf. Unallocated Derivatives at about USD 71+ trillion.


Barings Bank

Fate Collapsed (Purchased by ING).

Successor ING Group

Founded 1762

Defunct February 26, 1995

Headquarters London

Key people Sir Francis Baring (founder),NickLeeson

Industry Banking


Barings Bank

• Lost £827 million ($1.3 billion) speculating—primarily on futures contracts.


FINANCIAL DERIVATIVES

• The growth in the financial derivatives market over the last thirty years has been quite extraordinary.

• From virtually nothing in 1973, when Black, Merton and Scholes did their seminal work.

• Derivatives contracts today has grown to several trillion dollars.


GROWTH FACTORS

• This phenomenal growth can be attributed to two factors.

• The first, and most important, is the natural need that the products fulfill.

• The second factor is the parallel development of the financial mathematics needed for banks to be able to price and hedge the products demanded by their customers.


NATURAL NEED

• Any organization or individual with sizeable assets is exposed to moves in the world markets.

• Manufacturers are susceptible to moves in commodity prices; multinationals are exposed to moves in exchange rates; pension funds are exposed to high inflation rates and low interest rates.

• Financial derivatives are products which allow all these entities to reduce their exposure to market moves which are beyond their control.


DEVELOPMENT: FINANCIAL MATHEMATICS

• The breakthrough idea of Black, Merton and Scholes, that of pricing by arbitrage and replication arguments.

• It is only because of work in the field of pure probability in the previous twenty years that the theory was able to advance so rapidly.

• Stochastic calculus and martingale theory were the perfect mathematical tools for the development of financial derivatives.

• Models based on Brownian motion turned out to be highly tractable and usable in practice.


DERIVATIVE

• Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else (known as the underlying).

• The underlying value on which a derivative is based can be an asset (e.g., commodities, equities (stocks), residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer price index (CPI)), weather conditions, or other items.


DERIVATIVE

• A derivative is a financial instrument that derives or gets it value from some real good or stock.

• It is in its most basic form simply a contract between two parties to exchange value based on the action of a real good or service.

• Typically, the seller receives money in exchange for an agreement to purchase or sell some good or service at some specified future date.


DERIVATIVE

• The largest appeal of derivatives is that they offer some degree of leverage.

• Leverage is a financial term that refers to the multiplication that happens when a small amount of money is used to control an item of much larger value.

• A mortgage is the most common form of leverage. • For a small amount of money and taking on the

obligation of a mortgage, a person gains control of a property of much larger value than the small amount of money that has exchanged hands.


DERIVATIVE

• Derivatives offer the same sort of leverage or multiplication as a mortgage.

• For a small amount of money, the investor can control a much larger value of company stock then would be possible without use of derivatives.

• This can work both ways, though. If the investor purchasing the derivative is correct, then more money can be made than if the investment had been made directly into the company itself.

• However, if the investor is wrong, the losses are multiplied instead.


DERIVATIVE

• Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying.

• hedge risks;• reflect a view on the future behavior of the market,

speculate;• lock in an arbitrage profit;• change the nature of a liability;• change the nature of an investment;


HEDGING & SPECULATION

• Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging.

• Derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation.


HEDGING

Wheat Farmer MillerForward Contract

Cash

Wheat

Both parties have reduced a future risk:

for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat.

there is still the risk that no wheat will be available due to causes unspecified by the contract, like the weather, or that one party will renege on the contract.


HEDGING

• Hedging also occurs when an individual or institution buys an asset (like a commodity, a bond that has coupon payments, a stock that pays dividends, and so on) and sells it using a futures contract.

• The individual or institution has access to the asset for a specified amount of time, and then can sell it in the future at a specified price according to the futures contract.


SPECULATION

• Derivatives can be used to acquire risk, rather than to insure or hedge against risk.

• Some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset.

• Speculators will want to be able to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is low.


EXAMPLE 1 (SOURCES OF RISK)

• Suppose that a British investor holds a number of 10 year US T-Notes, and wants her investment to expire on the 1st December 01.

• The face value of the notes is $10m, and at the current market prices they are worth $10.38m. The exchange rate today is 1.4726$ / .

• Therefore, if she decides to liquidize the notes now, the investor would receive $ 7.049m.

• There are two sources of risk in this setting: Exchange rate risk and interest rate risk.


EXAMPLE 2 (EXCHANGE RATE RISK)

• The British pound might keep rising against the dollar.

• This is illustrated in figure. In this case, the value of the investment will decline. The investor examines the futures markets, and observes that the quote for a $ / Pounds exchange rate future that expires on the 1st December 01 is 1.4834$ / Pounds.

• By selling futures worth $10.38m she will ensure a payment of


EXAMPLE 2 (EXCHANGE RATE RISK)

• The above does not describe the perfect hedge position! Since the investor keeps the money in the 10y note until next year, she will enjoy the interest and the possible coupons, offered through that year. The right amount to be converted would be the one that will include those payments. But what is this value? The actual value of the notes will depend on the short rates that will be in place next year. This gives rise to the interest rate risk.


EXAMPLE 3 (INTEREST RATE RISK)

• If the US rates go up during the next year, the value of the investment will decline -the bond prices will fall. How can the investor hedge against this kind of risk? By selling T-Note futures.

• Setting up the portfolio for this hedge is not as easy for the investor as it sounds. Unlike the FX futures contract, there is no 10y T-Note futures contract available that expires on the 1st Dec 01.

• She investigates a bit more and collects some similar instruments that might be helpful: these are described in the following table.


EXAMPLE 3 (INTEREST RATE RISK)

• Unfortunately, the instruments on the 10y T-Note do not have the appropriate maturity, whereas the instruments that have the correct maturity have a different underlying.

• Using the 30y T-Bond will not hedge perfectly, the risk that remains from such situations is called the basis risk.


TYPES OF DERIVATIVES

• Over-the-counter (OTC) derivatives • Exchange-traded derivatives (ETD)


OVER-THE-COUNTER (OTC) DERIVATIVES

• These are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary.

• Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way.

• The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties.


EXCHANGE-TRADED DERIVATIVES (ETD)

• These are those derivatives products that are traded via specialized derivatives exchanges or other exchanges.

• A derivatives exchange acts as an intermediary to all

related transactions, and takes Initial margin from both sides of the trade to act as a guarantee.


DERIVATIVE CONTRACT TYPES

• Forwards/Futures• Options• Swaps


FORWARDS/ FUTURES

• Futures/Forwards are contracts to buy or sell an asset on or before a future date at a price specified today.

• A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold, while a forward contract is a non-standardized contract written by the parties themselves.


FORWARD CONTRACTS

• The most basic forward contract. • It is a contract negotiated between two parties for

the delivery of a physical asset (e.g., oil or gold) at a certain time in the future for a certain price fixed at the inception of the contract.

• No actual transfer of ownership occurs in the underlying asset when the contract is initiated.

• Instead, there is simply an agreement to transfer ownership of the underlying asset at some future delivery date.


FORWARD CONTRACTS EXAMPLE

100 OUNCES$ 400/OZ

Seller

Buyer

•The party that has agreed to buy has a long position.•The party that has agreed to sell has a short position.


FUTURE CONTRACTS

EXCHANGE

Seller

Buyer

It is essentially a forward contract that is traded on anorganized financial exchange• Futures markets began with grains, such as corn, oats,

and wheat, as the underlying asset. • Financial futures are futures contracts based on a

financial instrument or financial index. • Foreign currency futures are futures contracts calling

for the delivery of a specific amount of a foreign currency at a specified future date in return for a given payment of U.S. dollars.

• Interest rate futures take a debt instrument, such as a Treasury bill (T-bill) or Treasury bond (T-bond), as their underlying financial instrument.


FUTURE CONTRACTS

• With these kinds of contracts, the trader must deliver a certain kind of debt instrument to fulfill the contract.

• In addition, some interest rate futures are settled with cash.

• Financial futures also trade based on financial indexes. • For these kinds of financial futures, there is no

delivery, but traders complete their obligations by making cash payments based on changes in the value of the index.


FUTURE & FORWARD

• A futures contract is a forward contract traded on an organized exchange.

• Biggest problems traders face in using forward contracts:

• credit risk exposure• the difficulty of searching for trading partners, • the need for an economical means of exiting a

position prior to contract termination


CREDIT RISK EXPOSURE

• To mitigate credit risk, futures exchanges require periodic recognition of gains and losses.

• Daily, futures exchanges mark the value of all futures• accounts to current market-determined futures

prices. • The winners can withdraw any gains in value from the

previous mark-to-market period, and those gains are financed by the losses of the “losers” over that period.



• Marking to market creates a difference in the way futures and forward contracts allow traders to lock in prices.

• With a forward contract, the price of the asset exchanged at delivery is simply the price specified in the contract.

• With a futures contract, the buyer pays and the seller receives the spot price prevailing at the delivery date.

If this is so, then how is the price locked in?



• The gains and losses on a futures position are recognized daily so that over the life of the futures contract the accumulated profits or losses—coupled with the spot price at delivery—yield a net price corresponding with the futures price quoted at the time the futures position was established.

• Futures exchanges use a clearinghouse to serve as the counterparty to all transactions.


SEARCHING PARTNERS

• A second problem with a forward contract is that the heterogeneity of contract terms makes it difficult to find a trading partner.


EXITING A POSITION

• A third and related problem with a forward contract is the difficulty in exiting a position, short of actually completing delivery.


DIFFERENCES BETWEEN FORWARDS & FUTURES CONTRACTS

Forwards Futures

Primary market Dealers Organized Exchange

Secondary market None the Primary market

Contracts Negotiated Standardized

Delivery Contracts expire Rare delivery

Collateral None Initial margin, mark-the-market

Credit risk Depends on parties None [Clearing House]

Market participants Large firms Wide variety


OPTIONS

• An option is the right to buy or sell, for a limited time, a particular good at a specified price.

• For example, if IBM is selling at $120 and an investor has the option to buy a share at $100, this option must be worth at least $20, the difference between the price at which you can buy IBM ($100) through the option contract and the price at which you could sell it in the open market ($120).


OPTIONS

• Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset.

• The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option.

• The option contract also specifies a maturity date.


OPTIONS

• Options give the party with the long position one extra degree of freedom:

• she can exercise the contracts if she wants to do so; whereas the short party have to meet the delivery if they are asked to do so. This makes options a very attractive way of hedging an investment, since they can be used as to enforce lower bounds on the financial losses.

• In addition, options offer a very high degree of gearing or leverage, which makes them attractive for speculative purposes too.


OPTIONS

• Prior to 1973, options of various kinds were traded over-the-counter.

• In 1973, the Chicago Board Options Exchange (CBOE) began trading options on individual stocks.

• Since that time, the options market has experienced rapid growth, with the creation of new exchanges and many kinds of new option contracts.


CALL AND PUT OPTIONS

• call option gives the owner the right to buy a particular asset at a certain price, with that right lasting until a particular date.

• Ownership of a put option gives the owner the right to sell a particular asset at a specified price, with that right lasting until a particular date.


SWAPS

• Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets.


THE MARKET PARTICIPANTS

• Three kinds of dealers engage in market activities:

• Hedgers• speculators • Arbitrageurs

Each type of dealer has a different set of objectives


HEDGERS

• Hedging includes all acts aimed to reduce uncertainty about future [unknown] price movements in a commodity, financial security or foreign currency.

• This can be done by undertaking forward or futures sales or purchases of the commodity security or currency in the OTC forward or the organized futures market.

• Alternatively, the hedger can take out an option which limits the holder's exposure to price fluctuations.


SPECULATORS

• Speculation involves betting on the movements of the market and try to take advantage of the high gearing that derivative contracts offer, thus making windfall profits.

• In general, speculation is common in markets that exhibit substantial fluctuations over time.

• Normally, a speculator would take a ``bullish'' or ``bearish'' view on the market and engage in derivatives that will profit her if this view materializes. Since in order to buy, say, a European call option one has to pay a minute fraction of the possible payoffs, speculators can attempt to materialize extensive profits.


ARBITRAGE

• In economics and finance, arbitrage is the practice of taking advantage of a price differential between two or more markets:

• Striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices.

• When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, a risk-free profit.


ARBITRAGEURS

• A person who engages in arbitrage is called an arbitrageur—such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies.

Economy & Finance

001 Financial Derivatives