Derivatives Model

Chapter 1

Introduction

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Outline      

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

Introduction 

There is no universally satisfactory answer to the question of what a derivative is, however one explanation ......  –

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A financial derivative is a ‘financial ‘fi nancial instrument or security whose payoff depends on another financial instrument or security’ security’ ......the payoff or the value is d e r i v e d   from  from that underlying security derivatives are agreements or contracts between two parties

Introduction (cont’d) 

Futures, options and swap markets are very useful, perhaps even essential, parts of the financial system  –  –  –

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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 l ong history of being misunderstood -

Introduction (cont’d) 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

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case i.e a speculative application of derivatives that has gone

Introduction (cont’d) “What many critics of equity derivatives fail to realize is that the m a r k e ts f o r t h e s e i n s t r u m e n t s h a v e b e c o m e s o l a r g e n o t b e c a u s e o f s l i c k s a l es c a m p a ig n s , b u t b e c au s e t h e y a r e p r o v i d i n g e c o n o m i c value to their users  ”   – Alan Greenspan, 1988

„In our view, however, derivatives are f i n an c i a l w e ap o n s o f m a s s d e s t r u c t i o n , c a r r y i n g d a n g e r s t h a t , w h i l e la t en t n o w , a r e p o t e n t i a ll y

lethal‟   –

Warren Buffett 2002 Berkshire Hathaway annual report

’derivatives are something like electricity: dangerous if mishandled, but bearing the potential to do good’  –

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Arthur Leavitt- Chairman SEC 1995

Objectives of the Course  

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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 party’s gains are equal to another party’s losses

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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 

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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.

Types of Derivatives    

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Options Futures contracts Swaps Hybrids

Options 

An o p t i o n   is the right to either buy or sell something at a set price, within a set period of time  –  –

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The right to buy is a c a l l o p t i o n The right to sell is a p u t o p t i o n

 You can exercise an option if you wish, but you do not have to do so

Futures Contracts 

 involve a promise to F u t u r e s c o n t r ac t s  

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exchange a product for cash by a set delivery date - and are traded on a futures exchange  deal with transactions F u t u r e s c o n t r ac t s   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:  –

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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

Futures Contracts (cont’d)

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 s p o t m a r k et . 

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Futures Contracts (cont’d) 

A futures contract involves a process known as m ar k i n g t o m ar k e t  –

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A f o r w a r d c o n t r ac t   is functionally similar to a futures contract, however:  –  –

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Money actually moves between accounts each day as prices move up and down

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

Futures/Forward Contracts History 

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Forward contracts on agricultural products began in the 1840’s  –

producer made agreements to sell a commodity to a buyer at a price set today for delivery on a date following the harvest

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arrangements between individual producers and buyers - contracts not traded

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by 1870’s 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)

Futures/Forward Contracts History Cont’d 

1891 the Minneapolis Grain Exchange organized the first complete clearinghouse system  –

the clearinghouse acts as the third party to all transactions on the exchange

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designed to ensure contract integrity 

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buyers/sellers required to post margins with the clearinghouse daily settlement of open positions - became known as the mark-market system

Futures/Forward Contracts History Cont’d 

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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 70’s and 80’s - facilitated the sale of financial instruments and risk (of price uncertainty) in financial markets

Option Contracts - History 

Chicago Board Options Exchange (CBOE) opened in April of 1973  –

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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 1970’s Today we have option exchanges around the world trading contracts on various financial

Options Contracts 

Chicago Board of Trade

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Chicago Mercantile Exchange

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New York Mercantile Exchange

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Montreal Exchange

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Philadelphia exchange - currency options

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London International Financial Futures Exchange (LIFFE) London Traded Options Market (LTOM)

Swaps   

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Introduction Interest rate swap Foreign currency swap

Introduction 

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 are arrangements in which one party Swaps  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

Swap Market - History 

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Similar theme to the evolution of the other derivative products - swaps evolved in response to an economic/financial requirement Two major events in the 1970’s 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 

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Exchange rate volatility and associated risk has been with us since

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 

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 –

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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 80’s and emerged via the banking community - again in response to the above noted need

Interest Rate Swap 

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In an i n t e r e s t r a t e s w a p  , 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

Foreign Currency Swap 

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In a f o r ei g n c u r r en c y s w ap  , 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

Commodity Swap 

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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)

Product Characteristics 

Both options and futures contracts exist on a wide variety of assets  –

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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

Product Characteristics (cont’d) 

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The u n d e r l y i n g as s e t   is that which you have the right to buy or sell (with options) or to buy or deliver (with futures)

Product Characteristics (cont’d) 

 trade on an organized L i s t e d d e r i v a t iv e s   exchange such as the Chicago Board Options Exchange or the Chicago Board of Trade, the NYMEX or the Montreal Exchange

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 are customized products OTC d erivatives  that trade off the exchange and are individually negotiated between two parties

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Product Characteristics (cont’d) 

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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.

Participants in the Derivatives World 

Include those who use derivatives for:  –  –  –

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Hedging Speculation/investment Arbitrage

Hedging 

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If someone bears an economic risk and uses the futures market or other derivatives to reduce that risk, the person is a h e d g e r 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

Speculation 

A person or firm who accepts the risk the hedger does not want to take is a speculator

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Speculators believe the potential return outweighs the risk The primary purpose of derivatives markets is not speculation. Rather, they permit or enable t h e t r an s f er o f r i s k b e t w e en m ar k e t p a r t i c i p an t s a s t h e y d e s i r e

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Arbitrage 

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A r b i t r a g e   is the existence of a riskless

profit Arbitrage opportunities are quickly exploited and eliminated in efficient markets  –

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Arbitrage then contributes to the efficiency of markets

Arbitrage (cont’d) 

Persons actively engaged in seeking out minor pricing discrepancies are called arbitrageurs

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Arbitrageurs keep prices in the marketplace efficient  –

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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

Uses of Derivatives   

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Risk management Income generation Financial engineering

Risk Management 

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The hedger’s primary motivation is risk management

Someone who is b u l l i s h   believes prices are going to rise Someone who is b e a r i s h   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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A Framework for Integrated Risk Management Organization wide 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

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Market & Credit Risk -price - interest & fx. rate

Risk Identification

Impact

Response

Risk Management (cont’d)

FALLING PRICES EXPECTED

FLAT MARKET RISING PRICES EXPECTED EXPECTED

BEARISH

NEUTRAL

Increasing bearishness

….for a producer …the consumer has the opposite view

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BULLISH Increasing bullishness

Income Generation 

Writing a c o v e r ed c a l l   is a way to generate income  –

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Involves giving someone the right to purchase your stock at a set price in exchange for an upfront 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

Financial Engineering 

 refers to the practice F i n a n c i a l en g i n e e r i n g   of using derivatives as building blocks in the creation of some specialized product  –

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e.g linking the interest due on a bond issue to the price of oil (for an oil producer)

Financial Engineering (cont’d) 

‘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  –  –  –  –  –  –

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Implied volatility Delta hedging Short straddle Near-the-money Gamma neutrality Etc.