Derivative Fundamentals
Financial Markets Education
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SECTION 1
Derivatives an Overview
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By far the most significant event in finance during the past decade
has been the extraordinary development and expansion of
financial derivatives. These instruments enhance the ability to
differentiate risk and allocate it to those investors most able and
willing to take it - a process that has undoubtedly improved
national productivity growth and standard of living.
(Alan Greenspan, 1999)
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Derivative definitions
♦ A derivative derives its value from the ‘properties’ of the underlying
♦ There are two main types of derivatives:
– forwards/futures (swaps)
– options
♦ A forward/future is an agreement to buy or sell an underlying at some time in
the future at a fixed price (agreed today)
♦ An option is the right to buy or sell an underlying at some time in the future
at a fixed price (agreed today)
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Options Roadmap
Basis
Spot Forward
Volatility Value
Option
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Underlyings – Spot Risk
Price Risk
Value of spot
Capital
0
spot price spot price
today
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Forward (a derivative) versus Spot
♦ A ‘forward’ has a risk profile which is very similar to that of the underlying
Value of a future
Value of spot
0 0
spot price spot price spot price
today
Price Risk Price Risk
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Capital
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Option Risks
♦ Calls and puts represent different aspects of the price risk
– Options allow us to separately trade the upside and downside risk
ATM Options OTM Call, ITM Put
Value
Value
Long Call spot
price
spot
“good risk” today
price 0
today
strike
0 price
Strike
price
Short Put
“bad risk”
Short Long
Put Call Price Risk
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Who uses derivatives
♦ Arbitrageurs
– banks / trading houses
– hedge funds
♦ Hedgers
– corporates (treasurers)
– banks
♦ Investors
– pension funds
– insurance companies
– mutual funds
– private individuals
♦ Speculators
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Summary
♦ Derivatives can change your exposure to risk
♦ You can use them to reduce risk - hedging
♦ You can use them with no risk - arbitrage
♦ You can use them to create risk - speculating
♦ Derivatives are not inherently risky
♦ The behaviour of derivatives is predictable
♦ But understanding derivatives requires work!
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