Derivatives are financial instruments whose value is based on an underlying asset. They include forwards, futures, options, and swaps. Forwards involve an agreement to buy or sell an asset at a set price on a future date. Futures are similar to forwards but trade on an exchange and are marked to market daily. Options give the right but not obligation to buy or sell an asset at a strike price. Swaps allow parties to exchange interest or currency payments over time to hedge risks. Common derivatives are mortgage-backed securities which pool home loans and student loan instruments. Derivatives make up the largest part of the total financial market.

1. DERIVATIVES : <br />DERIVATIVES A Financial Instrument That Derives Its Value From An Underlying Security <br />Derivatives Explanation : <br />Derivatives Explanation An easy way to think of derivatives is as a “side bet” on interest rates, exchange rates, commodity prices, and practically ANYTHING that you can think of. <br />Why Derivatives? : <br />Why Derivatives? Not to raise capital Buy or sell to protect against adverse changes in external factors <br />Conventional Securities Market : <br />Conventional Securities Market <br />Types of Derivatives : <br />Types of Derivatives Forwards Futures Options Swaps <br />Forwards : <br />Forwards <br />Forwards Contracts : <br />Forwards Contracts The agreement to pay for and pick up, “Something” at a pre-determined date and or time, for a pre-determined price. Usually traded off of the trading floor between two firms. <br />Terms : <br />Terms Taking Delivery: Physical reception of item. Deliverable Instrument: The item to be delivered Making Delivery: Turning over the item. Forwards are not options, they are obligations and should be considered as a “cash transaction.” <br />Forwards : <br />Forwards <br />Forwards “OTC” : <br />Forwards “OTC” <br />A Modest Example : <br />A Modest Example An agreement on Monday to buy a book, (Fin 374c) from a bookstore on Friday for $1000.00. On Friday, you return to the bookstore and take delivery of the book and pay the $1000.00. The contract is actually the agreement. <br />Futures : <br />Futures <br />Futures : <br />Futures Similar to forwards in length of time. However, profits and losses are recognized at the close of business daily, “Mark-to-market.” Transactions go through a clearinghouse to reduce default risk. 90% of all futures contracts are delivered to someone other than the original buyer. <br />Futures Example : <br />Futures Example On Monday we enter into a futures contract to buy our book on Friday. We are required to place a deposit for the book of 50% ($500.00). We are told that if the book appreciates in value we may be required to increase the deposit. If the book depreciates in value, we may take back some of the money. Wednesday the book goes to $1500.00. We must deposit another $250.00. On Thursday the book drops to $750.00. We can collect $375.00. On Friday the book value is $800.00, therefore we owe $425.00 on the remaining balance. <br />Options : <br />Options Options come in many flavors. To name a few: collar, cylinder, fence, mini-max, zero-cost tunnel and straddle. These are all newer forms of options. The most common options discussed are put and call. An OPTION is the right, not the obligation to buy or sell an underlying instrument. <br />Option Terms : <br />Option Terms Put: the right to sell @ a certain price Call: the right to buy @ a certain price Long: to purchase the option Short: to sell or write the option Bullish: feel the value will increase Bearish: feel the value will decrease Strike/Exercise Price: Price the option can be bought or sold. <br />Option Market : <br />Option Market <br />Options Continued : <br />Options Continued <br />SWAPS : <br />SWAPS New in the market, late 70’s early 80’s Two Types: Interest Rate & Currency <br />Swaps : <br />Swaps <br />Swap Use : <br />Swap Use To smooth out interest rate payments in a cyclic environment. To secure and level out future interest payments. To secure foreign currency for loans when you are a visitor in that country and it would be too difficult to secure credit or the cost is prohibitive. <br />Derivative Securities : <br />Derivative Securities Mortgage Backed Securities: Fanny Mae, Freddie Mac Structured Notes: Sally Mae <br />Derivative Securities : <br />Derivative Securities <br />Explanation : <br />Explanation Freddie Mac & Fanny Mae: Both are derivative instruments used to pool Home Mortgage loans. This creates a secondary market which allows banks to sell the loans, therefore reducing their risk. It also reduces default risk for the holder. These are also known as pass through instruments. <br />Cont’d Explanation : <br />Cont’d Explanation Sally Mae: Same principal as the previous example except they use student loans. All of these also help to keep interest rates for the underlying asset low by keeping default risk down. <br />Standard Securities : <br />Standard Securities Stocks Bonds Cash <br />Total Market : <br />Total Market The standard market is what most people think of when they think of the market. The truth is that derivatives are the fastest growing sector of the market. In fact, they are the largest section of the market. We did not consider mutual funds in this presentation. There are more mutual funds in the market than there are stocks. Again, the next graph does not account for mutual funds. <br />