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Derivatives animations
- 2. What is a derivative? 1.If the price of milk goes up/down, the price of curds also goes up/down. 2.Curds derives its value from milk 3.Curds is a derivative of milk. Milk is the Underlying for curds. No Curds without milk 4. A Financial Derivative is an instrument whose value is “derived” from another security or economic variable.
- 3. Derivative- An instrument for management and transfer of risk. If derivatives are misused, the bridge will collapse. What is the result? Derivatives have also been called WMDs
- 4. Alan Greenspan Vs Warren Buffet • “These new financial instruments are an increasingly important vehicle for unbundling risks. They 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 and standards of living.”- Alan Greenspan (1999) • “I view derivatives as time bombs, both for the parties that deal in them and the economic system. These instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that while now latent, are potentially lethal.”- Warren Buffet (2002)
- 5. Financial losses and failures of the risk Process. • Showa Shell Seikyu- ¥ 165 billion- Currency options • Proctor and Gamble-$157 million- Swaps-Cur. & IRS • Metallgsellschaft- $1.3 billion-Energy Futures. • Orange County- $1.6 billion-Leveraged Repos. • Barings(Rogue Trader)-£900 million-Index F & O. • Sumitomo Corporation-$ 1.8 billion-Copper futures. • Long Term Capital Management*- When genius failed. • Enron*-The smartest guys in the room. • Allfirst. • Sub-prime crisis.
- 6. Summary-What are Derivatives? • Derivatives are instruments whose prices are derived from the prices of other financial instruments/commodities/economic variables (underlying). • Financial derivatives include forwards, futures, swaps and options. Major difference? • The underlying to which they relate include stocks, bonds, interest rates ,currencies and commodities. • The market for underlying is also referred to as spot/cash market and is distinct from the derivative market. • Purpose-Risk Management (Hedging) /Price discovery.(Arbitrage) • RM is a process -Identify desired and actual level, alter actual to equal desired. Hedging. • Derivatives can be dangerous if misused.
- 7. Application/ Uses of Derivatives • Reduce risk. (not eliminate) • Make profits taking risks • Make risk free profits.
- 9. Type 1995 2000 2005 2007 2008 2011 2012 2013 CAGR ETD 9.3 14.2 57.3 79.1 57.8 58.3 54.1 69.1 11.8% OTC Foreign exchange options 15.7 31.4 56.2 50 63.4 67.4 73.1 12.6% Equity and Commodity 2.6 11.2 16.9 10.9 9.1 8.8 9.3 10.3% Interest Rate derivatives 17.7 64.7 212 393.1 432.7 504.1 489.7 561.3 21.2% Credit default swaps 0.9 13.9 58.2 41.9 28.6 25.1 24.3 28.9% Unallocated 12.3 30.8 61.4 62.7 42.6 41.6 24.9 5.6% Total OTC 17.7 96.2 299.3 585.8 598.2 647.8 632.6 692.9 22.6% Grand Total 27.00 110.40 356.60 664.90 656.00 706.10 686.70 762.00 20.4% 1980 2012 World GDP (USD Trillions) 10 72 6.4% Anything Interesting? Notional Amount of Derivative contracts outstanding at year end: USD Trillions.
- 10. Introduction to Derivatives • What? • Why should you study? • Why are the used?/Who uses derivatives? • Risk. • Growth/explosion? $1,2,00,000,000,000,000 (2012) (Bretton woods/Oil Crises 1973/79/Petrodollars and Euro currency/low interest rates) • Types-derivatives/underlying/Derivatives on derivatives. • Are they safe? (WB-WMD) • Cutting edge/Option Pricing/Arbitrage • Short/long. • Economic functions.
- 11. Using derivatives properly. To use derivatives properly, you can go a long way by just answering a few questions: 1. Do we have a formal policy that defines: a. The risks we are exposed to? b. The risks we are willing to take and the ones we are unwilling to take? c. Which derivatives we can use? d. Under what circumstances we can use them? e. The chain of command for their usage? 2. Are our personnel involved with derivatives sufficiently knowledgeable? 3. Do we know what derivative positions we have in place right now?
- 12. Using derivatives properly 4. Can we measure our risk? 5. Do we have controls in place so that the risk can be quickly adjusted? 6. Are the personnel who engage in derivatives transaction different from and not supervisory to those who monitor the usage of derivatives? 7. Are senior managers and the board kept apprised of our derivative activities.